Foreign exchange, also referred to as FX trading or simply ‘forex’ is the largest financial market in the world, with US$1.5 trillion changing hands every day. While nearly everybody has had occasion to change money when they travel abroad, forex traders can be dealing in international currency markets every day. But while this was traditionally a marketplace for big banks and fund managers, it is now becoming increasingly accessible for private investors.
Currency trading advantages over other markets
Forex is very liquid, meaning it is easy to buy and sell currencies, and the forex market is open all day. The global foreign exchange market opens in Australia on Monday morning, and closes in New York on Friday evening. This is because currency prices are so important to the day-to-day operation of the global economy that market participants (like banks) cannot afford to have the market closed at any point in time during the week.
Choosing your currency trading account
To trade forex, you can either open a CFD (contracts for difference) account, or if you live in the UK or Ireland you can open a tax free spread betting account. It is also possible to open a dedicated forex trading account with many banks and brokers which will give you access to a wide range of currencies. In the United States, where spread betting and CFDs are not available, you can still open a forex trading account with a specialist forex broker.
Learn to trade currencies
Forex trading lets you trade any liquid currency against any other. You are not bound by your home currency. Just because you get paid in pounds or euros does not mean you can only trade these currencies against foreign currencies. A Forex broker should still be able to quote you a price on Japanese yen (JPY) against the US dollar (USD), regardless of your base currency.
All currencies have a three letter code to designate them, from AUD for Australian dollar to ZAR for South African rand. Currencies are quoted as pairs. You cannot trade them in isolation. You have to trade one currency against another.
For example, you might see EUR/USD quoted at 1.3225. This means that you need 1.3225 of the currency on the right (in this case the US dollar) to buy one unit of the currency on the left (one euro). The currency will usually be quoted as a ‘spread’: this means it will have a ‘buy’ price and a ‘sell’ price. You use the buy price if you think the price will go up, and the sell price if you think it will go down. In the above example, you might see EUR/USD 1.3218-1.3219. The number on the left is the sell or ‘bid’ price (which you would use if you think it is going to go down), the number on the right is the buy or ‘offer’ price (used if you think it is going to go up).
For currency ‘majors’ – namely the most widely traded currencies issued by the biggest economies, like the US dollar, the euro, and the yen – you should expect to see very ‘tight’ spreads (only one or two points of difference between the bid/sell price and the buy/offer price).
What are pips?
FX traders refer to the tiny difference in forex prices as ‘pips’ – 0.0001 would be one pip in the case of the EUR/USD currency pair, but this can change depending on which currencies you are trading. AUD/JPY is typically quoted with two decimal places, because it takes a double figure amount of yen (e.g. 85.10) to buy a single Australian dollar.
Currency trading carries risk
Forex trading usually requires high amounts of leverage. This is because the daily or weekly change in the value of a currency pair is small, much smaller than other financial markets. It is why Forex brokers will lend their customers money with which to trade, and hopefully make money. This is called ‘trading on margin’, with margin being the amount of money you are depositing for the trade.
As an FX trader, you will usually only need to finance a small portion of the overall value of your trade. If you are using a spread betting or CFD account, you will usually see fixed margin rates quoted as a percentage against each pair. A 1% margin rate is typical in foreign currency markets these days. This is the amount you need to deposit to open the trade. Your broker will put up the rest.
Managing your risk
Be warned: trading on margin means you are magnifying the total size of your trade. A 1% margin rate means £100 of your own money is being turned into £10,000 in the forex market. If you trade successfully, you can pocket the profit a £10,000 forex trade would bring you. If you take a loss, you are responsible for the loss to a £10,000 trade, NOT your £100 margin.
Therefore, it is possible to lose more money trading on margin that you originally deposited. It is important that you protect yourself against losses by using a stop loss.Advertisement