Traders are drawn to the foreign exchange market for its volatility and the opportunity to capitalize on rising and falling markets. Risk management techniques are essential.
By Investopedia
With the increasingly widespread availability of electronic trading networks, trading currencies is more accessible than ever.
The foreign exchange, or forex, market is notoriously the domain of central banks, multinational corporations, hedge funds, investment banks and other big players. At first glance, the participation of such heavyweights may appear daunting to the individual investor, but the presence of powerful groups in a massive international market can work to the individual's benefit.
Forex trading occurs 24 hours a day, five days a week. The volume of currencies traded in the currency market exceeded $3 trillion a day in 2007, making it the world's largest and most liquid market. The sheer number of currencies traded ensures extreme volatility. There will always be currencies moving rapidly up or down, offering traders opportunities for profit (or loss). Yet, as with the equity markets, the forex market offers instruments to mitigate risk and the opportunity to profit in rising and falling markets.
Relative to the equities markets, the forex market allows highly leveraged trading with low margin requirements. Perhaps best of all, there are no dealing commissions.
Many of the instruments utilized in forex trading –- forwards, futures, options, spread betting and the spot market -- are similar to those used in the equities markets. Since the instruments on the forex market often maintain minimum trade sizes (the spot market, for example, requires a minimum trade size of 100,000 units of the base currency), the use of margin is essential for the individual trader.
Buying and selling currencies
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.
* What world currencies are worth
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
Currency traders must become familiar with the way currencies are quoted. The first currency in the pair is the base currency, and the second is the counter, or quote, currency. Most of the time, the U.S. dollar is considered the base currency, and quotes are expressed in units of $1 per counter currency (for example, USD/JPY where the base currency is the dollar and the counter currency is the Japanese yen).
The only exceptions to this convention are quotes in relation to the euro, the pound sterling and the Australian dollar -- these three are quoted as dollars per foreign currency.
Quotes
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/JPY 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 or her profits, necessitating a favorable move in the position in order to simply break even.
Margin
Trading in the currency markets also requires a trader to think in a slightly different way 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 a potential currency-trading loss. A typical currency trading system will allow for a very high degree of leverage in its margin requirements, up to 100-to-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. If a trader sells currency units on Wednesday, say, he or she must deliver an equivalent number of units by Friday. But currency trading systems may allow for a "rollover," whereby open positions can be swapped forward to the next settlement date (giving an extension of two business days). 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 interest-rate differential between the base and the counter currencies. 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.
Rewards and risks
Extreme liquidity, a multitude of opportunities for large profits due to strong trends and high levels of available leverage make the currency market hard to resist for the advanced trader.
With such potential, however, comes significant risk, and currency traders should quickly establish an intimate familiarity with methods of risk management.
This article was reported by Jason Van Bergen for Investopedia.
From MSN Central published on March 9, 2010