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Trading Basics You Should Know.
What you should know before you get on board.
Lately, currencies have been on a rollercoaster ride with record breaking highs and lows. The world of foreign exchange is dominating news headlines; but what does it mean, and more importantly, what do you need to know before you get on board?
First of all, it's important that you understand that trading the Foreign Exchange market involves a high degree of risk, including the risk of losing money. Any investment in foreign exchange should involve only risk capital and you should never trade with money that you cannot afford to lose.
What is Forex?
You may have noticed that the value of currencies goes up and down every day. What most people don't realize is that there is a foreign exchange market - or 'Forex' for short - where you can potentially profit from the movement of these currencies. The best known example is George Soros who made a billion dollars in a day by trading currencies. Be aware, however, that currency trading involves significant risk and individuals can lose a substantial part of their investment. As technologies have improved, the Forex market has become more accessible resulting in an unprecedented growth in online trading. One of the great things about trading currencies now is that you no longer have to be a big money manager to trade this market; traders and investors like you and I can trade this market.
Forex in a nutshell.
The Forex market is the largest financial market on Earth. Its average daily trading volume is more than $3.2 trillion. Compare that with the New York Stock Exchange, which only has an average daily trading volume of $55 billion. In fact, if you were to put ALL of the world's equity and futures markets together, their combined trading volume would only equal a QUARTER of the Forex market. Why is size important? Because there are so many buyers and sellers that transaction prices are kept low. If you're wondering how trading the Forex market is different then trading stocks, here are a few major benefits.
Many firms don't charge commissions – you pay only the bid/ask spreads. There's 24 hour trading – you dictate when to trade and how to trade. You can trade on leverage, but this can magnify potential gains and losses. You can focus on picking from a few currencies rather than from 5000 stocks. Forex is accessible – you don’t need a lot of money to get started.
How is Forex traded?
The mechanics of a trade are virtually identical to those in other markets. The only difference is that you're buying one currency and selling another at the same time. That's why currencies are quoted in pairs, like EUR/USD or USD/JPY. The exchange rate represents the purchase price between the two currencies.
Important: be aware of the risks:
Finally, it cannot be stressed enough that trading foreign exchange on margin carries a high level of risk, and may not be suitable for everyone. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. Remember, you could sustain a loss of some or all of your initial investment, which means that you should not invest money that you cannot afford to lose. If you have any doubts, we recommend that you seek advice from an independent financial advisor.
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So You Want to Trade Forex?
Created by EQUITIES Magazine.
The current volatility and fluctuation in global currencies have attracted investors and traders to the foreign exchange market. The growing popularity of trading Forex, though, has also created the need for improved regulation to better protect beginners.
Thanks to the Commodities Futures Modernization Act of 2000, regulating bodies like the U. S. Commodity Futures Trading Commission and the National Futures Association have taken on larger roles in establishing proper procedures with the goal of improved oversight and stricter requirements.
"The industry is continuously growing," says Larry Dyekman, director of communications and education for NFA. "Growth with no regulation is ripe for fraud. Customers have lost hundreds of millions of dollars. The CFTC has taken much legal action and hopes that new requirements and regulation [will help] a lot of this fraudulent activity disappear."
As a self-regulating agency for the U. S. futures market, the NFA reports to the CFTC. The Commodities Futures Modernization Act requires that any firm acting as a counterparty to futures contract transactions must belong to some form of regulatory organization.
"There are a lot of reasons Forex is a little more difficult to regulate," Dyekman says. "It's more global, and there's no central clearinghouse. These dealers are acting as the counterparty to the trade, so it's not as transparent as on-exchange futures contracts. So when you don't have that kind of transparency and liquidity in a central location, it's a little harder to regulate."
There are a few major differences when comparing Forex trading to trading stocks. Whether these features create an advantage or disadvantage depends on the investor's preference. Retail Forex operators like FXCM, which boasts more than 100,000 live accounts, have made it easier than ever for beginning traders to enter the market.
"True 24-hour access is a major advantage that the Forex market has over equities and futures—it eliminates weekday overnight risk for traders," says Brendan Callan, managing director of sales and customer services for FXCM. "They can trade as news breaks on the other side of the world, and transaction costs are substantially lower than in the equities and futures market. Leverage capabilities are another draw. In Forex, retail traders can leverage their accounts 100 to 200 times. We don't suggest using that much leverage, but the ability to do so gives them a great deal of flexibility with their trading strategies."
Callan adds that FXCM shifted away from serving as a counterparty to trades, adopting a "No Dealing Desk" execution model three years ago. Forex brokers usually generate revenue by collecting bid-ask spreads, or pips. "FXCM simply passes on the best prices from the many banks that we have clearing relationships with," Callan says. "We don't need them to lose in order to earn revenue, which is the case with many of our competitors, who trade against their own clients."
When selecting an appropriate Forex broker to use, Dyekman recommends that traders do their due diligence and investigate each firm. "Before making any decisions about trading in Forex or any investment decisions, you need to know the product you're going to trade and know who you're trading with," he says.
On the flip side, increased regulation has put the onus on Forex operators to know their customers. The Patriot Act of 2001 requires that all financial institutions verify the identity of their customers as part of an anti-money laundering program. The NFA has put in place a program designed to mirror that of the federal government. In addition to identity verification, brokers are also required to evaluate customer information to provide the appropriate risk disclosures.
"We have a rule that requires our members to obtain certain information from a potential customer before accepting them," Dyekman says. "Things like their name, address, income, net worth, and their experience in trading the product they're going to be trading. There are definite procedures that we ask the firm to follow when they open a new account for a customer."
However, for investors looking to capitalize on the ups and downs of the Forex market, the information gathering and verification process to open and fund an account could take longer, says Darren Rennick, director of transaction software developer M2 Global.
M2 has developed a patent-pending technology called card-integrated acquiring, which streamlines the verification process for Forex brokers and shortens the time it takes to transfer money in and out of trading accounts. For many brokers, the quickest way for customers to fund an account still takes at least one or two days.
"Let's say you open up a trading account, but then it takes five days to get your money into your account and start trading," Rennick says. "You can imagine how frustrating an experience that is for somebody who wants to trade. It's so volatile an industry that the opportunity that you're looking to capitalize on might be gone after five days. The challenge is that it's not particularly easy for people to fund their trading accounts. M2 has solutions to a lot of these problems."
Rennick says that the technology works similarly to how online retailers complete transactions. M2 provides the Forex broker with a merchant account, and through that account, the company's proprietary technology will verify the customer's identity, process the transaction, and fund the account.
"Nobody's come up with a solution until now," Rennick says. "It's patent pending, so we just need to educate people about how it works, why it conforms to NFA regulations—which it does—and then walk them through the technical implementation aspect of it. It's a simple thing to do. The issue that we have right now is that it's new."
After the account is opened, traders should also fully understand the strategies and the potential consequences that they expose their portfolio to. One major risk that beginning traders need to be aware of is the power of using leverage, which is a popular investment strategy that magnifies the impact of trades and market movements.
"Leverage is the big one," Callan says. "Clients that come to this market need to use leverage wisely. Relatively speaking, Forex moves very little. A 1% to 2% move in a day would be considered significant volatility. While 1% to 2% isn't much, if you are leveraged 100 times, that becomes a 100% swing on your account in one trading day. As they say, leverage is a double-edged sword."
For investors that want to trade on the Forex market, Dyekman stresses that due diligence and information gathering is a must. "[The NFA website] goes into a lot of details that you should know," he says. "Please do your due diligence. It's a volatile market place, and you have to have a certain temperament to deal with it."
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Forex Trading: A Beginner's Guide.
Forex is short for foreign exchange, but the actual asset class we are referring to is currencies. Foreign exchange is the act of changing one country's currency into another country's currency for a variety of reasons, usually for tourism or commerce. Due to the fact that business is global, there is a need to transact with other countries in their own particular currency.
After the accord at Bretton Woods in 1971, when currencies were allowed to float freely against one another, the values of individual currencies have varied, which has given rise to the need for foreign exchange services. This service has been taken up by commercial and investment banks on behalf of their clients, but it has simultaneously provided a speculative environment for trading one currency against another using the internet. (If you want to start trading forex, check out Forex Basics: Setting Up an Account. )
Forex as a Hedge.
Commercial enterprises doing business in foreign countries are at risk due to fluctuation in the currency value when they have to buy goods or services from or sell goods or services to another country. Hence, the foreign exchange markets provide a way to hedge the risk by fixing a rate at which the transaction will be concluded at some time in the future. To accomplish this, a trader can buy or sell currencies in the forward or swap markets, at which time the bank will lock in a rate so that the trader knows exactly what the exchange rate will be and thus mitigate his or her company's risk. To some extent, the futures market can also offer a means to hedge currency risk, depending on the size of the trade and the actual currency involved. The futures market is conducted in a centralized exchange and is less liquid than the forward markets, which are decentralized and exist within the interbank system throughout the world.
[ Traditional puts and calls are the most common options and hedging tools available to retail forex traders. Learn more about options, and how they apply to stocks, through taking Investopedia Academy's Options for Beginners course. ]
Forex as a Speculation.
Since there is constant fluctuation between the currency values of the various countries due to varying supply and demand factors, such as interest rates, trade flows, tourism, economic strength, geopolitical risk and so on, an opportunity exists to bet against these changing values by buying or selling one currency against another in the hopes that the currency you buy will gain in strength or that the currency you sell will weaken against its counterpart. (For addition reading, see Top 7 Questions About Currency Trading Answered .)
Currency as an Asset Class.
There are two distinct features to this class:
You can earn the interest rate differential between two currencies. You can gain value in the exchange rate.
Why We Can Trade Currencies.
Until the advent of the internet, currency trading was really limited to interbank activity on behalf of their clients. Gradually, the banks themselves set up proprietary desks to trade for their own accounts, and this was followed by large multinational corporations, hedge funds and high net worth individuals.
With the proliferation of the internet, a retail market aimed at individual traders has sprung up that provides easy access to the foreign exchange markets, either through the banks themselves or brokers making a secondary market. (For more on the basics of forex, check out 8 Basic Forex Market Concepts .)
Forex Risk.
Confusion exists about the risks involved in trading currencies. Much has been said about the interbank market being unregulated and therefore very risky due to a lack of oversight. This perception is not entirely true, though. A better approach to the discussion of risk would be to understand the differences between a decentralized market versus a centralized market and then determine where regulation would be appropriate.
The interbank market is made up of many banks trading with each other around the world. The banks themselves have to determine and accept sovereign risk and credit risk, and for this they have many internal auditing processes to keep them as safe as possible. The regulations are industry imposed for the sake and protection of each participating bank.
Since the market is made by each of the participating banks providing offers and bids for a particular currency, the market pricing mechanism is arrived at through supply and demand. Due to the huge flows within the system, it is almost impossible for any one rogue trader to influence the price of a currency. Indeed, in today's high-volume market, with between $2 trillion and $3 trillion being traded per day, even the central banks cannot move the market for any length of time without the full coordination and cooperation of other central banks. (For more on the interbank system, read The Foreign Exchange Interbank Market. )
Attempts are being made to create an Electronic Communication Network (ECN) to bring buyers and sellers into a centralized exchange so that pricing can be more transparent. This is a positive move for retail traders who will gain a benefit by seeing more competitive pricing and centralized liquidity. Banks of course do not have this issue and can, therefore, remain decentralized. Traders with direct access to the forex banks are also less exposed than those retail traders who deal with relatively small and unregulated forex brokers, which can and sometimes do re-quote prices and even trade against their own customers. It seems that the discussion of regulation has arisen because of the need to protect the unsophisticated retail trader who has been led to believe that trading forex is a surefire profit-making scheme. (See also: Why It's Important to Regulate Foreign Exchange .)
For the serious and somewhat educated retail trader, there is now the opportunity to open accounts at many of the major banks or the larger, more liquid brokers. As with any financial investment, it pays to remember the caveat emptor rule – "buyer beware!" (For more on the ECN and other exchanges, check out Getting to Know the Stock Exchanges .)
Pros and Cons of Trading Forex.
If you intend to trade currencies, in addition to the previous comments regarding broker risk, the pros and cons of trading forex are laid out as follows:
1. The forex markets are the largest in terms of volume traded in the world and therefore offer the most liquidity, thus making it easy to enter and exit a position in any of the major currencies within a fraction of a second.
2. As a result of the liquidity and ease with which a trader can enter or exit a trade, banks and/or brokers offer large leverage, which means that a trader can control quite large positions with relatively little money of their own. Leverage in the range of 100:1 is not uncommon. Of course, a trader must understand the use of leverage and the risks that leverage can impose on an account. Leverage has to be used judiciously and cautiously if it is to provide any benefits. A lack of understanding or wisdom in this regard can easily wipe out a trader's account. (For more on leverage, check out Forex Leverage: A Double-Edged Sword .)
3. Another advantage of the forex markets is the fact that they trade 24 hours around the clock, starting each day in Australia and ending in New York. The major centers are Sydney, Hong Kong, Singapore, Tokyo, Frankfurt, Paris, London and New York.
4. Trading currencies is a "macroeconomic" endeavor. A currency trader needs to have a big-picture understanding of the economies of the various countries and their inter-connectedness in order to grasp the fundamentals that drive currency values. For some, it is easier to focus on economic activity to make trading decisions than to understand the nuances and often closed environments that exist in the stock and futures markets where microeconomic activities need to be understood. Questions about a company's management skills, financial strengths, market opportunities and industry-specific knowledge are not necessary in forex trading. (Take a look at Economic Factors That Affect the Forex Market to learn more.)
[ One of the underlying tenets of technical analysis is that historical price action predicts future price action. Since the forex market is a 24-hour market, there tends to be a large amount of data that can be used to gauge future price movements. This makes it the perfect market for traders that use technical tools. If you want to learn more about technical analysis from one of the world's most widely followed technical analysts, check out Investopedia Academy's technical analysis course. ]
Two Ways to Approach the Forex Markets.
For most investors or traders with stock market experience, there has to be a shift in attitude to transition into or to add currencies as a further opportunity for diversification.
1. Currency trading has been promoted as an "active trader's" opportunity. This suits the brokers because it means they earn more spread when the trader is more active.
2. Currency trading is also promoted as leveraged trading, and therefore, it is easier for a trader to open an account with a small amount of money than is necessary for stock market trading.
Besides trading for a profit or yield, currency trading can be used to hedge a stock portfolio. If, for example, one builds a stock portfolio in a country where there is potential for the stock to increase value but there is downside risk in terms of the currency, for example in the U. S. in recent history, then a trader could own the stock portfolio and sell short the dollar against the Swiss franc or euro. In this way, the portfolio value will increase, and the negative effect of the declining dollar will be offset. This is true for those investors outside the U. S. who will eventually repatriate profits back to their own currencies. (For a better understanding of risk, read Understanding Forex Risk Management. )
With this profile in mind, opening a forex account and day trading or swing trading is most common. Traders can attempt to make extra cash utilizing the methods and approaches elucidated in many of the articles found elsewhere on this site and at brokers' or banks' websites.
A second approach to trading currencies is to understand the fundamentals and the longer-term benefits, when a currency is trending in a specific direction and is offering a positive interest differential that provides a return on the investment plus an appreciation in currency value. This type of trade is known as a "carry trade." For example, a trader can buy the Australian dollar against the Japanese yen. Upon the original publication of this article, the Japanese interest rate is .05% and the Australian interest rate last reported is 4.75%, so a trader can earn 4% on this trade. (For more, read The Fundamentals of Forex Fundamentals .)
However, such a positive interest needs to be seen in the context of the actual exchange rate of the AUD/JPY before an interest decision can be made. If the Australian dollar is strengthening against the yen, then it is appropriate to buy the AUD/JPY and to hold it in order to gain in both the currency appreciation and the interest yield.
Bottom Line.
For most traders, especially those with limited funds, day trading or swing trading for a few days at a time can be a good way to play the forex markets. For those with longer-term horizons and larger fund pools, a carry trade can be an appropriate alternative.
In both cases, traders must know how to use charts for timing their trades, since good timing is the essence of profitable trading. And in both cases, as in all other trading activities, the trader must know his or her own personality traits well enough so that he or she does not violate good trading habits with bad and impulsive behavior patterns. Let logic and good common sense prevail. Remember the old French proverb, "Fortune favors the well prepared mind!" (To determine what type of trading is best for you, see What Type of Forex Trader Are You? )
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