The investor’s goal in Forex trading is to profit from foreign currency movements.
More than 95% of all currency trading performed today is for speculative purposes (e.g. to profit from currency movements). The rest belongs to hedging (managing business exposures to various currencies) and other activities.
Currency trades (trading onboard internet platforms) are non-delivery trades: currencies are not physically traded, but rather there are currency contracts which are agreed upon and performed. Both parties to such contracts (the FX trader and the currency trading platform) undertake to fulfil their obligations: one side undertakes to sell the amount specified, and the other undertakes to buy it. As mentioned, over 95% of the market activity is for speculative purposes, so there is no intention on either side to actually perform the contract (the physical delivery of the currencies). Thus, the contract ends by offsetting it against an opposite position, resulting in the profit and loss of the parties involved.
Easy Forex Trading Platform – Currency Deals and Transactions
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Components of a Forex Deal
A Forex deal is a contract agreed upon between the trader and the market-maker (i.e. the Currency Trading Platform). The contract is comprised of the following components:
- The currency pairs (which currency to buy; which currency to sell)
- The principal amount (or “face”, or “nominal”: the amount of currency involved in the deal)
- The rate (the agreed exchange rate between the two currencies).
Time frame is also a factor in some deals, but this chapter focuses on Day-Trading (similar to ‘Spot‘ or ‘Current Time’ trading), in which deals have a lifespan of no more than a single full day. Thus, time frame does not play into the equation. Note, however, that deals can be renewed (‘rolled-over’) to the next day for a limited period of time.
The Forex deal, in this context, is therefore an obligation to buy and sell a specified amount of a particular pair of currencies at a pre-determined exchange rate.
FX trading is always done in currency pairs. For example, imagine that the exchange rate of EUR/USD (euros to US dollars) on a certain day is 1.1999 (this number is also referred to as a ‘spot rate‘, or just ‘rate’, for short). If an investor had bought 1,000 euros on that date, he would have paid 1,199.00 US dollars. If one year later, the Forex rate was 1.2222, the value of the euro has increased in relation to the US dollar. The investor could now sell the 1,000 euros in order to receive 1222.00 US dollars. The investor would then have USD 23.00 more than when he started a year earlier.
Currency Exchange Rate
Because currencies are traded in pairs and exchanged one against the other when traded, the rate at which they are exchanged is called the exchange rate. The majority of currencies are traded against the US dollar (USD), which is traded more than any other currency. The four currencies traded most frequently after the US dollar are the euro (EUR), the Japanese yen (JPY), the British pound sterling (GBP) and the Swiss franc (CHF). These five currencies make up the majority of the market and are called the major currencies or ‘the Majors’. Some sources also include the Australian dollar (AUD) within the group of major currencies. Other frequently traded currencies are the New Zealand dollar (NZD) and Gold (XAU).
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The first currency in the exchange pair is referred to as the base currency. The second currency is the counter currency or quote currency. The counter or quote currency is thus the numerator in the ratio, and the base currency is the denominator.
The exchange rate tells a buyer how much of the counter or quote currency must be paid to obtain one unit of the base currency. The exchange rate also tells a seller how much is received in the counter or quote currency when selling one unit of the base currency. For example, an exchange rate for EUR/USD of 1.2083 specifies to the buyer of euros that 1.2083 USD must be paid to obtain 1 euro.
Currency Trading Spreads
It is the difference between BUY and SELL, or BID and ASK. In other words, this is the difference between the market maker’s “selling” price (to its clients) and the price the market maker “buys” it from its clients.
If an investor buys a currency and immediately sells it (and thus there is no change in the rate of exchange), the investor will lose money. The reason for this is ‘the spread‘. At any given moment, the amount that will be received in the counter currency when selling a unit of base currency will be lower than the amount of counter currency which is required to purchase a unit of base currency.
Prices, Quotes and Indications
The price of a currency (in terms of the counter currency), is called ‘Quote’. There are two kinds of quotes in the Forex market:
Direct Quote: the price for 1 US dollar in terms of the other currency, e.g. Japanese Yen, Canadian dollar, etc.
Indirect Quote: the price of 1 unit of a currency in terms of US dollars, e.g. British pound, euro.
The market maker provides the investor with a quote. The quote is the price the market maker will honour when the deal is executed. This is unlike an ‘indication’ by the market maker, which informs the trader about the market price level, but is not the final rate for a deal.
Cross rates – any quote which is not against the US dollar is called ‘cross’. For example, GBP/JPY is a cross rate, since it is calculated via the US dollar. Here is how the GBP/JPY rate is calculated:
GBP/USD = 1.7464;
USD/JPY = 112.29;
Therefore: GBP/JPY = 112.29 x 1.7464 = 196.10.
Banks and/or online trading providers need collateral to ensure that the investor can pay in the event of a loss. The collateral is called the ‘margin‘ and is also known as minimum security in Forex markets. In practice, it is a deposit to the trader’s account that is intended to cover any currency trading losses in the future.
Margin enables private investors to trade in markets that have high minimum units of trading, by allowing traders to hold a much larger position than their account value.
Leveraged financing is a common practice in Forex trading, and allows traders to use credit, such as a trade purchased on margin, to maximize returns. Collateral for the loan/leverage in the margined account is provided by the initial deposit. This can create the opportunity to control USD 100,000 for as little as USD 1,000.
There are five ways private investors can trade in Forex, directly or indirectly:
Please note that this book focuses on the most common way of trading in the Forex market, ‘Day-Trading’ (related to ‘Spot’).
Trading Currency Risks
Although Forex trading can lead to very profitable results, there are substantial risks involved: exchange rate risks, interest rate risks, credit risks and event risks.
Approximately 80% of all currency transactions last a period of seven days or less, with more than 40% lasting fewer than two days. Given the extremely short lifespan of the typical trade, technical indicators heavily influence entry, exit and order placement decisions.