FOREX Trading - How it works

Forex Trading Works

On the face of it, there is a lot to recommend trading foreign exchange (forex). It is the most liquid market in the world, with total daily trades reaching $1.5 trillion dollars - more than the turnover in shares from every stock market on the planet - and you can trade 24 hours a day.

That immense liquidity keeps bid-offer spreads way lower than for shares - as low as 0.01 per cent for the US dollar/euro, compared with 0.2 per cent for Vodafone, the FTSE's most liquid stock. There is no stamp duty to pay, saving you 0.5 per cent compared with trading UK equities, and usually no broker's commission.

Forex is also the fairest market in the world. There can be no selective disclosures from chief executives eager to curry favour with analysts, and no secret short-selling from directors. The dollar may slide, or the rand may soar, but the risk of an Enron-style meltdown in a major currency is tiny.

The Mechanics

For a more sceptical view on trading forex, you should read Chris Dillow's article on page 15. Here, the focus is on how the market works.

Every currency has a three-letter abbreviation - GBP for sterling, USD for the US dollar etc. And if you are bullish about sterling, you have to decide what other currency you are bearish about because buying sterling requires you to sell another currency, be it the dollar, the euro or the Polish zloty.

So every currency trade can be shortened to a six-letter code, where the first three letters refer to the currency you are buying, and the last three signal the currency to be sold. Trading GBPUSD means buying pounds and selling dollars at the prevailing exchange rate. Trading EURCHF means speculating that the euro will rise against the Swiss franc.

The exchange rate you see quoted refers to how many units of the second currency it takes to buy one unit of the first. For example, the relevant exchange rate for GBPUSD is 1.8854-1.8860 because £1 buys you $1.88. A USDGBP trade would be quoted as 0.5300-0.5306, since it would normally take £0.53 to buy $1. The GBPUSD rate is often called 'cable', since it was via a cable that the rate was first transmitted across the Atlantic in 1866.

Currencies are normally quoted to four decimal places (except the yen, which is quoted to two). So a sample bid-offer spread for USDEUR might be 1.3033-1.3037, which equates to an exchange rate of $1.3035 to E1. Here, the bid-offer spread is 0.0004. The standard way of expressing this spread is to say it is four 'pips' wide (some people use the term 'ticks' instead of pips).

Sport or Forward?

Most private investors are interested in the spot market. Traders move in and out of this market within hours or even seconds. But the forward market is useful for people who want to hedge their currency exposure over the coming weeks or months. Here, you are agreeing to buy/sell a pair of currencies at a specific date in the future.

There are two basic differences between a spot or forward trade. The prices offered will be different, as the forward will factor in interest-rate differentials and the market's consensus on where the currencies are heading. Because the future is less certain than the present, anyone offering you a price on cable in three or six months' time will widen the spread on offer. That way, they build in an extra layer of profit to compensate them for taking on the added risk.

The second big difference between a spot and a forward is that, with a forward trade, you do not have to put up any money until the time of the trade. That enables you to do other things with your capital, while guaranteeing the rate that you will pay for your dollars or euros. Forward hedges are mostly used by businesses wishing to hedge their commercial risk. But they can also be useful for people buying property overseas, or transferring money back to the UK and who want to avoid the risk of big exchange rate swings.

Forward contracts with some brokers are extremely flexible. For example, you can agree to convert £300,000 into euros at today's exchange rate on any day you choose between now and two years' time. Brokers offering such a service include MoneyCorp, HIFX and Foreign Currencies Direct. Your high-street bank would also offer such a service, but probably at far less competitive rates.

Interest Rate Differentials

For traders who want to keep open a position for a few days or weeks, there is a rolling daily market. If you hold open a currency trade overnight, you are both eligible and liable to pay interest. Suppose you have backed sterling against the dollar. To simplify things slightly, you will receive the UK rate of interest on the total value of pounds that you have bought, and must pay the prevailing US interest rate on the dollars you have sold.

There should be no other financing costs, even though you trade on a 1 per cent margin (in effect, borrowing the remaining 99 per cent from someone else).

Your broker will do the maths for you and credit or debit you with the difference. Some brokers will do this by narrowing or widening your spread. For example, you may have bought sterling at 1.8855 against the dollar, but, after holding it for a couple of days, your account will show that you bought it for 1.8853. Others will calculate the credit or debit as a separate item when you close your position.

For a GBPUSD trade, at present, you would make money because UK base rates are higher than in the US. Conversely, if you buy dollars and sell sterling, you would lose money. Besides the bid-offer spread, there is another potential source of currency brokers' profits. Some of them apply a 'haircut' to the interest rate differential. For example, a USDGBP trade left open overnight would, in theory, mean that you had to pay the difference between US rates and UK rates (2.25 - 4.75 = 2.5 per cent). In practice, the exact amount is determined by the market and may fluctuate slightly (the rate is sometimes called the 'tom/next' rate, short for tomorrow/next day).

But a broker might load 50 basis points onto each side, to make the rate that you pay not 2.5 per cent, but 3.5 per cent. For a 100,000 USDGBP contract, that would equate to around £5 for each night that you held open your position (bear in mind that the global trading 'day' closes at 10.00pm UK time).

Paul Hare, at City Index, points out to any would-be currency speculator that it is not just the spread that counts. If you intend to hold open a position for days or even weeks, he recommends having a good look at the tom/next rate. For GBPUSD, holding open the position for one day should improve the price at which you 'bought' by around 1.1 pips, provided that your broker deducts nothing and gives you market rates.

Depending on the broker, though, that 1.1-pip improvement could be nibbled away to a 0.6-pip improvement each day. It only takes two days for that difference to turn into a 1-pip deficit, so beware brokers that advertise tight spreads only to make up the difference by undercompensating you on the interest rates. Some spread-betters pay out nothing at all (Click here for a table of Forex Who's Who).

Trading on Margin

Some currency accounts will offer margin trading as low as 0.5 per cent, but 1 per cent is more usual. With that kind of margin, your initial deposit for a £100,000-trade would be between £500 and £1,000. The table above summarises how a GBPUSD trade would turn out if the exchange rate nudged up or down by 0.6 per cent (using an example from Hargreaves Lansdown).

Margin Calls

If you trade on a 1 or 2 per cent margin, and you are speculating on forex, it's only a matter of time before the markets against you. When that happens, you may receive a margin call. This is usually a telephone call from your broker asking you to top up your funds. At its simplest, imagine you open an account with a currency broker. You will be asked to leave some cash on deposit, say £2,000. At the start, that is your net equity. Once you start to trade, though, that will rapidly change.

Suppose that you have invested £500 in selling the dollar against the sterling, and £500 in buying the euro against sterling. Your GBPUSD trade may be showing a $500 profit, but the EURGBP trade may be down by £800. The broker will keep track of your net position, in pounds. In this case, your current loss would be £500 in the red. Compared with your £2,000 starting position, your net equity is now £1,500, and the margin you have invested is £1,000 (two trades of £500).

Under those circumstances, you would not get a margin call. The ratio of margin invested to net equity is £1,000 to £1,500, or 66.7 per cent. If you opened another £500 position, though, or if your net equity fell below £1,000, the ratio would move above 100 per cent.

You might face the choice of closing your position, or keeping it open by paying in more money. Each spread-better, contracts for difference (CFD) broker or forex market maker will have a different policy on when and how to make margin calls (see How to form hunches). Some try to avoid margin calls by creating automatic stop-losses, while others take a client-by-client approach.

You do not have to trade on 1 per cent margin, though. Some brokers set levels of 2.5 or 5 per cent, and the total amount at risk is always up to you. Just remember what trading on a 1 per cent margin means. It only takes a 1 per cent movement in the wrong direction to wipe out your stake.

To see how common such movements are on the forex markets, we looked at daily percentage movements in the GBPUSD and USDEUR rates (left). Since the beginning of last year, sterling rose or fell by more than 1 per cent on 32 trading days (out of a total of 279). That's over 11 per cent of the time.

The average investor will be right half of the time, suggesting that on 5.5 per cent of trading days, he will be wrong. Put differently, you have a one in 18 chance of losing your entire stake when trading on a 1 per cent margin on the GBPUSD exchange rate (that's roughly once a month for active day traders, see charts below).

The US dollar against the euro is even more volatile. On some 14 per cent of trading days, the exchange rate moved by more than 1 per cent, giving you a 7 per cent chance of betting in the wrong direction on any given day, and of being more than 1 per cent wrong (hence, losing all your initial stake when trading on a 1 per cent margin). On 2 March 2004, the euro fell 2 per cent in a single day.

These figures only refer to opening and closing prices. If you take into account intra-day volatility, the price variations would be even higher. And if you trade on a stop-loss, your broker is within his right to use the highest (or lowest) trade of the day to close your position and crystallise any losses.

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