Investing Basics: Foreign Exchange Trading

Most consumers will have undertaken some form of small scale transaction before going on holiday, but foreign exchange (FX or forex) is the world’s biggest financial market, with individual traders, businesses and central banks all taking part in order to speculate for profit, maintain money supply or facilitate international trade – by Christian Leeming.

There is no central exchange for FX and there are few limits to trading 24 hours a day with a high degree of liquidity via a global network of banks, dealers and brokers.

FX trading is how individuals and businesses convert one currency to another and prices are influenced by a range of different factors, including interest rates, inflation, government policy, employment figures and demand for imports and exports; currency prices tend to reflect the state of the issuing country’s economy.

Because of the sheer volume of currency traders and the amount of money exchanged, price movements can happen very quickly, making currency trading not only the largest financial market in the world, but also one of the most volatile.

Foreign Exchange Made Simple

When stocks and shares, or perhaps commodities, are traded via an exchange the transaction is relatively straightforward; a buyer of a particular stock gives their money to a broker who then pays it to a seller of that stock via an exchange.

Trading currencies is broadly similar in that it treats currencies as commodities and in each transaction simultaneously sells one currency to generate the money to pay for another; traders are speculating on the change in the value of one currency against another.

‘currency trading not only the largest financial market in the world, but also one of the most volatile’

FX is traded in ‘currency pairs’ which are made up of the ‘base currency’, which is being speculated upon and the ‘counter currency’ against which the value of the base currency is being measured; profits are made if you correctly predict which way the value of the base currency will move relative to the counter currency.

The base currency is the first currency quoted in an FX pair and the second, or counter currency, represents the amount of that currency required to buy a single unit of the base currency – in a trade speculating that the base currency will rise the investor buys (goes ‘long’ on)the base currency and sells (‘shorts’) the counter currency.

For instance, when trading GBP/USD, the pound is the base currency and the US dollar is the counter; if it is trading at ‘1.2207’, then 1.2207 dollars would be needed to buy a single pound.

When trading GBP/USD, if you believe the pound will strengthen against the dollar you would buy pounds whilst selling dollars in the hope that the GBP/USD value will increase and return you a profit.

Currency movements are measured in ‘PIPs’ (percentage in points) – the smallest movement in the price of a currency, usually meaning a one-digit move in the fourth decimal place of a currency, or 0.0001 although in currencies that have low values like the Yen the second decimal represents a one-point move.

Once the territory of major financial institutions, internet technology now enables the DIY investor to trade global foreign exchange markets on their chosen device, alongside their other investments.

Online FX platforms now deliver real-time quotes, charts, historical data and news to retail investors at the click of a button who now account for $250 billion, or around 5%, of FX trades per day.

FX is what’s known as an ‘over the counter’ or OTC market which means that there is no centralised exchange or mechanism; rather there is a global network of buyers and sellers of currencies and as much as any external influence it is the speculation or sentiment of market participants that moves prices.

FX trading is leveraged, or traded on ‘margin’, which means that it is possible for you to ‘buy’ far more market exposure than your original stake would ordinarily deliver by effectively putting down a deposit; however, just as this may magnify your gains when you correctly predict the relative appreciation, or otherwise, of a particular currency, it can also increase your losses if you get it wrong and in a fast moving environment such as FX, that can be significant.

‘(leveraged trading) can also increase your losses if you get it wrong and in a fast moving environment such as FX, that can be significant’

Currency pairs are traded with a bid/offer spread and the price you trade at depends upon whether you are speculating on the base currency to strengthen or weaken.

Of all of the markets available to the DIY investor, probably because of its sheer size and complexity, FX comes with seemingly more charting, analysis and ‘systems’ than any other – and some ‘sure-fire’ tools and training academies come with a healthy price tag.

When getting to grips with FX it is sensible to begin with relatively mainstream currency pairs and to invest amounts that will not cause irreparable damage to your wealth if you were to get it wrong.

FX platforms come with plenty of historical and market data to inform your decision making and, significantly, allow you to set limits on your trades to either prevent you from making significant losses if you get it wrong, or to lock in profits when things go your way.

Analysing charts of any tradable commodity displays peaks and troughs that represent market sentiment; points at which a price met ‘resistance’ – ie a price rising to a level at which the market felt it had become expensive and then falling back – or ‘support’ – a price falling to a point at which it was consider to offer good value and therefore attracting buyers.

Whilst traders may seek to time their trades to eke every last ounce of momentum out of a particular trend, the DIY investor may look at historical values at which a particular currency turned turtle and then buy on approaches to previous support, and sell when nearing a resistance point.