The ChoosaBroker Trading Academy
2.1. Foreign Exchange
From the birth of money to the famous George Soros attack on the Bank of England, foreign exchange and its trading has been an integral part of human civilization. But it’s only since the widespread adoption of the Internet in the 1990s that currency trading has exponentially grown in scope and reach. In this lesson, we will learn about –
- What is Foreign Exchange?
- What is Foreign Currency Exchange Rate?
- How to Trade Foreign Exchange?
- Advantages of Trading Foreign Exchange
What is Foreign Exchange?
Foreign exchange, more commonly known as Forex or FX, is defined as the relative value of one country’s currency to another. The foreign exchange market is by far the largest and the most liquid financial market. According to the Bank of International Settlements’ 2016 Triennial Central Bank Survey, average daily Forex turnover as of April 2016 was estimated to be in excess of $5 trillion.
Unlike stocks and commodities, foreign exchange has no physical marketplace. Instead, it is a globally decentralized online network of buyers and sellers. It remains open 24 hours a day, five days a week from Monday morning in Asia to Friday afternoon in the Americas. The primary trading centres are London, New York, Tokyo, Frankfurt, Singapore and Sydney. All levels of traders, from central bankers and institutional investors to retail speculators, trade currencies with one another. The market is connected through a number of brokers and dominated by relatively small group; see best forex brokers
The most frequently traded currencies are listed in the table below –
| CURRENCY SYMBOL | COUNTRY OF ORIGIN | CURRENCY NAME | TRADING NICKNAME |
|---|---|---|---|
|
USD |
UNITED STATES OF AMERICA |
DOLLAR |
GREENBACK |
|
EUR |
GREAT BRITAIN - UNITED STATES |
EURO |
FIBER |
|
GBP |
UNITED KINGDOM |
POUND |
CABLE |
|
JPY |
JAPAN |
YEN |
YEN |
|
CAD |
CANADA |
CANADIAN DOLLAR |
LOONIE |
|
CHF |
SWITZERLAND |
SWISS FRANC |
SWISSY |
|
NZD |
NEW ZEALAND |
NEW ZEALAND DOLLAR |
KIWI |
|
AUD |
AUSTRALIA |
AUSTRALIAN DOLLAR |
AUSSIE |
Currency symbols consist of three letters – the first two identify the country of origin and the third letter indicates the name of the currency. Take for instance JPY. JP stands for Japan, while Y stands for Yen.
Buying a currency is kind of like buying a particular country’s share. The price of the currency is generally a direct manifestation of the market’s opinion on the state of the underlying country’s economy. In Forex trading, when you buy, suppose, the Australian Dollar, you are basically betting that the Australian economy is faring well, and is likely to perform even better.
Foreign Exchange Rates
Forex trading always occurs in pairs. Market participants simultaneously buy one currency and sell another. The currency pairs included in the table below are called the “MAJORS” because they are the most widely traded.
| CURRENCY PAIR | RESPECTIVE COUNTRIES OF ORIGIN |
|---|---|
|
EUR-USD |
EURO ZONE - UNITED STATES |
|
GBP-USD |
GREAT BRITAIN - UNITED STATES |
|
USD-JPY |
UNITED STATES - JAPAN |
|
USD-CAD |
UNITED STATES - CANADA |
|
USD-CHF |
UNITED STATES - SWITZERLAND |
|
NZD-USD |
NEW ZEALAND - UNITED STATES |
|
AUD-USD |
AUSTRALIA - UNITED STATES |
The first currency listed in a pair is called the BASE CURRENCY, while the second currency is referred to as the counter or QUOTE CURRENCY. The rate at which a currency pair is trading indicates how much of the quote currency is needed to buy one unit of the base currency. In technical parlance, this is called the exchange rate. Simply put, EXCHANGE RATE is the rate at which one country’s currency can be converted in to another. For example, if in the interbank market, USD/JPY is currently trading at 110.00, it means that 110 Japanese Yen can be exchanged for 1 US Dollar, or that 1 US Dollar is equivalent in value to 110 Japanese Yen.
The foreign exchange rate is one of the most important indicators of a country’s relative economic health. Numerous factors determine this rate, the three most important among which are enumerated below:
- Difference in Inflation – Typically, a country with a lower inflation rate sees its purchasing power increase relative to other currencies, resulting in a rise in its currency’s value. If, for example, inflation in Switzerland is relatively lower than elsewhere, exports out of the country will become more competitive, lifting demand for the Swiss Franc to buy the Swiss goods. Contrarily, a country with higher inflation generally witnesses depreciation in its currency.
- Interest Rate Differentials – Central banks fix interest rates in a country to control both inflation and exchange rates. If interest rates in the UK rise relative to elsewhere, it will become more attractive for investors to deposit money in the country because of the better rate of return. This in turn will boost demand for the Pound.
- Current Account Deficits – Broadly speaking, a current account shows the balance of trade situation in a country, as well as its earnings from foreign investments. A deficit in the current account signifies that the country’s spending on foreign trade is greater than its earning. As a result, the country requires more foreign currency than it receives, lowering the demand for its own currency.
Foreign Exchange Transactions
The mechanics of foreign exchange trading are virtually similar to those of other asset markets. The only difference is that when you trade Forex, you buy one currency and sell another at the same time. That is why currencies are invariably quoted in pairs, like USD/JPY or EUR/USD.
A PIP is the smallest price move in any foreign exchange rate. Barring Japanese Yen pairs, all other Forex pairs are quoted to four decimal places.
- 1. For Forex pairs displayed to 4 decimal places, 1 pip = 0.0001
- 2. For Yen-based pairs, which are displayed to two decimal places, 1 pip = 0.01
As has been explained earlier, when you buy a Forex pair, the exchange rate denotes the number of units of the quote currency you have to pay to purchase one single unit of the base currency. If GBP/USD is currently trading at 1.3100, you have to dish out 1.3100 US Dollars to buy 1 UK Pound. Conversely, when you sell, the exchange rate depicts the number of units of the quote currency you will receive for selling one base currency unit. In the above example, you will get 1.3100 US Dollars for every 1 British Pound you sell.
From a trading/investing point of view, the base currency will be the “basis” for all of your buy and sell decisions.
- 1. You will buy a Forex pair if you expect the base currency to appreciate in value relative to the quote currency.
- 2. You will sell the currency pair if you believe the base currency will decrease in value compared to the quote currency.
The Bid, The Ask, The Spread
All foreign exchange rates are quoted with two distinct prices: the bid price and the ask price. The BID price represents what a seller will get in the quote currency when selling one unit of the base currency. Simply put, the bid is the best available rate you will get to sell to the market.
The ASK or the offer price, on the other hand, represents what a buyer has to pay in the quote currency to obtain one unit of the base currency. The ask is the best available rate at which you can buy from the market.
Generally, the bid price is lower than the ask price, and the difference between the two is known as the SPREAD.
Spot Trade
The foreign exchange market is very large, with different layers of activity. Investors may engage in Forex futures as well as trade in the spot currency market. A Forex spot transaction is an agreement between two parties to purchase a currency pair at an agreed upon price for settlement within a short period of time thereafter. The rate at which the transaction takes place is known as the spot rate. Spot trading is the most common form of Forex trading, with the average turnover of global spot FX transactions touching US$2.00 trillion daily, or 38.00% of all FX transactions, as of April 2013.
The standard settlement period for Forex spot transactions is two business days from the date of trade (T+2). Notable exceptions include USD/CAD, USD/RUB, USD/TRY and USD/PKR, which follow T+1 settlement.
Why Trade Forex?
Even though the foreign exchange market is the biggest financial market in the world, it is still a relatively unfamiliar territory for a large section of retail traders. Until a couple of decades ago, the FX market was predominantly the domain of Central Banks, large financial intuitions and hedge funds. However, the inroads made by online trading platforms have steadily increased retail participation. This has been supported by the growth in brokers, especially those offering greater educational resources for beginner traders. If you are located in the UK, there is a wide choice of UK London based brokers to work with.
Let us look at some of the key reasons why more and more people are choosing the Forex market as their primary financial playground:
- No Commissions – In Forex trading, there are no brokerage charges, exchange fees, clearing fees, or government charges. Most retail brokers make money by profiting from the “bid-ask spread,” which is typically less than 0.10% of the total transaction value.
- No Fixed Lot Size – A trader has the luxury to choose his or her own lot or position size. This enables even someone with as little as $25 to participate in the currency market.
- High Leverage – With currency trading, a market participant can, with a small initial deposit, control a much bigger contract value. For example, a foreign exchange broker may offer 20-to-1 leverage, meaning a $100 initial margin would allow an investor to buy or sell $2000 worth of Forex pairs. Similarly, with $1000, one could trade for $20,000 and so on.
- 24 Hour Market – The Forex market never sleeps. From the Monday morning open in Australia to the Friday afternoon close in New York, the market offers endless opportunities to profit. This is especially suitable for part-time traders, who can choose when they wish to trade.
- Beyond Manipulation – Due to its sheer size, no single entity, even if it is the United States Federal Reserve, can influence the price of a currency for a sustained duration of time.
Final Few Thoughts
With daily turnover exceeding $5 trillion, Forex is the most liquid financial market in the world. This liquidity often produces more actionable price moves than other popular assets like stocks and commodities. With the low entry cost and limitless profit opportunities, success in Forex may seem easy. But just like every other field, fortune awaits only the focussed and the hard-working.
Want to start trading Forex? Have a look at our leading FX brokers!