What is Forex?
It may be easily noticed that the value of currencies fluctuates on a regular basis. However, many don’t realize that this a foreign exchange market (Forex), whereby potential profit can be made from fluctuations of these currencies. The most famous example who made a billion dollars in a day by trading currencies is George Soros. However, currency trading involves significant risks and individuals can lose a substantial part of their investment. As era of technological advancements has emerged, Forex market has become more affordable and as a result led to inevitable growth of online trading. One of absolute advantages in currencies trading nowadays is that there is no longer need to be a big money manager to trade currencies; small traders and investors can trade this market.
Who trades Forex?
Anyone can trade Forex regardless of level of experience and geographical location. Because Forex trading has no centralized market place, it operates 24 hours a day from Monday to Friday and all trading is carried out via online trading platforms.
Trading on the Forex market is one of the most worthy investments available.
Buying and selling of currency is conducted in currencies pairs. For example, if you buy the EUR/USD at lower price and you sell it at a higher price, profit is made on such a price movement.
If, again, a trader purchased 1000 USD (US dollars) last year and the equivalent at the time was 800 Euros, this year the value of the USD may be 900 or 700 Euros (EUR). If you decide to sell now, you will lose or earn 100€ accordingly.
A trader can trade Forex via online trading platform and these are provided by Forex brokers. The platforms offered by FX brokers differ in features and styles, and the brokers are responsible for providing brokerage services to traders that will allow them to trade. The trader is usually offered a choice of different types of accounts, trading platforms, trading tools along with other specific trading conditions. The Broker company is responsible to assist clients with trading strategies available and provide the best prices in the market to facilitate trading process.
How do I manage risk in FX Trading ?
The most widespread risk management tools in Forex trading include “limit” order and “stop loss” order.
A “limit” order sets the maximum price to be paid or the minimum price to be received.
A “stop loss” order ensures that a specific trading position is liquidated at a predetermined price so to limit possible losses in case that the market moves against the trader’s opened position.
Contingent orders may not limit the risk for potential losses.
FX Currency prices are always presented in the form of a Bid/Ask spread. The spread is the difference between the Bid and the Ask. The Bid is the price which a trader is able to sell a currency pair for. The Bid price (“Sell”) in a given currency pair is always the lower price in a quote. The Ask price (“Offer”) in a given currency pair, is the price which traders are able to buy a currency pair for.
“PIP” stands for “Point In Percentage”. More simply, a pip in the currency market is referred to the “point” for calculating profits and losses. In a standard (10k) account, each pip is worth approximately one unit of currency in which trader’s account is denominated. If trading account is denominated in USD, each pip (depending on the currency pair) is worth about $1. In a micro account, each pip is worth somewhere 1/10th the amount it would be worth in a standard account (about $0.10).
In all currency pairs which have the Japanese Yen (JPY), a pip is the 1/100th place (2 places to the right of the decimal). In all other currency pairs, a pip is the 1/10,000 the place (4 places to the right of the decimal).
How to read Price Quotes?
When a currency is quoted, it is done so in relation to another currency, so that the value of one is reflected through the value of another. Therefore, if you are trying to calculate the exchange rate between the U.S. dollar (USD) and the Japanese yen (JPY), the quote would look like this: USD/JPY=118.49
This is referred to as a currency pair. The currency to the left of the slash is often referred to the “base currency”, while the currency on the right is called the “quote” or “counter currency”. The base currency (in this case, the U.S. dollar) is always equal to one unit (in this case, US$1), and the quoted currency (in this case, the Japanese yen) is what that one base unit is equivalent to in the other currency. The quote means that US$1 = 118.49 Japanese yen. In other words, US$1 can buy 118.49 Japanese yen. So, two things to remember:
The first currency listed is the “base currency”.
The value of the “base currency” is always 1 (one).
What Influences Currency Price?
If inflation of any given country is relatively lower than elsewhere, then this country’s exports will become more attractive and there will be an increase in demand for its currency to buy goods. Also foreign goods will be less competitive and so its citizens will buy fewer imports.
Therefore countries with lower inflation rates tend to see an appreciation in the value of their currency.
2. Interest Rates
If a country’s interest rates rise relative to elsewhere, it will become more attractive to deposit money in such a country. Therefore demand for this currency will rise. Higher interest rates cause an appreciation.
If speculators believe that a currency will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise. Therefore movements in the exchange rate do not always reflect economic fundamentals, but are often driven by the sentiments of the financial markets. For example, if markets see news which makes an interest rate increase more likely, the value of this currency will probably rise in anticipation.
4. Change in Competitiveness
If country’s goods become more attractive and competitive this will also cause the value of the Exchange Rate to rise. This is important for determining the long run value of the currency. This is similar factor to low inflation.
5. Relative strength of other currencies
In 2010 and 2011, the value of the Japanese Yen and Swiss Franc has gone up because markets were worried about all the other major economies – US and EU. Therefore, despite of low interest rates and low growth in Japan, the Yen kept increasing its value.
6. Balance of Payments
A deficit on the current account means that the value of imports (goods and services) is bigger than the value of exports. If this is financed by a surplus in the capital account, there is no problem whatsoever. But a country that struggles to attract enough capital inflows to finance its current account deficit will notice a drop in its currency value.
7. Government Debt
Under some circumstances, the value of government debt can influence the exchange rates. If markets expect a government to default on its debt, investors will start selling their bonds, which will cause a decrease in the value of the exchange rate. For example, Iceland financial problems in 2008 provoked instant decrease in the value of its domestic currency.
8. Government Intervention
Some governments try hard to influence the value of their local currency. For example, China tries to keep its currency undervalued to make Chinese exports more competitive. They can do this by buying US dollar assets which increases the value of the US dollar in relation to Chinese Yuan.
FX Currency Pairs
The reason for currency pairs to exist is that if we all had one single currency, we would have no way of measuring its relative value. By pairing two currencies against each other, the fluctuating value can be established for one currency against another.
Currency Pairs which don’t contain a US dollar in it are commonly named as “Cross Currency Pairs”. Trading Cross Currencies offers entirely new aspects of foreign exchange market to speculators. There are cross currencies that move very slowly and are quite stable. Other cross currency pairs move rather quickly and are extremely unstable with average movements exceeding 100 pips a day.
Major Currency Pairs
Most foreign currency transactions utilize term “Majors”, comprising of the British Pound (GBP), Euro (EUR), Japanese Yen (JPY), Swiss Franc (CHF) and the US Dollar (USD). These are the key five currencies, however Canadian Dollar (CAD) along with the Australian Dollar (AUD) are becoming additional ‘major’ currencies.
When a foreign currency transaction is executed, one currency is being borrowed while another one is being lent. This borrowing and lending is treated like a common banking transaction and therefore is a subject to interest rates on the borrowing and lending that are taking place. The interest is usually related to “SWAP” rate in the currency market. The Swap is a credit or debit as an effect of daily interest rates. When traders keep positions overnight, they are either credited or debited interest based on the rates at a given time.
The foreign exchange currency market gives its participants the opportunity to trade on margin. It is one of the most attractive yet, risky features of Forex trading. Basically, trading on margin allows Forex traders to trade on borrowed funds. The degree of such borrowing will depend on the broker company and the leverage offered.
In the currency market “margin” refers to the amount of money required to open a required position (contract).
Without such leverage Forex trader when placing a standard lot trade in the market would need to place the full contract value of $100,000 in order to have trade executed. Leverage allows a trader to execute $100,000 contract for an amount of margin (determined by the predetermined leverage level). For example, an account at 1:100 leverage needs $1,000 of margin to place a $100,000 trade.
By providing leverage to the clients, the brokerage firm basically allows traders to open a contractual position with significantly lower initial capital investment.
Trading currencies on margin should be used wisely as it magnifies both potential profits and losses. The rule here is the higher the leverage, the higher the risk.
Forex traders are usually a subject to the margin set of rules established by a specific broker. In order to protect themselves and their clients, brokers in the Forex market set margin requirements and levels at which traders are subject to margin calls. A margin call often occurs when a trader is using too much of available margin. Being spread across the losing trades, an over margined account can give a broker the right to close trader’s open positions. Every Forex trader should be aware on the features of their own accounts, i.e. at what is their level of a margin call. Every trader should carefully read the margin agreement in the company’s application when opening a live account.
Currency traders should examine on a regular basis their margin balance and stop-loss orders to limit their risk. On the other hand due to the excessive volatility of the Forex market, stop-loss orders are not always most effective tool for limiting the risk. There still remains the possibility of losing everything, and sometimes even more than the original investment.
Free Margin and Used Margin
In our example, we will have a $500 account balance. In order to open the position we are required to have initial margin of $100. This is referred to as “used margin”. The remaining $400 is considered to be as “free margin”. All things being equal, the free margin is always available for trading.
Current trading platforms are capable of calculating these figures in real time so there is no need to calculate them manually.
What is “Leverage”?
Forex trader should always be aware what level of risk they are willing to take. It is quite understandable desire to risk more in a pursuit to profit more, however it should also be mentioned that a slight movement in the market can result in a much higher loss in an over- leveraged account.
Currency traders always have a choice of using a lower level of leverage to an account or a trade. Choosing lower leverage may help reduce risk, but it is worth noting that a lower level of leverage requires a larger margin deposit in order to manage the same size contracts.
Concept of Forex Risk
For successful trading, one must fully be aware of all risks involved. Each trader will view the market rather differently, considering the fact that there is no right or wrong way to trade in the market. Essentially, each Forex trader must evaluate the risk that they can comfortably afford.
Determining which type of trader you are is much more important than it might first appear. One might be a systematic trader while the other would prefer trading during highly volatile periods. Are you capitalizing on short-term or long-term profits?
What is Risk?
Risk referred to “variability of returns from an investment or the chance that an investment’s actual return will be different than expected. This includes the possibility of losing some or all of the original investment. It is usually measured using the historical returns or average returns for a specific investment. The greater the variability of an investment (i.e. fluctuation in price or interest), the greater the risk.”
The instability of prices can be seen in every day coupled with mentioned leverage available in “off-the-market” foreign currency (Forex) compared to other financial instruments (e.g.bonds). That’s why Forex industry is viewed as highly risky. As traders usually tend to be risk averse, investments with greater risk must promise higher expected returns to justify accepting additional risk. As a rule higher risk promises greater returns or a higher risk for loss. Though higher return doesn’t always mean a higher degree of risk.