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Brief Introduction to FX Trading

admin — Tue, 15 Jul 2008 23:31:03 +0000

I’ve heard a lot about FX Trading and wanted to know what exactly it’s all about. So I went ahead and researched a bit more about it as a result you have the following article which I found very useful. Read on …

The History of FX

The Breton Woods Agreement was initiated in 1944 in an effort to keep cash from draining out of war-ravaged Europe. Currency movements were limited to 1% against the U.S. Dollar, which was fixed to the price of gold at 35 US Dollars an ounce. The modern era of foreign exchange first emerged in 1971 with the collapse of the Breton Woods Agreement. The U.S. Dollar was no longer convertible into gold and market forces were free to adjust foreign exchange rates, signalling an increase in currency market volatility and trading opportunities.

The collapse in 1973 of the subsequent Smithsonian and European Joint Float agreements signalled the true beginning of the free-floating currency exchange system that drives the markets today. Starting in the 1980’s, computer technology extended the reach of the exchange marketplace. Today, the values of the major world currencies are independent of each other.

What is Foreign Exchange Market

Foreign Exchange is a currency market where the trading of one currency against another takes place. It is often referred to as Forex or FX.

The foreign exchange market is the largest most liquid and most influential market in the world. It is a truly 24 hour global market, it trades from 9pm GMT Sunday until 10pm GMT Friday and trades in excess of $1.5 trillion dollars a day, Making it far bigger than the combined total of all the worlds stock exchanges.

Participants in Forex include central banks, corporations, individual investors and speculators, and hedge funds. With the advent of electronic trading platforms, self-directed investors and smaller financial firms now have access to the same liquidity as larger market participants.

Trading, or speculation, makes up 95% of the daily volume. The other 5% of daily volume consists of governments and commercial companies converting one currency into another from buying and selling goods and services.

51% of the market is in spot FX transactions, followed by 32% in currency swap transactions. Forward outright FX transactions represent another 5% of this daily turnover. Options on inter-bank FX transactions making up another 8%.

Why Trade FX?

Liquidity

The Forex market is the most liquid market in the world. Most speculators focus on trading the highly liquid Majors where approximately 85% of trading volume occurs. Other currency pairs are less liquid and therefore increases liquidity risk.

Unlike the stock market, where slippage can be a real concern, high liquidity in Forex means that trades will generally be filled at the order price. There are always plenty of buyers and sellers which helps make sure spreads are narrow.

24-Hour Trading

Since the market is almost always open, traders can react to market, economic and political news as it happens, locking in profits, protecting profits and cutting losses. The main trading centres are Sydney, Tokyo, London, Frankfurt and New York. Trading takes place during five overlapping trading sessions starting at 9pm GMT Sunday evening and ending on 10pm GMT Friday Evening.

Leverage - Trading on Margin

Trading on margin means that a trader can utilize more capital than they have in their account. The volatility of currency pairs is usually less than other markets, such as futures and equities. Since there is less movement, traders leverage their capital to make money on smaller moves. The amount of margin available in Forex is as high as 1% (100:1 leverage), and generally up to 2% (50:1 leverage). With £2,000 of capital, you can trade up to £400,000 at 50:1 and £500,000 at 100:1. Your individual broker will set the level of margin required on your account.

If you were to trade £100,000 GBP/USD you would be required to have at least £1000 at 1% margin or £2000 at 2% margin in your account to open the trade. Trading on margin is a double edged sword. You can lose money equally as fast as you make it. It is therefore vital to have a full understanding of the FX market and not commit too much of your equity to each trade.

Lower Transaction Costs – Tighter Spreads - No Commissions

Most Forex brokers do not charge commissions, but instead make money on the dealing spread. The Dealing Spread is difference between the bid and ask quote. The Bid is the price buyers are willing to buy, and the Ask is the price that sellers are willing to sell at any given time. Under normal market conditions the dealing spread would be no more than 5 pips.

Trade in rising or falling markets

With FX Trading you can trade long or short which means you can take a view on any currency pair and place a relevant trade. If you feel that the UK economy is strong and the US Dollar will weaken against the Sterling you would execute a BUY GBP/USD order. By doing so you have bought British pounds in the expectation that they will appreciate versus the US dollar. If you feel the UK will continue to weaken and this will hurt the British Pound, you would execute a SELL GBP/USD order. By doing so you have sold British pounds in the expectation that they will depreciate versus the US dollar.