6 Questions About Currency Trading

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6 Questions About Currency Trading

Although forex (FX) is the world’s biggest financial market, it is largely unknown territory for ordinary traders. FX was largely the province of huge financial institutions, multinational enterprises, and hedge funds prior to the popularity of online trading. However, circumstances have changed, and individual retail traders are now ravenous for currency knowledge.

Whether you are new to the FX market or just need a refresher course on the fundamentals of currency trading, here are the answers to some of the most commonly asked questions about the FX market.

Key Takeaways

  • Credit agreements, which are little more than a figurative handshake, underpin currency trading.
  • Because players must compete as well as cooperate, FX trading is self-regulated.
  • In FX, there is no uptick rule, as there is in stocks. Unlike futures, there are no size restrictions on a trader’s stake.
  • FX traders often utilize a commission-based broker.
  • A pip is a percentage point and the smallest increment in a foreign exchange deal.

Top 5 Questions About Currency Trading Answered

1. How Does Forex Compare to Other Markets?

Currency trading, unlike stocks, futures, or options, does not take place on a regulated exchange and is not governed by a central regulating authority. There are no clearing houses to ensure deals, and no arbitration tribunal to settle disputes. Credit agreements govern all transactions between members. Essentially, commerce in the world’s biggest and most liquid market is based on little more than a figurative handshake.

This impromptu arrangement seems perplexing to investors used to organized markets such as the New York Stock Exchange (NYSE) or the Chicago Mercantile Exchange (CME) (CME).In reality, though, this arrangement works. Because FX players must compete as well as cooperate, self-regulation offers effective market control.

Furthermore, respectable retail FX traders in the United States join the National Futures Association (NFA), agreeing to binding arbitration in the case of a disagreement. As a result, any retail consumer considering trading currencies should only do so via an NFA member business.

In other aspects, the forex market differs from other markets. Traders who believe the EUR/USD will fall may short the pair at any time. In FX, there is no uptick rule, as there is in stocks. There are no restrictions on the size of your position (as there are in futures).Thus, if a dealer has enough wealth, he or she may sell $100 billion in currency.

In another setting, a trader may act on knowledge in ways that would be deemed insider trading in regular markets. For example, if a trader learns through a customer who knows the governor of the Bank of Japan (BOJ) that the BOJ intends to hike interest rates at its next meeting, the trader is free to purchase as much yen as they like. Insider trading in FX does not exist—European economic statistics, such as German job numbers, are sometimes leaked days before they are officially disclosed.

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Before you get the sense that forex is the Wild West of finance, keep in mind that it is the world’s most liquid and fluid market. It trades 24 hours a day, from 5 p.m. EST Sunday to 4 p.m. EST Friday, and there are seldom price gaps. The currency market is the most accessible in the world due to its sheer size and spread (from Asia to Europe to North America).

The forex market operates 24 hours a day, yielding significant data that may be utilized to forecast future price fluctuations. It is an ideal market for traders that employ technical analysis tools.

2. What Is the Forex Commission?

Typically, investors who trade stocks, futures, or options employ a broker to serve as an agent in the transaction. The broker submits the order to the exchange and tries to execute it in accordance with the customer’s instructions. For providing this service, the broker is paid a commission when the consumer buys and sells the tradable instrument.

There are no commissions in the forex market. FX is a principals-only market, as opposed to exchange-based markets. FX businesses are not brokers, but rather dealers. Dealers, as opposed to brokers, take market risk by acting as a counterparty to the investor’s transaction. They do not charge commission; instead, they profit on the bid-ask spread.

In FX, the investor cannot purchase at the bid or sell at the offer, as in exchange-based markets. However, after the price has cleared the spread cost, there are no extra fees or charges. Every cent made is pure profit for the investment. Nonetheless, the need for traders to constantly exceed the bid/ask spread makes FX scalping considerably more difficult.

3. What Is a Pip?

Pip stands for percentage in point and is the lowest unit of trading in foreign exchange. Prices in the forex market are stated to the fourth decimal point. For example, if a bar of soap costs $1.20 at the pharmacy, the identical bar of soap would be offered at 1.2000 on the foreign exchange market. The shift in the fourth decimal point is referred to as a pip, and it is usually equivalent to 1/100 of 1%.

The lone exception among the main currencies is the Japanese yen. Because one dollar represents about 100 Japanese yen, the quote in the USD/JPY pair is only carried out to two decimal points (i.e., to 1/100 of a yen, as opposed to 1/1000 in other major currencies).

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4. What Are You Really Trading?

FX traders seek to benefit from fluctuations in currency exchange rates. All earnings and losses on dollar-denominated accounts are computed in dollars and reported as such on the trader’s account.

The FX market exists to facilitate the conversion of one currency into another, a service employed by international firms that must constantly swap currencies (i.e., for payroll, payment for goods and services from foreign vendors, and mergers and acquisitions).The forex markets are used by financial institutions to hedge positions and make directional bets on currency pairings based on basic research and technical analysis. Individual traders may also trade currencies in order to speculate on currency movements.

Because currencies are always traded in pairs, when a trader enters the market, he or she is always long one currency and short the other. If a trader sells one standard lot (equal to 100,000 units) of EUR/USD, they have swapped euros for dollars and are now short euros and long dollars.

To further grasp this dynamic, consider a $1,000 computer purchased from an electronics retailer as an exchange of cash for a computer. That person is short $1,000 and has one computer. The business would be $1,000 in debt yet only have one computer in stock. The same logic applies to the FX market, with the exception that no actual transaction occurs. Even if all transactions are only computer inputs, the repercussions are no less real. If the demand for this computer grows, the person may sell it for a higher price, say $1,100, and make a $100 profit.

5. What Currencies Trade in Forex?

Although some retail dealers deal in unusual currencies such as the Thai baht or the Czech koruna, the vast majority of dealers deal in the world’s seven most liquid currency pairings, known as the four “majors”:

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

The three commodity pairs are also traded:

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

These seven big currency pairings account for about 80% of all FX speculative trading. The FX market is significantly more concentrated than the stock market due to the limited number of trading instruments (around 50 pairs and crosses are frequently traded).

6. What Is a Currency Carry Trade?

Carry is the most common currency market transaction, executed by both major hedge funds and tiny individual speculators. The carry trade is predicated on the assumption that every currency in the world has a corresponding interest rate. The central banks of these nations set these short-term interest rates: the Federal Reserve in the United States, the Bank of Japan in Japan, and the Bank of England in the United Kingdom.

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The definition of “carry” is simple. The trader goes long on the currency with a high interest rate and funds the transaction with a low interest rate currency. For example, one of the greatest pairings in 2005 was the NZD/JPY cross. The New Zealand economy, fueled by massive Chinese commodities demand and a hot property market, saw interest rates climb to 7.25% and remain there, while Japanese rates stayed at 0%. A trader who went long on the NZD/JPY might have earned 725 basis points only in yield. On a 10:1 leverage basis, the NZD/JPY carry trade could have generated a 72.5% annual return from interest rate differentials without any contribution from capital appreciation. This is an illustration of why the carry trade is so popular.

However, before rushing out to find the next high-yield pair, keep in mind that when the carry trade is unwound, the drops may be swift and severe. The currency carry trade liquidation process begins when the bulk of speculators determine that the carry trade has no future potential.

Bids vanish for any trader looking to exit their position immediately, and earnings from interest rate differentials are insufficient to balance capital losses. The key to success is anticipation: the optimal moment to place the carry is at the start of the rate-tightening cycle, enabling the trader to ride the rise as interest rate differentials expand.

Other Forex Jargon

The currency market, like every other field, has its own language. A seasoned currency trader should be familiar with the following terms:

  • GBP nicknames include cable, sterling, and pound.
  • Greenback and buck are nicknames for the US dollar.
  • Swissie: a slang term for the Swiss franc.
  • Aussie: abbreviation for the Australian dollar
  • The New Zealand dollar is known as the Kiwi.
  • The loonie and the tiny dollar are two nicknames for the Canadian dollar.
  • Figure: An FX phrase that refers to a round number, such as 1.2000.
  • “I sold a couple of yards of sterling,” for example.

The Bottom Line

For both beginner and experienced investors, forex trading may be a successful yet unpredictable trading method. While entry to the market—via a broker, for example—is simpler than ever, the answers to the six questions above will serve as a good primer for individuals new to FX trading.

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