Fundamentals of Forex Trading: What Makes it so Different?

By: , dated January 25th, 2013

For five days every week and during each and every hour of those days – currency traders are usually working on trying to cash in on the most fluid market ever known. In 2005, an estimated 2 trillion dollars changed hands every single day in the forex market! But do most traders even think about the Forex (foreign currencies exchange) market when thinking about where to invest? In fact, the answer is no because the market was almost the exclusive domain of large market players like the multi-national corporations, financial institutions, and big hedge funds. Only recently and mostly due to the rise of Internet-based trading, has the average investor even had the chance to invest in this fluid and liquid market.

When an investor breaks FX trading down to its most basic, it really is little more than going to the airport and trading in the currency of one nation and receiving the currency of another in exchange – with the added element of having to predict how those exchange rates will change in the coming weeks, days, or even hours! However, FX trading is indeed very different from most other investment tools and investors should understand the fundamentals before investing.

So what makes FX trading so different? Well, if an investor wanted to purchase stocks, options, or futures – they would need to ultimately go through some sort of regulated exchange – such as the NYSE. Currency traders have no such regulated mechanism overseeing transactions. What exactly does this mean for the average investor? – an increased element of risk.

Basically, there is no grand body overseeing currency trades. Therefore, the traditional safety nets like clearing houses, arbitration boards, or even an overall governing exchange do not exist. Currency exchanges are simply made between Forex members based upon the credit arrangements and conditions agreed upon before the transaction – yep, that’s it!

This probably sounds very scary for most investors but this arrangement actually works exceedingly well – but how? Self-regulation works in currency trading because FX traders all compete and cooperate with one another regularly – basically, improper business practices are discouraged because it is in everyone’s best interest to play fair. However, the market does appear to be moving in the direction of a grand governing body because a growing number of FX dealers in the United States are opting to join the NFA (National Futures Association). When they join the NFA, dealers agree to abide by any necessary arbitration arising from disputed trades. So if an investor is new to FX, then it is a good idea to seek out only dealers that have opted to become members of the NFA. However, without true oversight, some really interesting transactions occur in the FX market. For one thing, position size is unlimited (unlike futures) so it is possible to buy as much currency as one can given the amount of capital available. There also is no up-tick rule in place to prevent momentum from continuing downward when currencies really begin to lose value (as the result of a national emergency, for instance). And perhaps most surprising of all - insider trading is not a crime in the world of FX!

Well, one thing that all investors familiar with the world of securities would be happy to hear is the fact that there are no commissions in FX trading! This is possible because there are no brokers – only FX dealers. So how do the traders make their money? The dealer pockets the difference between the bid/ask spread. There is a difference between the highest price that an investor is willing to pay when buying and the lowest price another investor is willing to sell for – that difference is the bid/ask spread. However, the fluid nature of the FX market tends to keep the bid/ask spread exceptionally low because of the sheer volume of the market itself. In fact, the average bid/ask spread for the entire FX market is less than 1%. For the individual investor, the absence of commissions is usually incentive enough to enter the FX market.

One of the biggest and most fundamental ideas for FX traders to understand is that nothing actually is being exchanged in any given trade. The entire currencies market is nothing more than pure speculation on price movement. No actual trading of currencies takes place and the speculators never have possession of them. The dealers record profits and losses in their database and monies are distributed at the conclusion of the transaction or rolled over into new ones.

So, the average investor may be wondering why exactly it is necessary to exchange two trillion dollars every day. Although multi-national corporations may have a legitimate need for buying materials and paying salaries in foreign markets, the vast majority of currency trades are purely investment opportunities for various investors - it is estimated that 75% or more fits into this category.

Many newcomers to the FX world find themselves wondering just how such currency transactions occur. It is important to remember that all currency trades involve two currencies – or the currency pair. Taking the USD/CAN currency pair as an example, the USD would be the base currency and the CAN the counter or “terms” currency. The base currency is used to set up the account, so for a USD/CAN currency exchange, the account would be set up using USD. In this transaction, a trader would be buying Canadian dollars with US dollars. As the exchange rate favors the USD, the investor would wind up with more Canadian currency than they had initially in U.S. currency.

But how does an investor make any money? If recent economic indicators pointed to a stronger U.S. economy but a weaker Canadian economy as a result of the same information, investors would likely believe that the USD will increase in value relative to the CAN. In other words, investors would be able to buy even more CAN dollars with the same initial investment of USD. Assume that an investor had $10,000 USD and wanted to buy Canadian dollars and the exchange rate at the beginning of the week was 1.2000CAN (1 USD will buy 1.2000 CAN at this rate). Therefore, with the exchange rate of 1.2000, an investor could buy 12,000 Canadian dollars with 10,000 U.S. dollars.

Now in order for the exchange rate to change (and the potential for profit or loss to exist), some factor must change that favors one currency over the other. Let’s assume that a major mishap occurs at an oil refinery in the Middle East – essentially, oil prices will rise. A savvy FX investor knows that Canada is a net exporter of oil while the U.S. receives half of its supply from foreign producers. Rising oil prices would benefit Canada while hurting the U.S. In the USD/CAN currency exchange, that means that 10,000 U.S. dollars would buy fewer Canadian dollars. Therefore, the savvy FX trader would realize that the short position would be best because he/she would be betting on the USD losing ground to the CAN in the exchange rate. If the investor believed that the USD would gain ground and increase in value relative to the CAN, he would choose the long position instead.

Novice FX investors are sometimes confused by the conversion rates themselves. FX trades involve currency rates carried out to .0001, or the fourth decimal point. This .0001 is the equivalent of 1 pip, or the smallest amount a currency can move in value. Pips are sometimes referred to as points. All major currencies are tracked down to the .0001 point with the exception of the yen from Japan. In USD/JPY transactions, the exchange rate is only reported to the .01 decimal place.

Just as options are written in 100-share blocks, currency trades have standard lot sizes and they equal 100,000 units. Thus, for a standard lot size transaction involving a USD/CAN currency trade, the base currency is the USD and will be used to set up the position with 100,000 USD being used to purchase however many CAN the current exchange rate permits – with an exchange rate of 1.2000CAN that would be 120,000 Canadian dollars. FX trades can also be conducted using mini-lots of 10,000 units and micro lots of 1,000 units.

Some newcomers to FX trading might be intimidated by lot sizes of 100,000 units but a 1% margin is all that is required by most dealers to create a position. However, investors must be careful about drawdown and have predetermined stop points that will limit risk because currencies can move rapidly and quickly eliminate any equity the investor has in their trading account. Once that equity is gone, the investor will be responsible for any remainingloss after the position has been liquidated.

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