How to trade the foreign exchange markets.
As an enabler for international trade the Foreign Exchange Market (FX) is the biggest most liquid market in the world. The FX market is multiples larger than all the stock markets in the world put together. Every day over $4 trillion of currency are exchanged.
The fx market is different because there is no central exchange, the transactions simply flow around the globe electronically to the exchange that is currently open at the time, this means traders can trade 24 hours per day, 5 days per week.
The main participants in the market are banks, institutions and individuals.
Individuals may use the fx market to exchange money before and after going on holiday to a foreign country. These transactions are usually committed through a bureau de change, or a local bank.
Retail FX Traders
Due to improved access and a plethora of new retail fx brokers joining the market, it is now possible for individuals to speculate on the fx markets. This represents an ever growing portion of the market. However, retail speculation is still a tiny proportion of the overall market.
Institutions may use the fx market to speculate in an attempt to make profit based on the fluctuations in the valuations of the different currency pairs. A currency pair is for example the USD/EUR, the value of the US Dollar versus the Euro. Major institutions such as central banks and commercial banks account for more than half of all transactions.
Central Banks usually hold substantial amounts of foreign exchange as an investment. The more they exchange their own currency for another currency the more they affect the value of the currencies. They can use this method to stabilize a currency or strengthen it depending on the economic strategy pursued.
A weakening currency (meaning the currency is losing value) can be very good for businesses located in that country as is means that their exports become cheaper, therefore boosting trade. However this is a double edged sword, because if the country needs to import a lot of raw materials to make their products then the imports become more expensive.
The foreign exchange market enables the exchanging of one currency into another. Therefore they are traded in pairs.
The most traded pair today is the USD/EUR or the EUR/USD
Understanding the pricing…
In the currency pair above the first listed currency is the USD, this is known as the base currency. The value of the base currency is always 1. The EUR the second currency is the counter currency.
In this example 1 U.S. dollar can buy 0.79 of a Euro.
In this example 1 Euro can buy 1.25 U.S. dollars
Day 1 – EUR/USD 1.25
Day 10 – EUR/USD 1.30
In this example on day 1 the quote for EUR/Dollar means you can buy 1.25 dollars per euro. By day 10 you could buy 1.3 dollars for each euro. This means that the base currency (Euro) has strengthened against the counter currency (Dollar).
So if you had purchased Euro using dollars on day one and then exchange the Euros back to dollars you would have realized a profit of 0.05 cents per euro owned. This would equal a gain of 4%.
A key advantage of investing in foreign exchange is the foreign exchange markets are highly liquid and highly competitive; this means low spreads (the difference between the Bid and Ask Price).
A big disadvantage is that the price fluctuations are very small, so to make a reasonable profit the retail investors usually use a large amount of leverage. Leverage is when you borrow money to add to your capital to make an investment, this helps to magnify the gains.
If you have $10 to invest, and you borrow $90, you will have $100 to invest. With this capital your make an investment and make a 10% profit. Now your total capital is $110. When you pay back the lender the $90, you are left with $20. This means you have actually made a 100% profit as you started with $10 and ended with $20.
The problem here is that if I had made a 10% loss instead of a 10% gain on my investment I would have lost all my money. Eventually this is what happens to most inexperienced retail investors. They lose all their money.
Trading foreign exchange is a high risk gamble and you are up against huge institutions and professionals across the globe.
If you are intent on trading currency, then you need to be an expert in technical analysis and market timing. The nature of FX is that any errors mean you lose a lot, currency trading is practiced by expert technical analysts in institutions, so do not speculate with your money unless you know what you are doing.