Forex Trading Basics
The global
foreign exchange market is the biggest market in the
world. The USD 1.2 trillion daily turnover dwarfs the
combined turnover of all the world's stock and bond
markets.
There are many reasons
for the popularity of foreign exchange trading, but among
the most important are the leverage available, the high
liquidity 24 hours a day and the very low dealing costs
associated with trading.
Of course many commercial
organizations participate purely due to the currency
exposures created by their import and export activities,
but the main part of the turnover is accounted for by
financial institutions. Investing in foreign exchange
remains predominantly the domain of the big professional
players in the market - funds, banks and brokers.
Nevertheless, any investor with the necessary knowledge of
the market's functions can benefit from the advantages
stated above.
Foreign exchange is
normally traded on margin. A relatively small deposit can
control much larger positions in the market. For trading
the main currencies, SaxoBank requires a 1% margin
deposit. This means that in order to trade one million
dollars, you need to place just USD 10,000 by way of
security.
In other words, you will
have obtained a gearing of up to 100 times. This means
that a change of, say 2%, in the underlying value of your
trade will result in a 200% profit or loss on your
deposit. See below for specific examples. As you can see,
this calls for a very disciplined approach to trading as
both profit opportunities and potential risks are very
large indeed. Please refer to our page
Forex Rates & Conditions for current Spreads, Margins
and Conditions!
When you trade, you will
always trade a combination of two currencies. For example,
you will buy US dollars and sell Euro. Or buy Euro and
sell Japanese yen, or any other combination of dozens of
widely traded currencies. But there is always a long
(bought) and a short (sold) side to a trade, which means
that you are speculating on the prospect of one of the
currencies strengthening in relation to the other.
The trade currency is
normally, but not always, the currency with the highest
value. When trading US dollars against German marks, the
normal way to trade is buying or selling a fixed amount of
US dollars, i.e. USD 1,000,000. When closing the position,
the opposite trade is done, again USD 1,000,000. The
profit or loss will be apparent in the change of the
amount of Euro credited and debited for the two
transactions. In other words, your profit or loss will be
denominated in Euro, which is known as the price currency.
As part of our service, Saxo Bank will automatically
exchange your profits and losses into your base currency
if you require this.
This way of trading is
different to the futures markets, for example, where the
marks, francs and yen are the fixed trade currency,
resulting in a US dollar denominated profit or loss. You
can, however, also choose to trade in this reciprocal
manner in foreign exchange markets but it is not the norm.
When trading foreign
exchange, you are quoted a dealing spread offering you a
buying and a selling level for your trade. Once you accept
the offered price and receive confirmation from our
dealers, the trade is done. There is no need to call an
exchange floor. There are no other time-consuming delays.
This is possible due to live streaming prices, which are
also a great advantage in times of fast-moving markets:
You can see where the market is trading and you know
whether your orders are filled or not.
The dealing spread is
typically 3-5 points in normal market conditions, e.g. USD/EUR
1.7780-85. This means that you can sell US dollars against
the Euro at 1.7780 and buy at 1.7785. There are no further
costs, commissions or exchange fees.
This ensures that you can
get in and out of your trades at very low slippage and
many traders are therefore active intra-day traders, given
that a typical day in USD/EUR presents price swings of
150-200 points.
When you trade foreign
exchange you are normally quoted a spot price. This means
that if you take no further steps, your trade will be
settled after two business days. Due to the fact that the
EU investment directive does not presently cover spot
foreign exchange trading we will, however, require you to
swap your trade forward at least another two business
days. This ensures that your trades are undertaken subject
to supervision by regulatory authorities for your own
protection and security. If you are a commercial customer,
you may need to convert the currencies for international
payments. If you are an investor, you will normally want
to swap your trade forward to a later date. This can be
undertaken on a daily basis or for a longer period at a
time. Often investors will swap their trades forward
anywhere from a week or two up to several months depending
on the time frame of the investment.
Although a forward trade
is for a future date, the position can be closed out at
any time - the closing part of the position is then
swapped forward to the same future value date.
Different currencies pay
different interest rates. This is one of the main driving
forces behind foreign exchange trends. It is inherently
attractive to be a buyer of a currency that pays a high
interest rate while being short a currency that has a low
interest rate.
Although such interest
rate differentials may not appear very large, they are of
great significance in a highly leveraged position. For
example, the interest rate differential between the US
dollar and the Japanese yen has been approximately 5% for
several years. In a position that can be supported by a 5%
margin deposit, this results in a 100% profit on capital
per annum when you buy the US dollar. Of course, an even
more important factor normally is the relative value of
the currencies, which changed 15% from low to high during
2005 - disregarding the interest rate differential. From a
pure interest rate differential viewpoint, you have an
advantage of 100% per annum in your favour by being long
US dollar, and an initial disadvantage of the same size by
being short.
Please refer to our page
Forex Rates & Conditions for current Spreads, Margins
and Conditions!
Such a situation clearly
benefits the high interest rate currency and as result,
the US dollar was in a strong bull market all through
2005. But it is by no means a certainty that the currency
with the higher interest rate will be strongest. If the
reason for the high interest rate is runaway inflation,
this may undermine confidence in the currency even more
than the benefits perceived from the high interest rate.
As you can see from the
description above, there are significant opportunities and
risks in foreign exchange markets. Aggressive traders
might experience profit/loss swings of 20-30% daily. This
calls for strict stop-loss policies in positions that are
moving against you.
Fortunately, there are no
daily limits on foreign exchange trading and no
restrictions on trading hours other than the weekend. This
means that there will nearly always be an opportunity to
react to moves in the main currency markets and a low risk
of getting caught without the opportunity of getting out.
Of course, the market can move very fast and a stop-loss
order is by no means a guarantee of getting out at the
desired level.
But the main risk is
really an event over the weekend, where all markets are
closed. This happens from time to time as many important
political events, such as G7 meetings, are normally
scheduled for weekends.
For speculative trading,
we always recommend the placement of protective stop-lossorders.
With Saxo Bank Internet Trading you can easily place and
change such orders while watching market development
graphically on your computer screen.
