What is Foreign Exchange?
Foreign exchange (FX) is the largest, most liquid, market in the world. Larger than the shares and futures markets combined, every day over $5.3 trillion of FX transactions is traded globally.
In addition to trading for profit – also called speculative trading, FX is traded typically to diversify investment portfolios and to hedge against exposures in other assets.
A key difference between FX and equity trading is the size of transactions; FX transactions tend to be significantly larger in value and size.
A 24/5, truly global market
FX trading begins when New Zealand opens and “follows the sun” across Asia, Europe and the Americas, when the cycle begins again. The trading window in each time zone overlaps – Asia with Europe, Europe with US, US with Asia – as such it is possible to trade FX 24 hours a day.
How does FX trading work?
To properly understand what Forex trading is, you need to know its inner workings. If you’ve ever been to a Bureau de Change, you’ve already traded foreign exchange. It means, simply, “exchanging” (buying or selling) one currency for another, for example, selling GB pounds to buy US dollars, or Euros.
FX transactions always involve two currencies e.g. Euro and US dollar or EUR/USD, called currency pairs
For all FX currency pairs, there is a bid price – the price at which ADS London will BUY currency from you (in exchange for the other currency) and an offer (or “ask”) price – the price at which ADS London will SELL to you (in exchange for the other currency).
Typically, the first currency is the “base” currency and the tradable “rate” shows the comparative value of the second displayed currency against the base currency. In other words, in the price shown below, EUR/USD1.35 means 1 euro is worth 1.35 dollars.
The numbers after the decimal point are called pips (“price interest points”). A pip measures the change in the exchange rate for a particular currency pair.
The value of a pip is dependent on the currency pair being traded, the size of the trade, and the exchange rate.
ADS London quotes FX prices to the fifth decimal place (1/1,000 or 0.0001).
The difference between a bid and offer price is called a spread
So in the example of EUR/USD1.35690/1.35697 the spread is 0.7 pips.
In FX trading, small movements of even a single pip can have a significant impact on the overall value of an open position. When trading FX, you will be looking to anticipate both the absolute movement of a currency – in either direction – AND to take advantage of the difference between what you paid to BUY one currency and what price you can SELL it at (the bid/offer spread). This is particularly relevant to short selling strategies.
FX trading “lots”
FX is traded in lots or parcels. ADS London offers lot sizes of:
- 1 lot = $100,000 (or currency equivalent)
- 1 mini lot = 10th of a lot or $10,000 (or currency equivalent)
- 1 micro lot = 100th of a lot or $1,000 (or currency equivalent)
As with equity transactions, you can hold “long” and “short” FX positions. Being long simply means buying the first currency and selling the second in any currency pair. So, if you expected the euro to strengthen against the dollar you would BUY EUR/USD. Conversely, if you anticipated a market fall, you might SELL a currency before the anticipated fall, with the aim of buying it back at the lower price.
Margin, or leverage, is a means of increasing your exposure in an FX position. For example, a 1:100 margin would mean that you would need to deposit only $1,000 in order to hold a position of $100,000, your deposit of $1,000 is ‘leveraged’ to allow you to trade in a much larger size. Similarly leverage of 1:500 means the same $1000 allows you to hold a $500,000 position. Margin is a double-edged sword; while it can result in significantly larger gains if the market moves in your favour, if it moves against you it can increase your potential losses accordingly.
Example of a Forex Trade
- An investor deposits $10,000 in an ADS Securities Trading Account. The account is set to 1% margin or 100:1 Leverage. What this means is that for one lot opened of 100,000 the investor must maintain at least $1,000 in Margin (100,000 x 1%=$1,000).
- If the investor expects that Euro is going to rise against the US Dollar, he will buy $100,000 of the EUR/USD pair as shown below.
- The market quotes EUR/USD 1.2414-1.2415. The investor buys EUR at 1.2415 against USD.
- By making this trade, the investor effectively commits to the simultaneous buying of EUR 100,000 (1 lot of $100,000) and the selling of USD 124,150 (100,000 x 1.2415) by using EUR 1,000 as Margin (100,000 x 1%) and borrowing $99,000 from ADS Securities.