Forex Trading Overview
Forex trading, or the foreign exchange trading market (also commonly known as FX trading or simply, currency exchange, involves trading one currency for another. Forex is by far and away the largest financial market in the world. Trades are made between large banks, central banks, currency speculators, multinational corporations, governments, and even the other financial markets. According to The Bank for International Settlements (BIS), a world-wide central bank organization, the average daily trade in the global forex and related markets is currently over three trillion US dollars – A DAY. This is several times larger than all the U.S stock markets combined. The trading is done from all round the world, with little or no hard cash changing hands.
Forex Trading vs Stock Market
Two of the main differences between (and some would say advantages over) the forex market compared to the stock market are:
1. Trading hours. The forex market is open 24 hours a day. Trading is done over three continents, allowing a trader to trade continuously and to react immediately to events and new developments. The market opens on Sunday evening and closes Friday night.
2. Commissions. Electronic trading and competition have brought about a sizeable reduction in the bid-offer spread (the equivalent of commissions). The spread covers the risk of the market maker. The spread for the majors remain very low, but can increase as the liquidity of a specific currency drops. Despite recent reductions of commissions through online stock brokers, the Forex market is considered, by some, to have the lowest commissions relative to trade size when compared to other financial markets. This is also in part due to the 100:1 leverage offered by most trading houses. A client with a $10,000 deposit can leverage this to $1,000,000. Some electronic communication network brokerages have introduced a per trade commision alongside a narrow pip spread.
Many retail trading houses would suggest that the large size of the market makes it impossible for a speculator to affect the market. This is not quite the truth – the stakes are higher, larger quantities of money are involved, and the bigger banks spend a lot of time and effort trying to manipulate the market. Governments have been known to step in and affect prices.
Unlike the stock market, where retail clients (individuals) have access to almost exactly the same prices as all other participants, the Forex market has several different levels of access and therefore commission costs or spreads. At the top are the largest investment banking firms such as Citi and Deutsche Bank, where the spreads or the difference between bid and ask prices are tiny. These spreads are a closely guarded secret, not normally known outside the inner circles of international finance.
Further down the trading chain, the spreads become wider. Basically, the larger the volume of trades, the narrower the spread. After the major top-tier banks come the smaller investment banks, large multi national corporations, pension funds, insurance companies and, more recently, some of the major retailers. Retail traders are a small fraction of the market and may only participate indirectly, through brokers or banks.
There are many influences on the value of currency when compared to other currencies, but the Forex market is almost a pure supply and demand market. Demand rises or supply falls, prices rise and vice versa. Electronic trading is slowly increasing in the Forex market with Algorithmic trading increasing also.
Spreads in Forex Trading
The BID price is the price at which a client can sell a unit of the base currency (in return for buying the secondary currency) and the ASK/OFFER price is the price at which a client can buy a unit of the base currency. For example, if the quote for the exchange rate of the Euro/U.S. Dollar in the market is 1.2583/1.2586, this means that the client can pay $1.2586 in order to buy one Euro (the base currency) and will receive $1.2583 if one Euro is sold. The BID price is lower than the ASK price and the difference or ‘spread’ between the two numbers is measured in ‘pips’ (3 pips here) and represents the profit of the dealing room or trading house.
Retail forex brokers or ” market makers ,” working on behalf of retail clients only handle a tiny fraction of the forex market. One retail broker estimates the total retail volume at $25–50 billion daily, which is approximately 2% of the whole market. Nonetheless, this is a substantial market for the individual trader and the ready availability of good quality trading platforms means this is an ever growing segment.
Trading Concepts and Mechanisms
Currency prices can only fluctuate relative to another currency, so they are always traded in pairs. Two of the most common currency pairs are the price for euros in US dollarsEUR/USD and the price for the British pound in US dollars GBP/USD
Most Forex brokers permit 100:1 leverage, some as much as 200:1, but also require that you have a certain amount of money in your account to protect against a critical loss point. A $100,000 position held in GBP/USD on 100:1 leverage means the trader has to put up $1,000 to control his position. However, in the event of a decline in value, Forex brokers do not allow traders to go negative. In order to make sure the trader does not lose more money than is held in the account, forex brokers employ automatic systems to close out positions should a client run out of margin (the amount of money in their account not tied to a position). If, for example, you have $2,000 in your account, and buy a $100,000 lot of EUR/USD, $1,000 of your $2,000 is tied up in margin, with $1,000 left to allow your position to fluctuate downward without being closed out.
An online trading platform will show three important numbers associated with your account: balance, equity, and margin remaining. If you have a $10,000 account and open one $100,000 position using 100:1 leverage, this has committed only $1,000 of your money plus you must maintain $1,000 in margin. While this leaves $9,000 free in your account, it is possible to lose it all if the position moves the wrong direction.
Commissions or Spreads
Brokers take part or all of the spread in all currency pairs traded. Here is an example:
EUR/USD. Prices are always quoted with both bid and offer prices ( Buy EUR/USD 1.2000, Sell EUR/USD 1.2003). That difference of 3 pips is the spread and can amount to a substantial amount of money. Because the standard lot is 100,000 units of the base currency, 3 pips on EUR/USD means $30 paid to the broker. A pip is the smallest amount the currency is traded in – 1/100th of a percent in the case of the US dollar. The currency pairs are always purchased by buying 100,000 of the quote currency , also known as the counter currency. For the pair EUR/USD, the base currency is USD, therefore 1/100th of a percent on a pair with USD as the base currency will always have a pip of $10. If, on the other hand, your currency has British Pounds as a base instead of US dollars, then 1/100th of a percent is now worth around $20, because you are buying 100,000 units of British pounds. Retail forex brokers make a lot of money without charging commissions.
Forex Trading Systems
There are more Forex Trading Systems , than fleas on a dog. Fibonacci analyses of market fluctuations, “Secret Trading Formulas,” “Set and Forget,” with automatic trades being done. No doubt some of these systems will work some of the time, but picking the jewels from the junk is not an easy matter. Caveat Emptor.
“If I had a foolproof way of making money on the foreign exchange market, I wouldn’t be uploading videos to YouTube and trying to sell you an e-book, I would be sitting on my private beach in Aruba, playing the market and enjoying my money.”
How to Start Trading Forex
Starting out trading forex is a very simple proposition: sign up with an online broker, download any software, deposit some money and you are ready to trade. Most of the reputable brokerage firms have a practice account facility where they will open an account, deposit fake money into the account and allow you to start trading in real time.
Some of these same brokers are also offering to open an account and start you trading for real using a very small deposit, say $100. Even with a 200:1 leverage applied, this amounts to only $20,000 – nowhere near enough to make a forex trade. My own feeling is that these “mini accounts,” are a complete waste of time and money (see leverage) and possibly just plain dangerous. In the unlikely event that you do make money with a $100 deposit and are then tempted to place a larger one, anything you learned trading at this level will not apply to a substantially larger trade. Try a practice account with one of the larger banks instead. N.B Trading on a practice account, regardless of how realistic it is, is not the same as trading for real. If it doesn’t matter whether you win or lose, you will behave differently to the way you will act when money is at stake.
Leverage in Forex Trading
Currency movements are measured in “pips” or fractions of a decimal point depending on the currency involved.
A typical example would be a currency pair like the GBP/USD. When this pair moves 50 pips from 1.9500 to 1.9550, that is just a $0.005 move of the exchange rate. With $100,000 invested, this equates to a profit or loss of $500. Therefore, currency transactions must be carried out in large amounts to take advantage of these small shifts. When you deal with a large amount of money, small changes in the price of the currency can result in significant profits or losses. Hence the leverage offered. A standard lot of this pair is 100,000. $1,000 invested and leveraged 100:1 would allow you to buy one standard lot. In this case, a 1% fluctuation will either double your investment or lose it.
Although brokers offer leverages of up to 200:1, it is not obligatory to use it. In this example, a $10,000 investment leveraged 10:1 instead of $1,000 leveraged 100:1 offers the same amount of profit/loss. A tenth of the profit compared to the amount invested, but a tenth of the risk.
Risk vs Reward
Clearly, there are large amounts of money to be made trading foreign exchange. The forex market is a game in which there are many experienced, well-capitalized, professional traders who do nothing else but trade currencies full time. An inexperienced retail trader has a significant information disadvantage compared to these traders. Retail traders are undercapitalized. In a fair game – one with no information advantages – between two players that continues until one trader goes broke – the player with the lower amount of capital has a highest likelihood of going broke first. Since the retail trader is effectively playing against the market as a whole – which has an almost unlimited supply of capital – he will almost certainly go broke.
The retail trader always pays the bid/ask spread making his odds of winning lower. Additional costs may include margin interest, or if a spot position is kept open for more than one day the trade must be “resettled” each day, costing the full bid/ask spread every day. Even people running the trading shops warn clients against trying to time the market. “If 15% of day traders are profitable,’ says Drew Niv, chief executive of FXCM, ‘I’d be surprised.” Source – Wall Street Journal
The retail brokers encourage individual traders to trade extremely large positions by offering high leverages, sometimes as high as 200:1. This increases the trading volume cleared by the broker, therfore his profits, but increases the risk that the trader will receive a margin call or a closed account. Professional currency dealers – banks, hedge funds et al, rarely use more than 10:1 leverage.
The US government regulating body for the Foreign Exchange Market the “National Futures Association” warns traders in a Forex Training presentation of the risk in trading currency. “As stated at the beginning of this program, off-exchange foreign currency trading carries a high level of risk and may not be suitable for all customers. The only funds that should ever be used to speculate in foreign currency trading, or any type of highly speculative investment, are funds that represent risk capital; in other words, funds you can afford to lose without affecting your financial situation.”
The forex market is largely unregulated and along with a substantial increase in retail trading, there has been a proportionate increase in scam artists, bent on parting a trader from his money. Forex, like any other investment, has the potential to lose money as well as make profit. The fast paced nature of the market and high leverage offered means that a $10,000 investment can be wiped out in a matter of seconds. The U.S Commodity Futures Trading Commision (CTFC) has witnessed a sharp rise in foreign currency trading scams in recent years and advises potential customers to be aware of the potential for fraud. Some claims to be wary of are these type. Anyone making statements like these, is probably best avoided:
- Whether the market moves up or down, in the currency market you will make a profit.
- Make $1,000 per week, every week.
- We are out-performing 90 percent of domestic investments.
- The main advantage of the forex markets is that there is no bear market. We guarantee you will make at least a 30-40 percent rate of return within two months.
- With a $10,000 deposit, the maximum you can lose is $200 to $250 per day.
- We promise to recover any losses you have.
- Your investment is secure.
Forex trading is a high-risk, high-reward pastime. Fortunes are made and lost every time a currency changes value. The small investor is at a disadvantage compared to the major institutional banks for two major reasons: wider spreads and under-capitalisation. The consensus amongst the professional traders is that somewhere between 80 and 95% of day traders lose money and even the majors get in to trouble on occasion. In 2002, Allied Irish Banks revealed that it lost US$750 million at its Baltimore subsidiary on spot and forward forex trades made by forex trader John Rusnak and in 2003, the National Australia Bank admitted to losses of US$1.13 billion as a result of unauthorised forex trades, although it seems any time a bank loses money, it’s a result of “unauthorised,” activity.
Realistically, a private individual should only enter the forex market with a bare minimum of $10,000 “risk capital,” i.e money that can be lost without causing hardship, and a good understanding of the mechanisms of the market. The nature of the forex market means that the smaller the sum risked, the greater the price fluctuation needs to be before a position becomes profitable. This doesn’t mean it is not possible to make money trading foreign currencies, CitiGroup would not be interested if there wasn’t an awful lot of money in forex trading, but it’s not necessarily as easy as some would have you believe.