by Grace Cheng
Every one has been involved in foreign exchange – even unknowingly – whenever there has been a conversion of different currencies. For me, my involvement with the forex market has brought me unimaginable success and deep emotional satisfaction. Success with the forex market does not come easy at all; one must constantly shed blood and tears throughout the trading game. If you have heard of how forex trading can be a lucrative profession or a second stream of income to your day job, do not get overexcited. Get to know all that you can about how the forex market works before you leap into this money pit.
If you are new to forex trading, you probably don’t know what you need to know about forex.
Hence, in this article, I will touch on the basics of the foreign exchange market so that you will have a general idea of how things work.
Why Trade Forex?
The term ‘forex’ refers to foreign exchange – the exchange of one currency for another. The foreign exchange market is the biggest and fastest growing market in the world, with an average daily turnover of more than $1 trillion. This market is a global network of buyers and sellers of currencies, and is done over-the-counter (OTC), which means that there is no central exchange and clearinghouse where orders are matched. If you are looking for 24-hour action, you can find it in this global trading system, where no physical barriers exist, as activities seamlessly move from one major financial centre to another.
Once the domain of banks, hedge funds, corporations and financial institutions, trading of the forex market has gradually become very easily accessible to retail investors and traders with the emergence of online currency trading platforms which are well-equipped with charts, real-time news and order systems. It has become an extremely attractive alternative asset group to trade.
I personally much prefer to trade forex to stocks or futures because of the following reasons:
A global 24-hour market
It is a market that operates worldwide, starting from morning from the dealing centres in Sydney, Tokyo and Singapore, through daytime in the European centres, across New York and Chicago to sunset in Los Angeles. From my base in Singapore, I can monitor the Asian session once I get up, through to the afternoon when the London and European markets are opened, and watch the US markets react when they open after my dinner-time. As an active day and position trader, I find this to be a great advantage because I can trade during anytime of the day or night, and do not have to wait for any markets to be opened before I can place my trades.
With the stock and futures markets, one would need to have access to electronic communication networks (ECN) for pre-market trading, or would have to wait till the markets open, and sometimes with a gap if there have been news while the markets are closed. Since the Asian session is usually quiet for currencies like the Euro or Swiss Franc, I use this time to do market research, calculate and set up my trades for the afternoon when the European markets open. This gives me ample time to digest the news of the night before and the morning itself, which allows me to anticipate in the movements of currency pairs later on in the day.
Welcome to the planet’s most liquid market. With more than $1 trillion changing hands every day, and about 80 percent of foreign exchange transactions having a dollar leg, you no longer have to worry about liquidity when trading any of the these big-economy currencies, which are namely, USD, GBP, Euro, CHF, JPY, CAD, AUD and NZD. The London market is the most volatile session of the day, with the majority of forex transactions completed during the London hours due to the market’s liquidity and efficiency. With stocks, market liquidity depends mainly on the stock’s daily volume.
There are usually problems with limited liquidity when you trade stocks, futures or commodities, and when those markets have limited turnover, you may be getting in and out of your positions with significant slippage. Some online forex firms can guarantee fills on stop-loss and limit orders on up to a certain number of standard lots, and many of them provide instantaneous trade executions from real-time quotes which are displayed on the screen. There is no discrepancy between the displayed price and the execution price. In the futures market, execution price is vague because all orders must be done through the exchange.
Ability to long or short anytime
When trading stocks, short-selling is only allowed with an uptick, so it can be very frustrating for traders to wait and see their stocks trend downward, while waiting for an uptick. However, in the forex market, you can short a currency pair immediately without having to wait for any upticks, and this translates to a more efficient and instant order execution. In a market where time equals money, a second’s delay could cost you money.
Who doesn’t like trading on other people’s money? The forex market offers the highest leverage available for any market. Leveraged trading allows forex traders to execute trades up to $500,000 with an initial margin of only $5000. That means you get as high as 100-to-1 leverage or more, offered by most online forex firms on standard-sized accounts. However, it is important to note that while this type of leverage allows investors to maximize their profit potential, the potential for loss is equally large. Leverage of up to 400-to-1 can be offered on mini trading accounts due to the smaller lot sizes and lower minimum account deposit requirements.
Since the forex market is done the OTC way with traders dealing directly with the market maker, exchange and clearing fees are not applicable to forex trading, whereas futures traders are charged with commission (on top of the spread) to compensate the middlemen and ticket fees involved in transactions. Because of liquidity risk, traders in the stock market and other exchange-traded markets face wider dealing spreads compared to the tight spreads on currency pairs due to their 24/7 liquidity. Spreads are what the brokers charge in order to make money from their clients. It is the difference between the price at which a currency can be bought and the price at which it can be sold for. Sometimes, different online brokers charge different spreads for the same currency pair, and that is when you need to make a balanced comparison of what the various brokers offer in terms of not just the spreads, but also their reputation, trading platform, charting abilities and so on.
Reading forex rates
A market maker will usually quote a two-way market price – the bid and the ask price. A bid is a price at which a market maker is willing to buy a currency ( at which the trader is willing to sell), and an ask is a price at which a market maker is willing to sell a currency (at which the trader is willing to buy).
Some examples of two-way quotes are:
EUR/USD 1.2807 – 1.2810
USD/CHF 1.2236 – 1.2240
GBP/USD 1.8444 – 1.8448
The quote on the left-hand side is the bid, whereas the one on the right-hand side is the ask. As you can see, the ask is always higher than the bid, and the difference, which is called the spread, is where the market maker makes its money from. In the example of the EUR/USD quote above, the spread is 3 pips. One pip refers to a movement of one in the last decimal point in the currency pair.
Based on the USD/CHF example quote above, you can sell US$1 for Sfr 1.2236 according to the bid price, or you can buy US$1 for Sfr 1.2240 according to the ask price. If you are buying USD/CHF to go long, you are buying US dollar, and are at the same time selling the Swiss Franc. If you are selling USD/CHF to go short, then you are selling US dollar, and at the same time buying the Swiss Franc.
Price ticker showing the bid and the ask price of USD/CHF.
A standard lot refers to a face value of 100,000 of the base currency (the first currency unit in a pair). If you want to buy 100,000 EUR/USD, you are actually buying 100,000 Euros. But if your account is denominated in US dollars, then the amount that this position would take up in your account would be however much 100,000 Euros is equivalent to in US dollars at the time. At the same time that you have bought 100,000 Euros, you have sold an amount of US dollars to get this 100,000 Euros.
Relating pips to value
For currency pairs where the counter currency is the US dollar like EUR/USD or GBP/USD, one pip equals US$10, for every 100,000 in face value, i.e., for every standard lot. So if you have traded one standard lot of GBP/USD, and you have a 20 pip profit, you would get 20 x US$10, which is US$200 profit. However, if you are trading a sub-standard lot of 10,000 in face value, then your profit would be ten times less the amount of that for a standard lot. If the US dollar is not the counter currency in currency pairs, the value of a pip will be in whatever the counter currency is. In most online trading platforms, you will have access to a pip calculator to calculate for you how much that pip value is when converted to the US dollar if your account is in US dollars.
In the spot forex market, transactions must be settled in two business days from the trade date. This means that if you sell 100,000 US dollars on Monday, you must deliver 100,000 US dollars on Wednesday, unless the position is rolled over. If you hold a spot forex position overnight, your position will be rolled over at 5 p.m. New York time, to the next settlement date two business days in the future.
However, do you know that you can earn or be charged an extra amount of money when you hold your positions overnight, as is true with futures? Depending on the interest rate differential, you may pay or receive interest fees, also known as rollover fees.
If you long a currency pair where the base currency has a higher interest rate than the counter currency, then you will receive interest, and vice versa. Let’s say you buy USD/CHF, and since the interbank interest rates are higher in the US than in Switzerland, you will gain a rollover fee. The amount you receive is determined by the interest rate differential between the two currencies, and fluctuates daily with the movement of prices. On the other hand, if the interest rates are higher in Switzerland, then you may have to pay a rollover fee. The rollover fee is usually a relatively small amount, compared to your profits and losses.
Rollover transactions will be recorded in your account statement, and may be presented in various ways according to different brokers. For example, you may see it in the following simplified format:
|Date||Type||Buy / Sell||Rate|
The USD/CHF short position was opened at 1.2389, and during rollover, it was roll-closed (RCL) at 1.2378, and roll-opened (ROP) at 1.23762. Since the US dollar has a higher interest rate than the Franc, going short on USD means I had to pay the difference between the RCL and ROP prices as interest fees.
One thing to keep in mind is that for positions that are open on Wednesday, and held through 5 p.m. New York time, your rollover fees, whether added or subtracted, as a result of rolling over a position tends to be around three times the usual amount. The reason for this is that a three-day rollover accounts for settlement of trades through the weekend period. The total interest you can pay or receive for the week can only be a maximum of seven days.
Experiment First with Virtual Money
The best way to learn how to trade forex is to trade it real-time, but with a demo account initially. When I first started out with forex trading, it was the demo account that saved me from burnt holes in the pocket. I was able to experiment real-time trading with different currency pairs using various trading techniques and time-frames.
Slowly gain trading confidence through trial and error. Learn about all the ways of losing, because in order to profit, it is imperative to know how to avoid losses as much as you can. So, don’t underestimate what the demo trading account can do for you. Your tuition fees need not necessarily be spent on experimentations.
If you are new to forex, it is inevitable that you may feel like you have a lot to learn, but the most important step to take is always the first step.