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2011-11-15 14:08:57
Although forex is the largest financial market in the world, it is relatively
unfamiliar terrain for retail traders. Until the popularization of internet
trading a few years ago, FX was primarily the domain of large financial
institutions, multinational corporations and secretive hedge funds. But times
have changed, and individual investors are hungry for information on this
fascinating market. Whether you are an FX novice or just need a refresher
course on the basics of currency trading, read on to find the answers to the
most frequently asked questions about the forex market.
How does the forex market differ from other markets?
Unlike stocks, futures or options, currency trading does not take place on a
regulated exchange. It is not controlled by any central governing body, there
are no clearing houses to guarantee the trades and there is no arbitration
panel to adjudicate disputes. All members trade with each other based on credit
agreements. Essentially, business in the largest, most liquid market in the
world depends on nothing more than a metaphorical handshake.
At first glance, this ad-hoc arrangement must seem bewildering to investors who
are used to structured exchanges such as the NYSE or CME. (To learn more, see
Getting To Know Stock Exchanges.) However, this arrangement works exceedingly
well in practice; because participants in FX must both compete and cooperate
with each other, self regulation provides very effective control over the
market. Furthermore, reputable retail FX dealers in the United States become
members of the National Futures Association (NFA), and by doing so they agree
to binding arbitration in the event of any dispute. Therefore, it is critical
that any retail customer who contemplates trading currencies do so only through
an NFA member firm.
The FX market is different from other markets in some other key ways that are
sure to raise eyebrows. Think that the EUR/USD is going to spiral downward?
Feel free to short the pair at will. There is no uptick rule in FX as there is
in stocks. There are also no limits on the size of your position (as there are
in futures); so, in theory, you could sell $100 billion worth of currency if
you had the capital to do it. If your biggest Japanese client, who also happens
to golf with the governor of the Bank of Japan tells you on the golf course
that BOJ is planning to raise rates at its next meeting, you could go right
ahead and buy as much yen as you like. No one will ever prosecute you for
insider trading should your bet pay off. There is no such thing as insider
trading in FX; in fact, European economic data, such as German employment
figures, are often leaked days before they are officially released.
Before we leave you with the impression that FX is the Wild West of finance, we
should note that this is the most liquid and fluid market in the world. It
trades 24 hours a day, from 5pm EST Sunday to 4pm EST Friday, and it rarely has
any gaps in price. Its sheer size and scope (from Asia to Europe to North
America) makes the currency market the most accessible market in the world.
Where is the commission in forex trading?
Investors who trade stocks, futures or options typically use a broker, who acts
as an agent in the transaction. The broker takes the order to an exchange and
attempts to execute it as per the customer's instructions. For providing this
service, the broker is paid a commission when the customer buys and sells the
tradable instrument.
The FX market does not have commissions. Unlike exchange-based markets, FX is a
principals-only market. FX firms are dealers, not brokers. This is a critical
distinction that all investors must understand. Unlike brokers, dealers assume
market risk by serving as a counterparty to the investor's trade. They do not
charge commission; instead, they make their money through the bid-ask spread.
In FX, the investor cannot attempt to buy on the bid or sell at the offer like
in exchange-based markets. On the other hand, once the price clears the cost of
the spread, there are no additional fees or commissions. Every single penny
gain is pure profit to the investor. Nevertheless, the fact that traders must
always overcome the bid/ask spread makes scalping much more difficult in FX.
What is a pip?
Pip stands for "percentage in point" and is the smallest increment of trade in
FX. In the FX market, prices are quoted to the fourth decimal point. For
example, if a bar of soap in the drugstore was priced at $1.20, in the FX
market the same bar of soap would be quoted at 1.2000. The change in that
fourth decimal point is called 1 pip and is typically equal to 1/100th of 1%.
Among the major currencies, the only exception to that rule is the Japanese
yen. One Japanese yen is now worth approximately US$0.01; so, in the USD/JPY
pair, the quotation is only taken out to two decimal points (i.e. to 1/100th of
yen, as opposed to 1/1000th with other major currencies).
What are you really selling or buying in the currency market?
The short answer is "nothing". The retail FX market is purely a speculative
market. No physical exchange of currencies ever takes place. All trades exist
simply as computer entries and are netted out depending on market price. For
dollar-denominated accounts, all profits or losses are calculated in dollars
and recorded as such on the trader's account.
The primary reason the FX market exists is to facilitate the exchange of one
currency into another for multinational corporations that need to trade
currencies continually (for example, for payroll, payment for costs of goods
and services from foreign vendors, and merger and acquisition activity).
However, these day-to-day corporate needs comprise only about 20% of the market
volume. Fully 80% of trades in the currency market are speculative in nature,
put on by large financial institutions, multibillion dollar hedge funds and
even individuals who want to express their opinions on the economic and
geopolitical events of the day.
Because currencies always trade in pairs, when a trader makes a trade he or she
is always long one currency and short the other. For example, if a trader sells
one standard lot (equivalent to 100,000 units) of EUR/USD, she would, in
essence, have exchanged euros for dollars and would now be "short" euros and
"long" dollars. To better understand this dynamic, let's use a concrete
example. If you went into an electronics store and purchased a computer for
$1,000, what would you be doing? You would be exchanging your dollars for a
computer. You would basically be "short" $1,000 and "long" one computer. The
store would be "long" $1,000 but now "short" one computer in its inventory. The
exact same principle applies to the FX market, except that no physical exchange
takes place. While all transactions are simply computer entries, the
consequences are no less real.
Which currencies are traded in the forex market?
Although some retail dealers trade exotic currencies such as the Thai baht or
the Czech koruna, the majority trade the seven most liquid currency pairs in
the world, which are the four "majors":
EUR/USD (euro/dollar)
USD/JPY (dollar/Japanese yen)
GBP/USD (British pound/dollar)
USD/CHF (dollar/Swiss franc)
and the three commodity pairs:
AUD/USD (Australian dollar/dollar)
USD/CAD (dollar/Canadian dollar)
NZD/USD (New Zealand dollar/dollar)
These currency pairs, along with their various combinations (such as EUR/JPY,
GBP/JPY and EUR/GBP), account for more than 95% of all speculative trading in
FX. Given the small number of trading instruments - only 18 pairs and crosses
are actively traded - the FX market is far more concentrated than the stock
market.
What is a currency carry trade?
Carry is the most popular trade in the currency market, practiced by both the
largest hedge funds and the smallest retail speculators. The carry trade rests
on the fact that every currency in the world has an interest rate attached to
it. These short-term interest rates are set by the central banks of these
countries: the Federal Reserve in the U.S., the Bank of Japan in Japan and the
Bank of England in the U.K.
The idea behind the carry is quite straightforward. The trader goes long the
currency with a high interest rate and finances that purchase with a currency
with a low interest rate. For example, in 2005, one of the best pairings was
the NZD/JPY cross. The New Zealand economy, spurred by huge commodity demand
from China and a hot housing market, saw its rates rise to 7.25% and stay
there, while Japanese rates remained at 0%. A trader going long the NZD/JPY
could have harvested 725 basis points in yield alone. On a 10:1 leverage basis,
the carry trade in NZD/JPY could have produced a 72.5% annual return from
interest rate differentials, without any contribution from capital
appreciation. Now you can understand why the carry trade is so popular!
But before you rush out and buy the next high-yield pair, be aware that when
the carry trade is unwound, the declines can be rapid and severe. This process
is known as carry trade liquidation and occurs when the majority of speculators
decide that the carry trade may not have future potential. With every trader
seeking to exit his or her position at once, bids disappear and the profits
from interest rate differentials are not nearly enough to offset the capital
losses. Anticipation is the key to success: the best time to position in the
carry is at the beginning of the rate-tightening cycle, allowing the trader to
ride the move as interest rate differentials increase
Forex Market Jargon
Every discipline has its own jargon, and the currency market is no different.
Here are some terms to know that will make you sound like a seasoned currency
trader:
Cable, sterling, pound - alternative names for the GBP
Greenback, buck - nicknames for the U.S. dollar
Swissie - nickname for the Swiss franc
Aussie - nickname for the Australian dollar
Kiwi - nickname for the New Zealand dollar
Loonie, the little dollar - nicknames for the Canadian dollar
Figure - FX term connoting a round number like 1.2000
Yard - a billion units, as in "I sold a couple of yards of sterling."
by Boris Schlossberg