The ChoosaBroker Trading Academy

5.2. Benefits and Drawbacks of the Currency Market

Rapid technological advances in the foreign currency market have led to an exponential growth in the number of retail traders and investors. Currency markets are no longer the sole preserve of the big and wealthy individuals and corporations. There are more active retail market participants in the currency market than in any other financial marketplace. And the inherent advantages are not hard to find. In this lesson, we will look at:

Foreign Exchange Market Benefits

Listed below are the most notable benefits of the foreign exchange market:

1. Most Liquid Market with Greater Price Volatility

  • Liquidity represents the total number of buyers and sellers in a market. Typically, the greater the liquidity in a market, the better is the price fill. The foreign exchange market is the largest and the most liquid financial market in the world. Average daily activity exceeds US$4 trillion, with over US$1.50 trillion conducted in spot transactions.

Volatility is a measure of how much the price of an underlying asset changes over time. The major foreign currency pairs are highly volatile, providing traders and investors enough opportunities to profit from the fluctuations in the exchange rate.

2. Increased Market Hours

The foreign exchange market is open 24 hours a day, five days a week. The trading sessions can be broken down into four major time zones: the Sydney session, the Tokyo session, the London session, and the New York session. Maximum liquidity is generated when market hours in two time zones overlap. Trading during those time periods results in greater price volatility, increasing the odds of an open position meeting its price objective.

3. Lower Transaction Costs

The only major transaction cost that a market participant has to incur while trading foreign currencies through a big broker is the spread. The spread is the difference between the bid price and the ask price of an underlying currency pair. Spreads in the foreign exchange market also tend to be much tighter than those in other popular securities like stocks and commodities.

4. Availability of Substantial Margin

Besides the easy accessibility, foreign exchange brokers and dealers also offer margin to traders. Margin-based accounts are different from credit accounts in that a trader or an investor first has to open an account with a broker and deposit money. Once a margin account has been funded, the trader can engage in any market activity as long as he or she maintains sufficient margin in the account. The initial deposit is dependent on the margin percentage that is agreed upon between the broker/dealer and the investor. For accounts trading in 100,000 currency units, the margin requirement is usually 1.00%. So, if an investor wants to trade $100,000, he will need to deposit a mere $1000. The remaining 99.00% is supplied by the broker. The availability of such huge levels of leverage can help small, retail traders earn potentially big profits from the market.

5. Ability to Profit from Falling Markets

Short-selling is the act of selling a currency pair without owning it. The ability to execute short trades enables a trader to profit irrespective of the direction in which the market is trending. When the exchange rates are increasing, a trader can earn a profit by going buying a currency pair, only to sell it later for more than his purchase price. Contrarily, when exchange rates are declining, the trader can profit by first short selling the currency pair and then it buying back for less than what he had initially paid for.

Foreign Exchange Market Drawbacks

Foreign currency trading, like any other form of financial trading, is not without its fair share of drawbacks. The most notable demerits of currency trading are listed below.

1. Excessive Leverage

The leverage offered by foreign exchange brokers is like a double-edged sword, whereby both profits and losses can get magnified. If the market suddenly moves against you, and a pre-determined risk management strategy is not in place, the losses can easily spiral out of your control, with the potential to even erode your entire trading capital.

2. Liquidity Risk

Even though liquidity in the foreign exchange market is much greater than any other financial asset class, there have been periods of low liquidity, especially outside of the U.S. and European trading hours. In addition, several countries have in the past enforced trading restrictions on their sovereign currencies, preventing investors from executing their trades.

3. Volatility Risk

During periods of greater market volatility that accompany major economic releases or geopolitical news, the bid – ask spreads of foreign currencies get widened, leading to poorer execution prices for traders.

Foreign Exchange Transaction Costs

Foreign exchange brokers either charge a per-trade COMMISSION, or make their money on the SPREAD between the bid price and the ask prices they quote to customers. By understanding what each of these mean, a trader will be better prepared to manage his or her capital.

1. Foreign Exchange Commissions

A commission is the fee that a broker charges a trader for every trade placed. Forex commissions come in two main forms:

  • Fixed Commission – The broker can charge a trader a fixed sum of money regardless of the size and volume of the trade being initiated. For example, a fixed fee broker may charge a commission of $1 per executed trade, irrespective of the size involved.
Relative CommissionStrategy – – Under this model, the broker charges the trader based on the size of the trade. As such, the bigger the trading volume, the higher will be the commission charged. For example, the broker may charge “$X per $Million in traded volume”.

2. Foreign Exchange Spreads

Currency brokers that don’t charge commission make their money through the bid-ask spread. Your broker will quote you two prices for every currency pair on offer – a price to buy (the bid price) and a price to sell (the ask price). The spread is the difference between the bid price and the ask price, and is what the broker earns from each trade placed. To illustrate, let us say you want to initiate a long position (buy trade) on EUR/USD. The broker will quote two prices, 1.1003 and 1.1000. When you click on the buy button of your trading platform, you will be entered into a long position with a fill at 1.1003. This means that you have been charged 3 pips for the spread, which will represent your transaction cost for entering in to the trade.

Final Few Thoughts

Despite the overwhelming size of the market, when it comes to trading and investing in foreign currencies, the underlying concepts are relatively simple. The benefits of currency trading easily outweigh the drawbacks. The most important rule to survive in the business is to trade only with capital you can afford to lose. Limit your losses, and the profits will take care of themselves.

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