Why Trade Foreign Currencies?
In today's marketplace, the dollar constantly fluctuates against the other currencies of the world. Several factors, such as the stagnation of global equity markets and declining world interest rates, have forced investors to pursue new opportunities. The global increase in trade and foreign investments has led to many national economies becoming interconnected with one another. This interconnection, and the resulting fluctuations in exchange rates, has created a huge international market: FOREX.
- No commissions. No clearing fees, no exchange fees, no government fees, and no brokerage fees if you trade with a market maker.
- No middlemen. Spot currency trading does away with the middlemen and allows clients to interact directly with the market maker responsible for the pricing on a particular currency pair, if you trade with an electronic communications network (ECN).
- Multiple lot sizes. In the futures markets, lot or contract sizes are determined by the exchanges. A standard-size contract for silver futures is 5,000 ounces. Even a mini-contract of silver, 1,000 ounces, represents a value of approximately $30,000. In spot FOREX, the lot size can be appropriate for your grubstake. Common sizes are 1,000 units (micro), 10,000 units (mini), 100,000 units (standard), and 250,000 units (bank). This allows traders to effectively participate with accounts of well under $1,000. It also provides a significant money management tool for astute traders as well as for new participants to step up gradually as they gain skill and confidence. Some retail brokers have no fixed lot sizes at all; you might trade two units or 12,445 units although almost everyone stays with the sizes mentioned here.
- Low transaction cost. The retail transaction cost (the bid-ask spread) is typically less than 0.1 percent under normal market conditions. At larger dealers, the spread could be as low as 0.05 percent. Prices are quoted in pips for currencies. Today pip spreads can be zero at some periods for the most actively traded pairs, but typically range from two to five pips for the majors. Pip spreads vary somewhat from broker to broker and also from trading session to trading session. The JPY pairs usually have the lowest during the Asian session, and highest during the North American session. But the variance on major pairs is slight; typically one or two pips.
- High liquidity. With an average trading volume of more than $4 trillion per day, FOREX is the most liquid market in the world. It means that a trader can enter or exit the market at will in almost any market condition, instantly. I must note that at the time of the first edition of Getting Started in Currency Trading in 2005, the daily volume was slightly less than $2 trillion.
- Almost instantaneous transactions. This is an advantageous byproduct of high liquidity. Your online order is filled as quickly as you can hit the buy or sell button on the trading platform.
- Low margin, high leverage. These factors increase the potential for higher profits (and losses) and are discussed later. Traders in some countries have access to leverage of up to 400 percent, although 50 percent to 100 percent is most common. 400:1 leverage means $1 controls $400 of currency. In the United States, the maximum leverage is now set to 50:1 for majors and 10:1 for exotics. Leverage was recently lowered for multiple reasons, as I discuss in Regulation: Past, Present, and Future.
- A 24-hour market. A trader can take advantage of all profitable market conditions at any time. There is no waiting for the opening bell. Markets are closed from Friday afternoon to Sunday afternoon. As the markets transition to the Asian session, they usually go quiet from 5 P.M. to 7 P.M. Eastern Standard Time. This can allow those busy with full-time careers and families to still find a little time here and there to learn and to trade. The author likes very much trading late at night, when it is the height of the European session but quiet as a mouse locally, at his home.
- Not related to the stock market. Trading in the FOREX market involves selling or buying one currency against another. Thus, there is no hard correlation between the foreign currency market and the stock market, although both are measures of economic activity in some way and may be correlated in specific respects for a limited time. A bull market or a bear market for a currency is defined in terms of the outlook for its relative value against other currencies. If the outlook is positive, we have a bull market, in which a trader profits by buying the currency against other currencies. Conversely, if the outlook is pessimistic, we have a bull market for other currencies and traders take profits by selling the currency against other currencies. In either case, there is always a good market trading opportunity for a trader. Because currencies are relative, one cannot get too far away from another over long periods of time. This results in currency pairs actually trading in large bands. Although big price moves occur frequently, a crash is less likely to happen in currencies than stocks because a pair measures relative value. The U.S. Dollar (USD) can be in deep trouble, but so can the European Euro (EUR). The game is the ratio between the two. The top four traded currencies are: the U.S. Dollar (USD), the Euro Dollar (EUR), the Japanese Yen (JPY), and the British Pound (GBP). Fund managers are beginning to show interest in FOREX because of this lack of correlation with other investable instruments.
- Interbank market. The backbone of the FOREX market consists of a global network of dealers. They are mainly major commercial banks that communicate and trade with one another and with their clients through electronic networks and by telephone. There are no organized exchanges to serve as a central location to facilitate transactions the way the New York Stock Exchange serves the equity markets. The FOREX market operates in a manner similar to that of the NASDAQ market in the United States; thus, it is also referred to as an over-the-counter (OTC) market. The lack of a centralized exchange permeates all aspects of currency trading.
- No one can corner the market. The FOREX market is so vast and has so many participants that no single entity, not even a central bank, can control the market price for an extended time. Even interventions by mighty central banks are becoming increasingly ineffectual and short-lived. Thus, central banks are becoming less and less inclined to intervene to manipulate market prices. (You may remember the oil billionaire Hunt Brothers' attempt to corner the silver futures market in the late 1970s. Such disruptive excess, while not impossible, is much less likely in the FOREX markets.)
- No insider trading. Because of the FOREX market's size and decentralized nature, there is virtually no chance for ill effects caused by insider trading. Fraud possibilities, at least against the system as a whole, are significantly less than in any other financial instrument, as the interbank offers considerable redundancy.
- Limited regulation. There is but limited governmental influence through regulation in the FOREX markets, primarily because there is no centralized location or exchange. Of course, this is a sword that can cut both ways, but the author believesâwith a hearty caveat emptorâless regulation is, on balance, an advantage. Nevertheless, most countries do have some regulatory say and more seems on the way. Regardless, fraud is always fraud wherever it is found and subject to criminal penalties in all countries. Regulatory bodies such as the Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA) are now beginning to get a handle on some limited control of the retail FOREX business, much to the chagrin of many speculators, both large and small.
- Online trading. The capability of trading online was the impetus for retail FOREX in the late 1990s. Today, you can select from more than 200 online FOREX broker-dealers. Although none is perfect, the trader has a wide variety of options at his disposal.
- Time frames. The charts, which depict real-time currency prices, are usually shown as bars for a certain fixed period of time. The bars' vertical ends are the high and low for that time period. Short-term traders can use charts with five-minute chart bars and a position or long-term traders may use four-hour or one-day chart bars. Combining this capability with being able to trade whenever you want, as long as you want, and in any size you want, makes FOREX a space for just about everyone with an interest in participating in the global economy and financial machinery.
- Volatility. Currency pair prices move muchâin frequency, rapidity, and duration. This should not be confused with liquidity, which relates to volume of transactions over a specified time. The more price movement in an investment vehicle, the more potential for profitâand loss. Most investors think of long, sustained trends when they imagine profitable opportunities. While these do occur in FOREX, there is actually more to be made in the volatile trading or sideways markets, which dominate the action 70 percent of the time.
- Third-party products and services. The immense popularity of retail FOREX has fostered a burgeoning industry of third-party products and services available to the FOREX trader.