common questions about currency trading

Common Questions About Currency Trading
by Boris Schlossberg

Although forex is the largest financial market in the world, it is relatively unfamiliar terrain to retail
traders. Until the popularization of internet trading a few years ago, FX was primarily the domain of
large financial institutions, multinational corporations and secretive hedge funds. But times have
changed, and individual investors are hungry for information on this fascinating market. Whether
you are an FX novice or just need a refresher course on the basics of currency trading, read on to
find the answers to the most frequently asked questions about the forex market.
How does this market differ from other markets?
Unlike the trading of stocks, futures or options, currency trading does not take place on a regulated
exchange. It is not controlled by any central governing body, there are no clearing houses to
guarantee the trades and there is no arbitration panel to adjudicate disputes. All members trade
with each other based upon 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 must seem bewildering to investors who are used to
structured exchanges such as the NYSE or CME. (To learn more, see Getting To Know Stock
Exchanges.) However, this arrangement works exceedingly well in practice: because participants in
FX must both compete and cooperate with each other, self regulation provides very effective control
over the market. Furthermore, reputable retail FX dealers in the United States become members of
the National Futures Association (NFA), and by doing so they agree to binding arbitration in the
event of any dispute. Therefore, it is critical that any retail customer who contemplates trading
currencies do so only through an NFA member firm.
The FX market is different from other markets in some other key ways that are sure to raise
eyebrows. Think that the EUR/USD is going to spiral downward? Feel free to 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); so, in theory, you could sell $100 billion worth of currency if you had the
capital to do it. If your biggest Japanese client, who also happens to golf with Toshihiko Fukui, the
Governor of the Bank of Japan, told you on the golf course that BOJ is planning to raise rates at its
next meeting, you could go right ahead and buy as much yen as you like. No one will ever prosecute
you for insider trading should your bet pay off. There is no such thing as insider trading in FX; in fact,
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, we should note that
this is the most liquid and fluid market in the world. It trades 24 hours a day, from 5pm EST Sunday
to 4pm EST Friday, and it rarely has any gaps in price. Its sheer size (it trades nearly US$2 trillion each
day) and scope (from Asia to Europe to North America) makes the currency market the most
accessible market in the world.
Where is the commission in FX?
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 as per the
customer's instructions. For providing this service, the broker is paid a commission when the
customer buys and sells the tradable instrument. (For further reading, see our Brokers And Online
Trading tutorial.)
The FX market does not have commissions. Unlike exchange-based markets, FX is a principals-only
market. FX firms are dealers, not brokers. This is a critical distinction that all investors must
understand. 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 bidask
spread.
In FX, the investor cannot attempt to buy on the bid or sell at the offer like 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 gain 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. (To
learn more, see Scalping: Small Quick Profits Can Add Up.)
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. Because the Japanese yen has never
been revalued since the Second World War, 1 yen is now worth approximately US$0.08; 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).
What are you really selling or buying in the currency market?
The short answer is "nothing". The retail FX market is purely a speculative market. No physical
exchange of currencies ever takes place. All trades exist simply as computer entries and are netted
out depending on market price. For dollar-denominated accounts, all profits or losses are calculated
in dollars and recorded as such on the trader's account.
The primary reason the FX market exists is to facilitate the exchange of one currency into another
for multinational corporations who need to trade currencies continually (for example, for payroll,
payment for costs of goods and services from foreign vendors, and merger and acquisition activity).
However, these day-to-day corporate needs comprise only about 20% of the market volume. Fully
80% of trades in the currency market are speculative in nature, put on by large financial institutions,
multi-billion dollar hedge funds and even individuals who want to express their opinions on the
economic and geopolitical events of the day.
Because currencies always trade in pairs, when a trader makes a trade he or she 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, she would, in essence, have exchanged euros for dollars and would now be
"short" euro and "long" dollars. To better understand this dynamic, let's use a concrete example. If
you went into an electronics store and purchased a computer for $1,000, what would you be doing?
You would be exchanging your dollars for a computer. You would basically be "short" $1,000 and
"long" 1 computer. The store would be "long" $1,000 but now "short" 1 computer in its inventory.
The exact 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.
Which currencies are traded?
Although some retail dealers trade exotic currencies such as the Thai baht or the Czech koruna, the
majority 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)
and the three commodity pairs:
* AUD/USD (Australian dollar/dollar)
* USD/CAD (dollar/Canadian dollar)
* NZD/USD (New Zealand dollar/dollar)
These currency pairs, along with their various combinations (such as EUR/JPY, GBP/JPY and
EUR/GBP) account for more than 95% of all speculative trading in FX. Given the small number of
trading instruments - only 18 pairs and crosses are actively traded - the FX market is far more
concentrated than the stock market.
What is carry?
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 rests on the fact that every currency in the world
has an interest rate attached to it. These short-term interest rates are set by the central banks of
these countries: the Federal Reserve in the U.S., the Bank of Japan in Japan and the Bank of England
in the U.K. (To learn more, see What Are Central Banks?)
The idea behind the carry is quite straightforward. The trader goes long the currency with a high
interest rate and finances that purchase with a currency with a low interest rate. 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, has seen its rates rise to 7.25% and stay there (at the
time of writing), while Japanese rates have remained at 0%. A trader going long 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 alone without any
contribution from capital appreciation. Now you can understand why the carry trade is so popular!
But before you rush out and buy the next high-yield pair, be aware that when the carry trade is
unwound, the declines can be rapid and severe. This process is known as carry trade liquidation and
occurs when the majority of speculators decide that the carry trade may not have future potential.
With every trader seeking to exit his or her position at once, bids disappear and the profits from
interest rate differentials are not nearly enough to offset the capital losses. Anticipation is the key to
success: the best time to position in the carry is at the beginning of the rate-tightening cycle,
allowing the trader to ride the move as interest rate differentials increase.
FX Jargon
Every discipline has its own jargon, and the currency market is no different. Here are some terms to
know that will make you sound like a seasoned currency trader:
* Cable, sterling, pound - alternative names 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 like 1.2000
* Yard - a billion units, as in "I sold a couple of yards of sterling."
To learn more about FX trading, see A Primer On The Forex Market, Getting Started In Forex and
Demo Before You Dive In.
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by Boris Schlossberg