The ChoosaBroker Trading Academy
5.4. Basic Foreign Exchange Trading Concepts
The foreign exchange market is the world’s largest financial marketplace. Despite its enormous size, when it comes to trading and investing with currencies, the underlying concepts are relatively simple. In this lesson, we will look at the following three basic Forex processes that all traders need to be aware of –
Why Currencies Fluctuate?
Most of the foreign currencies available for trading are bought and sold at exchange rates that fluctuate based on the demand-supply dynamics in the global Forex market. Relatively higher demand for a currency or a shortfall in its supply will cause the price to increase. Contrarily, if supply of a currency is greater than the market demand, the price will decline.
A currency’s demand and supply are linked to a number of entwined factors, the three most important among which are briefly explained below:
1. Interest Rates
2. Inflation Differential
3. Political and Economic Conditions
Carry Trades and Their Functions
In simple terms, a carry trade can be defined as the borrowing or selling of a financial asset with a low interest rate, and then using it to purchase an asset with a higher interest rate. The profit earned is the difference between the two interest rates.
Let us suppose you walk in to a bank and borrow $10,000 at an annual interest rate of 1%. With that borrowed money, you go to a broker and purchase a $10,000 bond that pays 5% a year.
What is your profit? The interest rate differential, which in this case is 4%.
While the 4% may not sound as exciting or profitable as catching a strong swing in the foreign exchange market, when you consider the higher leverage that Forex brokers offer, the returns can get pretty substantial. To give you an idea, a 4% interest rate differential becomes 80% annualized return on an account that is 20 times leveraged.
The Japanese Yen carry trade has been a favourite among big currency traders. Investors borrow the Yen at the near-zero interest rates prevailing in Japan. The Yen are then converted to U.S. Dollars, which are invested in the much higher-yielding Treasury bonds. This creates a “positive carry” for the investor because of the difference in interest rates. The investor gets to make additional profits if the U.S. Dollar rises against the Yen, or the Treasuries appreciate in price. However, if the Yen were to gain in value, the investor would have to obtain more Dollars to pay back the Yen he or she has borrowed, opening up the prospect of a major loss.
The key to building a successful carry trade strategy is not simply pairing the currency that offers the highest interest rate with the currency that has the lowest rate. Far more critical than the absolute interest rate differential is the underlying trajectory of the respective rates. In order for carry trades to work in your favour, you need to buy a currency with an interest rate that is rising against a currency whose interest rate is either stationary or better still, declining.
Final Few Thoughts
The widespread availability of electronic trading networks has made foreign exchange trading more accessible than any time in history. The biggest financial market in the world offers potentially endless opportunities for those investors who are willing to take the time to first understand how the market operates, and then devise strategies to profit from the demand-supply mismatches that often arise. There is a detailed review and summary of the leading forex brokers that is worth a look. If you are serious about day trading Forex check out our broker reviews.