What is Forex (FX) trading?

Foreign exchange or Forex trading is the simultaneous buying of one currency and selling of another and involves trading currencies from different countries against each other.  Currencies are quoted in pairs and you can choose a currency pair that you expect to change in value and place a trade accordingly speculating on the changes in the relative prices between the currencies.  When one currency in the pair increases in value, it strengthens against the other.

With currency pairs, the buy price is quite often referred to as the “base currency” and the sell price is referred to as the “quote currency”. In any price quote, the figure tells you how much you would receive of the quote currency for one unit of the base currency. For example, a quotation of “EUR/USD 1.36568” means that one Euro is exchanged for 1.36568 US dollars.

Price quote

FX – the largest & most liquid of the world’s financial markets

Foreign Exchange is a truly 24 hour marketplace making it an attractive and the most traded financial market in the world.  Unlike other financial markets, investors can respond immediately to currency fluctuations, whenever they occur - day or night.  This therefore makes it an ideal part of any trader’s portfolio.

Despite the market’s relative size and liquidity, Forex trading remains a challenge to many private traders.  This is perhaps because they perceive Forex trading to be available only to large institutional players. However, this is not the case as currency trading has become increasingly accessible to (and popular with) individual traders due to the widespread availability of online trading platforms.

Who takes part in Foreign exchange trading?

Daily turnover in the world's currencies comes from two sources:

•    Foreign trade (5%) - companies buy and sell products in foreign countries, plus convert profits from foreign sales into domestic currency.

•    Speculation - for profit (95%).

Most traders focus on the biggest, most liquid currency pairs.  The top 5 most traded currencies (“the majors”) include:
 
Types of currency

1) US dollar (USD)
2) Euro (EUR)
3) Japanese yen (JPY)
4) British pound (GBP)
5) Swiss franc (CHF)

In fact, more than 85% of daily Forex trading happens in the major currency pairs.


Benefits of Forex trading:

1)    Leverage - Forex is traded on margin, typically 2% or quite often referred to as 50:1 leverage.  Trading on margin can be a more efficient use of your capital because you only have to allocate a very small proportion of the value of your position to secure a trade, while maintaining full exposure to the market.
For example, with $1,000 as initial margin, you could open up a $50,000 currency trading position.  It is important to remember though that markets can move against you and losses can exceed your initial deposit.

2)    24 hour market - Forex is an over-the-counter (OTC) market which means trades do not take place through a centralised exchange.  Therefore currency trading takes place around the world, whenever the markets are open.  Unlike any other financial market, investors can respond to currency fluctuations caused by economic, political and social events as they occur, without having to wait for markets to open.

3)    Liquidity - the currency market is the most heavily traded financial market in the world, with a daily average turnover of well over US$4 trillion.  With so many market participants trading over 24 hours, the currency markets are more liquid than any other financial market.
So, if you trade a particular currency pair, whether it is for a $1,000 trade or a $10,000 trade, you will typically receive the same quoted price, which may not be the case in less liquid markets, such as the share market.

4)    No one is in control - the currency markets are so large that they are beyond the financial control of any individual participant.  Even central banks, which may intervene heavily to influence the short-term direction of a currency, will not find it an easy task to control the underlying trend in their own currency.

Currency Trade Example

The Bank of England is meeting in a few days and you feel they may increase their interest rates due to current inflationary pressure. As such you think the pound will strengthen on the back of this as it becomes more attractive due to its higher interest potential.

Trade example
 
•    Enter Trade: In this quote panel the price of 1 British Pound (GBP) is equivalent to 1.59883 Australian Dollars (AUD). You therefore decide to buy £5,000 and in doing so simultaneously sell AUD 7,994.15.

•    Deposit: Using maximum leverage of 2% you will only need to deposit £100 (£5,000 x 2% = £100) to take out this position. Please be aware that using margin means you can lose more than your initial deposit. The CFD trading software at CMC Markets will automatically convert this into the equivalent amount in Singapore dollars using the current spot rate between SGD and GBP. Therefore your deposit will be around SGD 198 (100 x 1.9800 - GBP/SGD rate).

•    Interest Cost: If you hold the position past 17:00 New York time your account will be debited or credited at the prevailing rate. If you have bought a higher yielding currency you will generally receive interest, if you have bought a lower yielding currency you will generally be charged interest.

•    Close out Trade: The Bank of England do indeed raise interest rates and GBP strengthens against the AUD to 1.65000 and you decide to sell to take your profit. Simply click the close out X in the accounts menu and this will automatically close out the trade by selling £5,000 and buying back AUD 8,250 (5,000 x 1.65000 = AUD 8,250)

•    Profit Scenario: Your initial AUD 7,994.15 has now turned into AUD 8,250, meaning you have made a profit of AUD 255.85. The Next Generation software will automatically convert this for you at the prevailing rate so your overall profit in Singapore dollars is approximately SGD 330.56 (AUD 255.85 x 1.29200 AUD/SGD rate). To make it even easier when your trade is live, the Positions tab under Accounts Summary will always show you your profits in your local currency.

•    Loss Scenario: If the pound had decreased in value due to there being no interest rate rise for example, and the value of the GBP/AUD fell to 1.55000, by closing the position you would only been able to buy back AUD 7,750 (5000 x 1.55000 GDP/AUD rate) meaning a loss of AUD 244.15 or SGD 315.44 (AUD 244.15 x 1.29200 AUD/SGD rate)

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