Although forex (FX) is the largest financial market in the world, it is relatively unfamiliar terrain for retail traders. Until the popularization of internet trading, FX was primarily the domain of large financial institutions, multinational corporations, and hedge funds. However, times have changed, and individual retail traders are now hungry for information on forex.
Whether you are an FX novice or just need a refresher course on the basics of currency trading, here are the answers to some of the most frequently asked questions concerning the FX market.
- Currency trading is based on credit agreements, which are nothing more than a metaphorical handshake.
- FX trading is self-regulated because participants must both compete and cooperate.
- There is no uptick rule in FX as there is in stocks. Unlike futures, there are no limits on the size of a trader's position.
- FX traders typically use a broker who charges commission fees.
- A pip is a percentage point and is the smallest increment in an FX trade.
Top 5 Questions About Currency Trading Answered
1. How Does Forex Compare to Other Markets?
Unlike stocks, futures, or options, currency trading does not take place on a regulated exchange, and it is not controlled by any central governing body. There are no clearing houses to guarantee trades, and there is no arbitration panel to adjudicate disputes. All members trade with each other based on credit agreements. Essentially, business in the largest, most liquid market in the world depends on nothing more than a metaphorical handshake.
At first glance, this ad-hoc arrangement is bewildering to investors who are used to structured exchanges such as the New York Stock Exchange (NYSE) or the Chicago Mercantile Exchange (CME). However, this arrangement works in practice. Self-regulation provides effective control over the market because participants in FX must both compete and cooperate.
Additionally, reputable retail FX dealers in the United States become members of the National Futures Association (NFA), and by doing so, FX dealers agree to binding arbitration in the event of any dispute. Therefore, it is critical that any retail customer who contemplates trading currencies does so only through an NFA member firm.
The FX market is different from other markets in other unique ways. Traders who think that the EUR/USD might spiral downward can short the pair at will. There is no uptick rule in FX as there is in stocks. There are also no limits on the size of your position (as there are in futures). Thus, in theory, a trader could sell $100 billion worth of currency if they have sufficient capital.
In another context, a trader is free to act on information in a way that would be considered insider trading in traditional markets. For example, a trader finds out from a client who happens to know the governor of the Bank of Japan (BOJ) that the BOJ is planning to raise rates at its next meeting; the trader is free to buy as much yen as they can. There is no such thing as insider trading in FX—European economic data, such as German employment figures, are often leaked days before they are officially released.
Before we leave you with the impression that FX is the Wild West of finance, note that this is the most liquid and fluid market in the world. It trades 24 hours a day, from 5 p.m. EST Sunday to 4 p.m. EST Friday, and it rarely has any gaps in price. Its sheer size and scope (from Asia to Europe to North America) make the currency market the most accessible in the world.
The forex market is a 24-hour market producing substantial data that can be used to gauge future price movements. It is the perfect market for traders that use technical tools.
2. What Is the Forex Commission?
Investors who trade stocks, futures, or options typically use a broker who acts as an agent in the transaction. The broker takes the order to an exchange and attempts to execute it per the customer's instructions. The broker is paid a commission when the customer buys and sells the tradable instrument for providing this service.
The FX market does not have commissions. Unlike exchange-based markets, FX is a principals-only market. FX firms are dealers, not brokers. Unlike brokers, dealers assume market risk by serving as a counterparty to the investor's trade. They do not charge commission; instead, they make their money through the bid-ask spread.
In FX, the investor cannot attempt to buy on the bid or sell at the offer as is the case in exchange-based markets. On the other hand, once the price clears the cost of the spread, there are no additional fees or commissions. Every single penny gained is pure profit to the investor. Nevertheless, the fact that traders must always overcome the bid/ask spread makes scalping much more difficult in FX.
3. What Is a Pip?
Pip stands for percentage in point and is the smallest increment of trade in FX. In the FX market, prices are quoted to the fourth decimal point. For example, if a bar of soap in the drugstore was priced at $1.20, in the FX market the same bar of soap would be quoted at 1.2000. The change in that fourth decimal point is called 1 pip and is typically equal to 1/100th of 1%.
Among the major currencies, the only exception to that rule is the Japanese yen. One dollar is worth approximately 100 Japanese yen; so, in the USD/JPY pair, the quotation is only taken out to two decimal points (i.e., to 1/100th of yen, as opposed to 1/1000th with other major currencies).
4. What Are You Really Trading?
FX traders hope to profit from changes in exchange rates between currency pairs. For dollar-denominated accounts, all profits or losses are calculated in dollars and recorded as such on the trader's account.
The FX market exists to help with the exchange of one currency into another, a facility used by multinational corporations that need to continually trade currencies (i.e., for payroll, payment for goods and services from foreign vendors, and mergers and acquisitions). Financial institutions use the forex markets to hedge positions and take directional bets on currency pairs based on fundamental research and technical analysis. Individual traders may also trade currencies to speculate on exchange rate moves.
Since currencies always trade in pairs, when a trader makes a trade, that trader is always long one currency and short the other. For example, if a trader sells one standard lot (equivalent to 100,000 units) of EUR/USD, they would have exchanged euros for dollars and would now be short euros and long dollars.
To better understand this dynamic, an individual who purchases a computer from an electronics store for $1,000 is exchanging dollars for a computer. That individual is short $1,000 and long one computer. The store would be long $1,000, but now short one computer in its inventory. The same principle applies to the FX market, except that no physical exchange takes place. While all transactions are simply computer entries, the consequences are no less real. If demand for this computer increases, the individual could sell the computer for a higher amount, say $1,100, booking a $100 profit.
5. What Currencies Trade in Forex?
Although some retail dealers trade exotic currencies such as the Thai baht or the Czech koruna, the majority of dealers trade the seven most liquid currency pairs in the world, which are the four "majors":
- EUR/USD (euro/dollar)
- USD/JPY (dollar/Japanese yen)
- GBP/USD (British pound/dollar)
- USD/CHF (dollar/Swiss franc).
The three commodity pairs are also traded:
- AUD/USD (Australian dollar/dollar)
- USD/CAD (dollar/Canadian dollar)
- NZD/USD (New Zealand dollar/dollar)
These seven major currency pairs account for about 80% of all speculative trading in FX. Given the small number of trading instruments—over 50 pairs and crosses are actively traded—the FX market is far more concentrated than the stock market.
6. What Is a Currency Carry Trade?
Carry is the most popular trade in the currency market, practiced by both the largest hedge funds and the smallest retail speculators. The carry trade is based on the fact that every currency in the world has an associated interest. These short-term interest rates are set by the central banks of these countries: the Federal Reserve in the United States, the Bank of Japan in Japan, and the Bank of England in the United Kingdom.
The concept of "carry" is straightforward. The trader goes long on the currency with a high interest rate and finances that purchase with a currency that has a low interest rate. For example, in 2005, one of the best pairings was the NZD/JPY cross. The New Zealand economy, spurred by huge commodity demand from China and a hot housing market, saw its rates rise to 7.25% and stay there while Japanese rates remained at 0%. A trader going long on the NZD/JPY could have harvested 725 basis points in yield alone. On a 10:1 leverage basis, the carry trade in NZD/JPY could have produced a 72.5% annual return from interest rate differentials without any contribution from capital appreciation. This example illustrates why the carry trade is so popular.
Before rushing out in pursuit of the next high-yield pair, however, be advised that when the carry trade is unwound, the declines can be rapid and severe. This process is known as the currency carry trade liquidation and occurs when the majority of speculators decide that the carry trade may not have future potential.
For every trader seeking to exit their position at once, bids disappear, and the profits from interest rate differentials are not nearly enough to offset capital losses. Anticipation is the key to success: the best time to position the carry is at the beginning of the rate-tightening cycle allowing the trader to ride the move as interest rate differentials increase.
Other Forex Jargon
Every discipline has its jargon, and the currency market is no different. Here are some terms that a seasoned currency trader should know:
- Cable, sterling, pound: nicknames for the GBP
- Greenback, buck: nicknames for the U.S. dollar
- Swissie: nickname for the Swiss franc
- Aussie: nickname for the Australian dollar
- Kiwi: nickname for the New Zealand dollar
- Loonie, the little dollar: nicknames for the Canadian dollar
- Figure: FX term connoting a round number such as 1.2000
- Yard: a billion units, as in "I sold a couple of yards of sterling."
The Bottom Line
Forex can be a profitable, yet volatile, trading strategy for both inexperienced and experienced investors. While accessing the market—through a broker, for instance—is easier than ever before, the answers to the above six questions will serve as a valuable primer for those diving into FX trading.