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With the increasingly widespread availability of electronic trading
networks, trading on the currency exchanges is now more accessible than
ever. The foreign exchange market, or FOREX, is notoriously the domain
of government central banks and commercial and investment banks, not to
mention hedge funds and massive international corporations
At first glance, the presence of such heavyweight entities may appear
rather daunting to the individual investor. But the presence of such
powerful groups and such a massive international market can also work to
the benefit of the individual trader. FOREX offers trading 24-hours a
day, five days a week, and the daily dollar volume of currencies traded
in the currency market exceeds $1.4 trillion, making it the largest and
most liquid market in the world Trading Opportunities
The sheer number of currencies traded serves to ensure a rather extreme
level of volatility on a day-to-day basis. There will always be
currencies that are moving rapidly up or down, offering opportunities
for profit (and commensurate risk) to astute traders.
Yet, like the equity markets, FOREX offers plenty of instruments to
mitigate risk and allows the individual to profit in both rising and
falling markets. FOREX also allows highly-leveraged trading with low
margin requirements relative to its equity counterparts. Perhaps best of
all, FOREX charges zero dealing commissions!
Many of the instruments utilized in FOREX--such as forwards and futures,
options, spread betting, contracts for difference, and the spot
market--will appear similar to those used in the equity markets. Since
the instruments on the FOREX often maintain minimum trade sizes in terms
of the base currencies (the spot market, for example, requires a minimum
trade size of 100,000 units of the base currency), the use of margin is
absolutely essential for the person trading these instruments.
Buying and Selling Currencies
Regarding the specifics of buying and selling on FOREX, it is important
to note that currencies are always priced in pairs. All trades result in
the simultaneous purchase of one currency and the sale of another. This
necessitates a slightly different mode of thinking than what you might
be used to. While trading on the FOREX, you would execute a trade only
at a time when you expect the currency you are buying to increase in
value relative to the one you are selling. If the currency you are
buying does increase in value, you must sell the other currency back in
order to lock in a profit. An open trade (or open position), therefore,
is a trade in which a trader has bought or sold a particular currency
pair and has not yet sold or bought back the equivalent amount to close
the position.
Base and Counter Currencies and Quotes
Currency traders must become familiar also with the means by which
currencies are quoted. The first currency in the pair is considered the
base currency; and the second is the counter or quote currency. Most of
the time, the US currency is considered the base currency, and quotes
are expressed in units of $1 USD per counter currency (for example,
USD/JPY or USD/CAD). The only exceptions to this convention are in
relation to the Euro, the Pound Sterling, and the Australian
dollar--these three are quoted as dollars per foreign currency.
FOREX quotes always include a bid and an ask price. The bid is the price
at which the market maker is willing to buy the base currency in
exchange for the counter currency. The ask price is the price at which
the market maker is willing to sell the base currency in exchange for
the counter currency. The difference between the bid and the ask prices
is referred to as the spread.
The cost of establishing a position is determined by the spread, and
prices are always quoted using five numbers (for example, 134.85), the
final digit of which is referred to as a point or a pip. For example, if
USD/CAD was quoted with a bid of 134.85 and an ask of 134.90, the
five-pip spread is the cost of trading this position. From the very
start, therefore, the trader must recover the five-pip cost from his
profits, necessitating a favorable move in his position in order simply
to break even.
More about Margin
Trading in the currency markets requires a trader to think in a slightly
different way also about margin. Margin on the FOREX is not a down
payment on a future purchase of equity but a deposit to the trader’s
account that will cover against any currency-trading losses in the
future. A typical currency trading system will allow for a very high
degree of leverage in its margin requirements, up to 100:1. The system
will automatically calculate the funds necessary for current positions
and will check for margin availability before executing any trade.
Rollover
In the spot FOREX market, trades must be settled within two business
days. For example, if a trader sells a certain number of currency units
on Wednesday, he or she must deliver an equivalent number of units on
Friday. Yet currency trading systems may allow for a "rollover," with
which open positions can be swapped forward to the next settlement date
(giving an extension of two additional business day). The interest rate
for such a swap is predetermined, and, in fact, these swaps are actually
financial instruments that can also be traded on the currency market.
In any spot rollover transaction the difference between the interest
rates of the base and counter currencies is reflected as an overnight
loan. If the trader holds a long position in the currency with the
higher interest rate, he or she would gain on the spot rollover. The
amount of such a gain would fluctuate day-to-day according to the
precise interest-rate differential between the base and the counter
currency. Such rollover rates are quoted in dollars and are shown in the
interest column of the FOREX trading system. Rollovers, however, will
not affect traders who never hold a position overnight, since the
rollover is exclusively a day-to-day phenomenon. |
