The foreign exchange or 'Forex Market' is the world's largest financial market. It is a non-stop cash market where currencies of nations are traded off-exchange through brokers.
It is estimated that, on average, $3.6 trillion is traded each day in the world Forex markets. The vast majority of Forex trading does not occur on any one centralized or organized exchange but through brokers on the interbank currency market. The interbank currency market is a twenty four hour market that follows the sun around the world. Opening in Australia and closing in the U.S. Whilst the market exists for organizations with exchange risk, speculators also participate in the Forex markets in an effort to profit from their expectations regarding shifts in exchange rates.
Who trades Forex
In the early part, the Forex market was used by institutional investors that transacted large amounts for commercial and investment purposes. Today however, importers and exporters, international portfolio managers, multinational corporations, speculators, day traders, long term holders and hedge funds all use the Forex market to pay for goods and services, transact in financial assets and speculate or to reduce the risk of currency movements by hedging their exposure or increasing their exposure through speculation.
In today's information superhighway the Forex market is no longer solely for the institutional investor. The last 10 years have seen an increase in non-institutional traders accessing the Forex market and the benefits it offers. Trading platforms such as MetaQuotes MetaTrader have been developed specifically for the private investor and educational material has become more readily available. These have all added to the attractiveness of the Forex market for the private investor.
The growth in the Forex market over the last decade has led to a number of advantages for the private investor. Trading material to educate the trader has become far more readily available. Support services via forums have become increasingly popular and in the event that you the private investor no longer wish to trade the account yourself, you have professional money managers that will take-over via managed accounts. In brief the main advantages for the private investor and the shorter term trader are:
24 hour trading, 5 days a week with 24 hour cover provided by the broker.
- ECNOptions provides 24 hour cover for its clients
- Cover from Sunday night through to Friday night.
An enormous liquid market.
- $3.6 trillion traded daily
- The Forex market is constantly moving providing volatility. It is this volatility that provides both long and short term traders the opportunity to profit from the Forex market.
Products that are traded
- With over twenty products being offered there are always opportunities in the market.
The ability to go long or sell short.
- You are not restricted to long positions only. If you believe that a currency pair is going down you have the ability to take a short position.
Low margin requirements.
- With the low margin requirement you are able to leverage your account up to 1000.
A Wealth of Trading Resources & Forums.
Forex prices are displayed in the form of a Bid/Ask spread. The spread is the difference between the Bid and the Ask. The Bid and Ask serve as the prices that similar to other financial products. The Bid is the price at which a trader is able to sell a currency pair. The Bid price or sell price of a currency pair is always the lower price in a quote. The Ask, also sometimes referred to as the "Offer", is the price at which traders are able to buy a currency pair.
The difference between the Bid and Ask is called the "Spread" and is effectively the cost of trade. There are typically no additional broker commissions involved in trading the Forex market, although we are witnessing a move towards commission based trading due to market execution.
Market increments are measured in 'Percentage in Point' or Pips for short. A pip is the last digit in the value of a currency pair (if you are trading from a 4 digit price feed); 1.3294, 115.13 etc. All Forex currency pairs, except for the Japanese Yen, measure the pip from the 4th decimal place.
Price Quotes: What do they mean?
Reading a Forex quote may seem a bit confusing at first. However, it's really quite simple if you are able to remember two things:
- The first currency listed is the base currency
- The value of the base currency is always 1 (one)
A quote of GBP at 1.5000 is to say that 1 Sterling Pound (GBP) = 1.5000 US Dollar (US). When the Sterling Pound is the base unit and a currency pair's price increases, comparatively the Sterling Pound has appreciated and the other currency in the pair (usually known as the quote currency) has weakened. Using the above GBPUSD example as a reference, if the GBP/USD increases, from 1.5000 to 1.5100 (100 pips), the GBP is stronger because it will now buy more USD than before.
There are four currency pairs involving the US dollar in which the US dollar is not the base currency. These exceptions are the Australian dollar (AUD), the British Pound (GBP), the Euro (EUR), and the New Zealand dollar (NZD). A quote on the GBP/USD of 1.7600 would mean that one British Pound is equal to 1.7600 US dollars. If the price of a currency pair increases the value of the base currency in comparison to the quote currency thus increases. Conversely, if the price of a currency pair decreases, such is to say that the value of the base currency in comparison to quote currency has weakened.
What Influences Price?
Forex markets and prices are mainly influenced by international trade and investment flows. It is also influenced, but to a lesser extent, by the same factors that influence the equity and bond markets: economic and political conditions, especially interest rates, inflation, and political stability, or as is often the case, political instability. Though economic factors do have long term effects, it is often the immediate reaction that causes daily price volatility, which makes Forex trading very attractive to intra-day traders.
Currency trading can offer investors another layer of diversification. Trading currencies can be viewed as a means to protect against adverse movements in the equity and bond markets, movements that of course also impact mutual funds. You should bear in mind that trading in the off-exchange foreign currency market is one of the riskiest forms of trading and you should only invest a small portion of your risk capital in this market.
Most currency transactions involve the "Majors", consisting of the British Pound (GBP), Euro (EUR), Japanese Yen (JPY), Swiss Franc (CHF) and the US Dollar (USD). Whilst these are the key five currencies, the Canadian Dollar (CAD) and the Australian Dollar (AUD) are starting to be considered as additional 'major' currencies.
Currencies in Pairs
The logic for currency pairing, is that if we had a single currency alone, we would have no means to measure its relative value. By pairing two currencies against each other a fluctuating value can be established for one versus the other.
Currency Pairs that do not include the US dollar are commonly referred to as Cross Currency Pairs. Cross Currency trading can open a completely new aspect of the Forex market to speculators. Some cross currencies move very slowly and trend very well. Other cross currency pairs move very quickly and are extremely volatile with daily average movements exceeding 100 pips
When we execute a Forex transaction, we essentially borrow one currency and lend another. This borrowing and lending is like any other banking transaction and therefore subject to interest rates. The interest is referred to as the SWAP rate in the currency markets. The Swap is a credit or debit as a result of daily interest rates. When traders hold positions overnight, they are either credited or debited interest based on the rates at the time.
What is FX Margin?
The Forex market offers its participants the potential to trade on margin. The ability to trade on margin is one of the attractive - but at the same time risky- features of forex trading. Essentially trading on margin allows the forex trader to trade on borrowed funds. The degree to which the trader can borrow will depend on the broker they are using and the leverage or gearing they offer.
In the Forex market the term margin is the amount of money required to open a leveraged position, or a contract in the market.
Without leverage a trader placing a standard lot trade in the market would need to post the full contract value of $100,000 in order to have his or her trade executed. Leverage allows a trader to place the same $100,000 contract for an amount of margin (determined by the set level of leverage). For example, an account at 1:100 leverage would require $1,000 of margin to place a $100,000 trade.
By offering leverage to the trader, the brokerage is essentially allowing the trader to open a contractual position with considerably less initial capital outlay. Without leverage, a trader placing a standard lot trade in the market would need to post the full contract value of $100,000. With a leverage of 1:100, the trader can in fact open the position with an initial leverage of USD $1,000.
Trading Forex on margin should be used wisely as it magnifies both your potential profits and potential losses. Remember, the higher the leverage, the higher the risk.
Forex traders are subject to the margin rules set by their chosen brokers. In order to protect themselves and their traders, brokers in the Forex market set margin requirements and levels at which traders are subject to margin calls. A margin call would occur when a trader is utilizing too much of their available margin. Spread across too many losing trades, an over margined account can give a broker the right to close a trader's open positions. Every trader should be clear on the parameters of their own account, i.e. at what level are they subject to a margin call. Be sure to read the margin agreement in the account application when opening a live account.
Traders should monitor margin balance on a regular basis and use stop-loss orders to limit downside risk. However, due to the extreme volatility that can be found in the Forex market, stop-loss orders are not always an effective measure in limited downside risk. There is still the possibility of losing all, or more, of your original investment.
Every trader should know what level of risk they wish to take. Whilst the attraction of taking on a big position to receive increased profits is quite clear, it should also be noted that a slight movement in the market will result in a much higher loss in an overly leveraged account.
Traders always have the option of applying a lower level of leverage to an account or transaction. Doing so may help manage risk, but bear in mind that a lower level of leverage. will mean that a larger margin deposit will be required in order to control the same size contracts.
Working Example of Margin
To calculate the margin required to execute 1 mini lots of USD/CAD (10,000 USD) at 1:100 leverage in a $500 mini account, simply divide the deal size by the leverage amount e.g. (10,000 / 100 = 100). Therefore, $100 margin will be required to place this trade, leaving an additional $400 marginable balance in the trading account.
Most Forex trading software platforms automatically calculate FX margin requirements and check available funds before allowing a trader to enter a new position.
Free Margin and Used Margin
In the above example we had a $500 account. In order to open the position above we were required to have initial margin of $100. This is referred to as used margin. The remaining $400 is known as the free margin. All things being equal, the free margin is always available to trade upon.
The trading platforms used have become very sophisticated calculating these figures in real time so there is no need to calculate them manually.
Each standard lot traded in the Forex market is a 100,000 (of the base currency) contract. In other words, when trading one lot in a standard account, a trader is essentially placing a $100,000 trade in the market. Without leverage, many investors would not be able to afford such a transaction. Leverage of 1:100 would allow a trader to place the same one lot ($100,000) trade by posting $1,000 in margin.
Many retail Forex brokers also offer the ability to trade mini lots. Mini lots essentially allow the trader to trade one tenth of a standard lot. Trading in this size is often referred to as trading a mini lot. Mini lot contracts are $10,000 (of the base currency). A trade of one mini lot would be a $10,000 trade. Trading with 1:100 leverage would mean that $100 of margin would control a $10,000 contract.
Here at ECNOptions we have also introduced the Micro account offering 1:1000 leverage and a minimum trade size of 1 micro lot or $1,000.