Currency Trading 6 Questions

Currency trading is a 24-hour market that is only closed from Friday to Sunday, however, the 24-hour trading sessions are deceiving. The European, Asian, and American trading sessions are the three trading sessions.

Although some sessions overlap, the main currencies in each market are traded mostly during certain market hours. This means that during certain sessions, certain currency pairs will have more volume. Traders that stick to dollar-based pairs will see the maximum volume during the U.S. trading day.

Despite the fact that forex (FX) is the world’s largest financial market, it is relatively uncharted territory for ordinary traders. FX was primarily the domain of huge financial institutions, multinational enterprises, and hedge funds before the widespread use of online trading. However, circumstances have changed, and individual retail traders now have a voracious appetite for currency knowledge.

Here are the answers to some of the most frequently asked questions about the foreign exchange market, whether you’re a beginner or just need a refresher course on the fundamentals of currency trading.

Credit agreements, which are little more than a figurative handshake, are the foundation of currency trading.  Because players must both compete and cooperate, FX trading is self-regulated.  In FX, unlike stocks, there is no uptick rule. There are no constraints on the size of a trader’s position in forex, unlike futures. FX traders almost always employ a commission-based broker.  The smallest increment in an FX exchange is a pip, which is a percentage point.

Answers to the Top 6 Currency Trading Questions

What Are the Differences Between Forex and Other Markets?

Of course, the most significant distinction between forex and the stock market is what you are trading. The stock market deals in shares, which are units of ownership in a firm, whereas forex, or foreign exchange, is a marketplace for buying and selling currencies.

The scale of the forex market is one of the most significant distinctions between forex and equities. The EUR/USD, USD/JPY, GBP/USD, and AUD/USD are just a few of the major currency pairings that trade on a daily basis. The volume of the forex market eclipses the total dollar volume of all global stock exchanges, which is almost $200 billion every day on average. 

Having such a big trading volume can provide traders with numerous benefits. Because of the high volume, dealers can usually get their orders completed more quickly and at the pricing they want. While gaps exist in all markets, having more liquidity at each pricing point allows traders to better join and leave the market.

Currency trading, unlike stocks, futures, or options, is not conducted on a regulated exchange and is not regulated by any central authority. There are no clearing houses to ensure deals, and no arbitration panel to resolve disagreements. On the basis of credit agreements, all members trade with one another. In essence, business in the world’s largest and most liquid market is based solely on a figurative handshake.

Investors who are used to structured exchanges such as the New York Stock Exchange (NYSE) or the Chicago Mercantile Exchange may find this ad hoc setup perplexing at first (CME). In practice, though, this arrangement works. Because FX players must both compete and cooperate, self-regulation enables effective market control.

Furthermore, reputable retail foreign exchange dealers in the United States join the National Futures Association (NFA), agreeing to binding arbitration in the event of a disagreement. As a result, any retail consumer considering trading currencies should do so only through an NFA member firm.

In other aspects, the FX market is distinct from other markets. Traders who believe the EUR/USD will continue to fall can short the pair at any time. In FX, unlike stocks, there is no uptick rule. In addition, there are no restrictions on the size of your position (as there are in future). If a trader has enough capital, he or she could theoretically sell $100 billion worth of currency.

A trader is free to act on knowledge in ways that would be considered insider trading in regular markets in another environment. If a trader learns via a client who knows the governor of the Bank of Japan (BOJ) that the BOJ intends to hike rates at its next meeting, the trader is free to purchase as much yen as they like. Insider trading is illegal in the forex market, yet European economic data, such as German job figures, is sometimes leaked days before they are officially disclosed.

Before you get the notion that foreign exchange is the Wild West of finance, keep in mind that it is the world’s most liquid and fluid market. It is open for business 24 hours a day, from 5 p.m. EST Sunday to 4 p.m. EST Friday, and there are very little pricing gaps. 2 The currency market is the most accessible in the world due to its sheer size and spread (from Asia to Europe to North America).

What Is the Forex Commission and How Does It Work?

An FX broker’s foreign-exchange commission is part of the cost of completing foreign currency transactions. Brokers are middlemen that strive to match their clients’ purchase and sell orders with those of other clients. They can offer very tight spreads because they have established relationships with liquidity suppliers.

Brokers impose fixed foreign exchange commissions to compensate for the tight spreads. If a broker charges 50% of a pip spread, it can also charge a set EUR 6 commission for each standard lot of EUR 100,000 bought and sold. So a EUR 100,000 buy-and-sell trade would net the broker EUR 17. Still, this is a bargain compared to the EUR 30 charged by a dealer who does not charge a foreign currency commission but instead charges a full pip spread.

Typically, investors who trade stocks, futures, or options utilize a broker who acts as an intermediary. The broker submits the order to an exchange and tries to execute it according to the customer’s wishes. For providing this service, the broker is paid a commission when the consumer buys and sells the tradable instrument.

Commissions are not charged on the foreign exchange market. FX is a principals-only market, unlike exchange-based markets. Dealers, not brokers, are FX companies. Dealers, unlike brokers, take on market risk by acting as the counterparty to an investor’s trade. They don’t charge commission; instead, the bid-ask spread is how they generate money.

In FX, unlike in exchange-based markets, the investor cannot attempt to purchase on the bid or sell on the offer. There are no additional fees or commissions once the price has cleared the cost of the spread. To the investor, every cent earned is pure profit. Nonetheless, scalping in FX is significantly more difficult due to the fact that traders must always overcome the bid/ask spread.

What Is a Pip, Exactly?

A pip, short for “percentage in point” or “price interest point,” is a minuscule unit of measurement in the forex market that signifies a change in a currency pair. It can be expressed as a percentage of the quoted currency or as a percentage of the underlying currency. A pip is a defined unit that represents the smallest change in a currency quote.

The lowest increment of trade in foreign exchange is the pip, which stands for percentage in point. Prices in the foreign exchange market are quoted to the fourth decimal point. For example, if a bar of soap costs $1.20 in a drugstore, the identical bar of soap would cost 1.2000 in the FX market. 1 pip is the change in the fourth decimal point, which is usually equal to 1/100th of a percent.

The Japanese yen is the only major currency that does not follow this criterion. Because one dollar is roughly equal to 100 yen in Japan, the USD/JPY pair’s quotation is only taken out to two decimal places (i.e., to 1/100th of a yen, as opposed to 1/1000th in other major currencies).

What Exactly Are You Trading?

FX traders hope to profit from fluctuations in currency pairings’ exchange prices. All earnings and losses on dollar-denominated accounts are computed in dollars and recorded as such on the trader’s account.

The FX market is a facility utilized by global organizations that need to trade currencies on a regular basis (i.e., for payroll, payment for goods and services from foreign vendors, and mergers and acquisitions). The forex markets are used by financial institutions to hedge positions and place directional bets on currency pairs based on basic research and technical analysis. Individual traders can speculate on exchange rate movements by trading currencies.

Because currencies are always traded in pairs, when a trader enters the market, he or she is always long one currency and short the other. If a trader sells one standard lot of EUR/USD (equal to 100,000 units), they have exchanged euros for dollars and are now short euros and long dollars.

To better grasp this dynamic, consider how a $1,000 computer purchased from an electronics retailer is exchanged for a computer. That person is in need of $1,000 and has one computer. The store would be short $1,000 if it didn’t have one PC in stock. The FX market operates on the same basis, with the exception that there is no actual transaction. While all transactions are merely computer entries, the ramifications are no less serious.

What Currencies Are Traded in the Forex Market?

The most heavily traded currencies in today’s foreign exchange market roughly reflect the countries’ international commercial operations.

The United States dollar, for example, is one of the most actively traded currencies in the forex market. The United States Dollar, the Euro of the European Union, the Japanese Yen, the British Pound Sterling, the Swiss Franc, the Australian Dollar, the Canadian Dollar, and the New Zealand Dollar are all examples of currencies.

The United States currently dominates the foreign exchange market. The dollar, which presently accounts for more than 80% of all transactions on the global market.

The Euro against the US Dollar is the most actively traded currency pair in the forex market. The currency pair of the dollar and the euro is known as EURUSD. On a typical day, this pair alone accounts for around 28% of worldwide forex market trading activity.

Although some retail dealers trade exotic currencies like the Thai baht or the Czech koruna, the majority of dealers trade the four “majors,” which are the seven most liquid currency pairs in the world:

• 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)

Around 80% of all FX speculative trading is done on these seven key currency pairs. The FX market is significantly more concentrated than the stock market due to the small number of trading instruments (around 50 pairs and crosses are actively traded).

What Is a Currency Carry Trade, and How Does It Work?

FX carry trade, also known as the currency carry trade, is a financial strategy in which a higher-yielding currency is used to fund a lower-yielding currency. A trader who employs the FX carry trade method attempts to reap the benefits of risk-free profit-making by exploiting the differential in currency rates.

Carry is the most common currency market trade, and it is used by both major hedge funds and small individual traders. The carry trade is predicated on the notion that every currency has an interest rate connected with it. The Federal Reserve in the United States, the Bank of Japan in Japan, and the Bank of England in the United Kingdom are in charge of setting these short-term interest rates.

The term “carry” is self-explanatory. The trader goes long on the currency with the highest interest rate and funds the transaction with a low-interest currency. The NZD/JPY cross, for example, was one of the finest pairs in 2005. New Zealand’s rates rose to 7.25 percent and stayed there, owing to strong commodity demand from China and a hot housing market, while Japanese rates remained at 0%. A trader who went long on the NZD/JPY may have profited by 725 basis points. The carry trade in NZD/JPY could have generated a 72.5 percent annual return from interest rate differentials on a 10:1 leverage basis, without any contribution from capital appreciation. This illustration exemplifies why the carry trade is so popular.

Before you rush out to find the next high-yield pair, keep in mind that when the carry trade is unwound, the losses can be swift and severe. The currency carries trade liquidation process occurs when the bulk of speculators believe that the carry trade has limited future potential.

Bids vanish for every trader looking to close their position quickly, and interest rate differential profits aren’t nearly enough to cover capital losses. The key to success is anticipation: the best time to position the carry is at the start of the rate-tightening cycle, allowing the trader to ride the trend as interest rate differentials widen.

Other Forex Terminology

Every field has its own lingo, and the currency market is no exception. A seasoned currency trader should be familiar with the following terms:

• 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.”

Final Thoughts

For both beginner and expert investors, forex may be a profitable yet volatile trading method. While getting into the market—say, through a broker—is now easier than ever, the answers to the six questions above will serve as a useful primer for individuals new to FX trading.

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