Introduction to Currency Trading

Lately, currencies have been on a rollercoaster ride with record breaking highs and lows. The world of foreign exchange is dominating news headlines. But what really is currency trading? Before you get on board, here’s a brief introduction.

What is Forex?

The currency market, or forex (FX), is the largest investment market in the world. While there is about 55 billion of daily volume on the New York Stock Exchange, the Forex market has hit 4 trillion in its daily average turnover. But why are many people not familiar with it? In the past, most of Forex’s volume came from professional traders. Until recently, as technologies have improved, the Forex market has become more accessible, resulting in an unprecedented growth in online trading. You no longer have to be a professional trader or money manager to trade this market; retail traders and investors can all trade this market without needing much to get started.

How is Forex traded?

Trading in pairs. Currencies always trade in pairs. You are not bidding on the value of a single currency, but its exchange rate with another one. Therefore trading options always appear in pairs, such as EUR/USD (euro/dollar), USD/JPY (dollar/Japanese yen). So when you makes a trade you always long one currency and short the other. For example, if a trader sells one standard lot (which is 100,000 units) of EUR/USD, she would have exchanged euros for dollars and would now be “short” euros and “long” dollars. This short for long concept takes place in our daily lives. When you are buying a phone for 500 bucks, you would basically be “ short” 500 and “ long” a phone. And the phone store is doing the exact opposite: “long” 500 but “short” one phone in its inventory. The exact same principle applies to the FX market, except that no physical exchange takes place. While all transactions are simply computer entries, the same consequences still apply.

Commissions?

Investors who trade stocks, futures or options typically use a broker, who acts as an agent in the transaction. The broker takes the order to an exchange and attempts to execute it as per the customer’s instructions. For providing this service, the broker is paid a commission when the customer buys and sells the tradable instrument.

The critical distinction of the Forex market is that it does not have commissions. Unlike exchange-based markets, FX is a “principals-only” market. FX firms are all dealers, not brokers. They assume market risk by serving as a counter-party to the investor’s trade. They do not charge commission, but rather make their money through the bid-ask spread.

In FX, the investor cannot attempt to buy on the bid or sell at the offer — similar to exchange-based markets. On the other hand, once the price clears the cost of the spread, there are no additional fees or commissions. Every single penny gained is pure profit to the investor. Nevertheless, the fact that traders must always overcome the bid/ask spread makes scalping much more difficult in FX.

Which currencies are traded?

• EUR/USD (euro/dollar)
• USD/JPY (dollar/Japanese yen)
• GBP/USD (British pound/dollar)
• USD/CHF (dollar/Swiss franc)

Known as the four “ majors” , these are the most commonly traded currency pairs traded in the the market. There are are also 3 commodity pairs.

• AUD/USD (Australian dollar/dollar)
• USD/CAD (dollar/Canadian dollar)
• NZD/USD (New Zealand dollar/dollar)

These currency pairs, along with their various combinations (such as, GBP/JPY EUR/JPY and EUR/GBP), account for more than 95% of all speculative trading in FX. Since 18 pairs of currency are actively traded, the FX market is far more concentrated than the stock market. You can focus on picking from a few currencies rather than from 5000 stocks.

Thinly traded currencies, known as exotic currencies, are also traded by some retail dealers. Some examples include the Thai baht, Uruguay peso or Iraqi dinari. Exotic currencies are illiquid, lack market depth, and trade at low volumes. Trading an exotic currency can be expensive, as the bid-ask spread is usually large. Therefore, they are not easily traded in standard brokerage accounts.

Speculative and risks?

The primary reason the FX market exists is to facilitate the exchange of one currency into another for multinational corporations that need to trade currencies continually. However, these day-to-day corporate needs comprise only about 20% of the market volume. The other 80% of trades in Forex market are purely speculative. It is put on by multi-billion dollar hedge funds, large financial institutions, and individuals who want to express their opinions on current economics as well as politics situation.

So now you know some basics of currency trading, but what are you really selling or buying in the Forex market? The short answer is — nothing. The retail FX market is purely a speculative market. No physical exchange of currencies ever takes place. All trades exist simply as computer entries and are netted out depending on market price. Therefore, trading foreign exchange carries a high level of risk, and may not be suitable for everyone. Before deciding to trade foreign exchange, you should carefully consider your investment objectives, level of experience, and risk appetite. Like anything in the investment market, learning about currency trading is easy but finding the winning strategy takes a long time. Therefore, it’s usually recommended for new traders to open a virtual account and practice before they find strategies that suit their goals and objectives the best.