If you have been interested in trading for any time, you have probably got on the e-mail lists of some Forex brokers. Traders are attracted by the fact that the foreign exchange market is a very liquid market and is open throughout a day. This can make it an attractive market to deal for a part-time online trader who logs on after work. According to a BIS Triennial Survey last year, the average daily turnover on the Forex markets is US$4 trillion, with one third of the activity happening during UK trading hours.
Margin trading means that traders can trade large positions with a relatively small amount of capital. Forex gives you great leverage of your money, controlling lots of 100,000 units of currency in the standard form, or mini-contract size of 10,000 units designed for private traders, with little margin needed to open a position. But you can also trade in currency from your standard CFD account, which saves you having to open several accounts at different dealers.
A forex pair is one currency compared to another such as the Euro against the American dollar. The main forex pairs start with the US dollar followed by the euro, the Japanese yen, the British pound and more recently the Canadian dollar. Most activity in currencies involves one or more of these pairs. A forex pair is divided into a primary or base currency, the one that is listed first in any pair, with the secondary, or terms currency, listed second. As with conventional Forex trading, there is always a bull market – and a bear market for that matter – as you have a choice of which currency you think will increase against the other. There is no problem, as there can be with trading shares, in taking a ‘short’ position as one side of the currency pair is always short in your trade.
The reason they are described as forex pairs is because buying an Euro/US dollar contract is the equivalent of buying (or going long) in the Euro primary currency and selling (or going short) in the secondary or terms currency, the US dollar.
Traders in forex can go both long and short which allows them to take advantage of all market movements, irrespective of whether the prices of forex pairs are going up or down. When you trade Forex using CFDs, the situation is quite clear – the base price is the price when you buy the CFD, which can be bought in convenient sizes. This is your reference price and your profit or loss has a direct connection to this starting point. Like other CFDs, foreign exchange contracts are traded on margin with the most common deposit that secures a trade amounting to just 1% of the base currency value (the rest is a margin loan). This means trades require only a small initial outlay giving you exceptional profit potential, although it also means traders need to be aware an adverse move can make a big dent in this margin and land you into trouble equally quickly. You may also find that the spread, that is the difference between the buying price and the selling price, is very tight, and this is usually the only charge that you will incur when trading Forex CFDs.
As far as forex trading is concerned, currencies trade in ‘pips’ with a pip representing the minimum movement of the exchange rate. In the case of the Australian dollar against the USA dollar this would be the fourth decimal place. For a CFD trader who buys a 10,000 unit Australian dollar/USA dollar contract if the exchange rate is currently US97c for A$1 he will be long A$10,000 and short $US9,700. Every one pip move up or down in the USA currency (from US97c to US97.01c, for instance) will result to a $US1 profit or loss to the CFD trader.
One point worth noting here is that certain CFD providers also offer micro lots which are trades based on a $1000 contract instead of the more usual $10,000 so ‘every pip in the dollar has 10¢ at risk instead of $1’. These are great to get familiar to the market withotu risking big amounts so you get an idea of trading a leverage product.
Let’s take another example involving the US dollar exchange rate (EUR/USD). In the foreign exchange market, CFD contracts trade per one percentage in point (pip) change – this is the fourth decimal place of a foreign exchange rate. At IG the full EUR/USD contracts for difference contract has a value $10 a point, which with the market at €1.25 is equivalent to an exposure of $125,000. Now, on a turbulent trading day this could easily move a couple of hundred points so providers sometimes offer a mini-contract that trades at $2 a point.
Suppose you are interested in trading the euro against the dollar, and think that the euro will fall in value against the US dollar. A trader who sold the EUR/USD contract at £1 per point would gain (or lose) £100 per one cent movement down (up) in the exchange rate. For instance, if the trader opened the trade at 1.2600 and closed it at 1.2500, the profit amount to £100 highlighting the leverage potential. The euro to US dollar exchange rate (EUR/USD) is currently quoted at 1.2542/1.2543, meaning that a euro is worth about $1.25 – a euro would buy $1.2542, but you would have to pay $1.2543 for each euro that you bought. Given your position on the euro, you want to sell the contract, effectively shorting the euro, which you can do at a price of $1.2542. Taking a value of €10,000, which is called a mini contract in Forex jargon, the contract value would be $12,542, and your margin to trade this at say 1% is $125.42, which you should have deposited in your account.
In the foreign exchange market, CFD contracts trade per one percentage in point (pip) change – this represents the fourth decimal place of a foreign exchange rate. Aan trader who thought that the EUR was looking weak against the dollar would sell the EUR/USD contract. Selling the contract at £1 per point would gain (or lose as the case may be) £100 per one cent movement down (up) in the exchange rate. For example, if they opened the trade at 1.2500 and closed it at 1.2400, the profit is £100. This highlights the leveraged nature of CFD products.
Now there will be some small interest adjustments while you are holding the position, but the main changes in value will be due to the currency fluctuations. If the rate of exchange goes against you, you may get a margin call, which would require you to deposit more money or be involuntarily stopped out of the position. But assume that the trade goes the way you plan, to a quoted price of 1.2236/1.2237 for the sake of example. You would take an opposite trade to exit the position, buying euros at $1.2237. The contract value to close would be $12,237, giving you a difference of $305, less any minor interest payments.
On Monday May 10 2010 the British pound started the day relatively strong against the dollar, but the day would turn into one of the most turbulent days in British political history. Analysts concluded that, against the backdrop of political turmoil a couple of events had bolstered the pound.
The $975 billion support package as agreed by the European Union and the International Monetary Fund to guarantee that the problems in Greece would not spread throughout the euro zone had a positive affect on the pound. So too the Bank of England’s decision to keep the key interest rate and the quantitative easing programme as they are. The latter would have calmed traders, reminding them that not all key monetary policy decisions in the UK are decided by the government.
At one point the rising pound was worth $1.502. However, when we reached the halfway point of the US trading day, the British PM Gordon Brown announced his willingness to step down as leader of the Labour party. Certain commentators argued that this was evidence that a pact between Labour and the Liberal Democrats was becoming a distinct possibility, and many not only fear that such a coalition would be short-lived but also that the tough measures that are required to cut the UK’s budget deficit would not be carried out.
What most people agreed on was that the process of getting a working government in the UK was becoming increasingly protracted. Sterling would fall back to trade around $1.485 as currency traders voted with their fears. It will be interesting to watch what happens to sterling and the UK as the political landscape continues to shift around.
When trading currencies, forex traders must be aware of the basic principles, such as how much each pip movement is worth on a given trade. Apart from that the main considerations for a forex trader is anything that will have an impact on interest rates, which could relate to news about employment figures, inflation and the strength of economic activity. It boils down to any market news that highlights the relative strength or weakness of the currency of one country against another.
The biggest moves in the forex markets tend to occur after key data briefings such as the UK jobless rate, USA non-farm payroll numbers and interest-rate meetings for the central bank. Note also that the most liquid part of a trading session runs from 8am to 8pm (Monday to Friday, UK time), particularly in the first few hours of the London-New York exchanges overlap when most banks, insitutions and traders are active and market data is flowing from both Europe and the USA. This is naturally the easiest and cheapest time to trade.
One thing to note is that currencies are prone to governments manipulation; for instance recently we have witnessed governments trying to weaken their currencies to suit their economic needs i.e. designed to achieve a competitive advantage by either weaking their currency or preventing the appreciation of an undervalued currency. The move by Japan sometime ago to sell a reported ¥2 trillion was a good example of this manipulation. A strong currency represents a substantial risk to exports, which are seen to be more expensive and consequently such countries struggle to export successfully. The problem is particularly exasperated by China which has been criticised in recent years of artificially keeping its currency weak which has forced Japan and other big exporting countries to look into devaluing their home currencies to boost exports. In fact many nations now consider the act of weakening their currencies as an instrument to help economic recovery.