6 Questions About Currency Trading

Although forex (FX) is the largest financial market in the world, it tends to be unfamiliar territory for retail traders. This market was largely dominated by financial institutions, multinational corporations, and hedge funds. But, it saw increased interest from individual retail traders with the rise of online trading. Whether you're a novice or need a refresher on the basics of currency trading, here are the answers to some of the most frequently asked questions about the FX market.

1. How Does Forex Compare to Other Markets?

Currency trading is not like other markets. There are no regulated exchanges and it isn't controlled by a central governing body. Trades aren't guaranteed by clearinghouses and there is no arbitration panel to adjudicate disputes. Rather, members trade with each other. Banks, brokers, and large institutions typically act as intermediaries and facilitators. Business in the largest, most liquid market in the world depends on a metaphorical handshake.

This ad-hoc arrangement may bewilder investors who are used to structured exchanges like the New York Stock Exchange (NYSE). However, this arrangement works in practice. Self-regulation provides effective control over the market because participants must compete and cooperate.

Reputable retail forex dealers in the U.S. become members of the National Futures Association (NFA). By doing so, FX dealers agree to binding arbitration in the event of any dispute. Therefore, retail customers who contemplate trading currencies should only do so through an NFA member firm.

Traders who think the EUR/USD might spiral downward can short the pair at will. There is no uptick rule in FX as there is in stocks. There are also no limits on the size of your position as there are in futures contracts. A trader could theoretically sell $100 billion in currency with sufficient capital.

Forex trades 24 hours a day, from 5 p.m. ET Sunday to 5 p.m. ET Friday, and rarely has any price gaps. Its sheer size and scope (from Asia to Europe to North America) make the currency market the most accessible in the world.

2. What Is the Forex Commission?

Investors who trade stocks, futures, or options typically use a broker who acts as an agent in the transaction. The broker takes the order to an exchange and attempts to execute it according to the customer's instructions. The broker is paid a commission when the customer buys and sells the tradable instrument for providing this service.

The FX market does not have commissions. Unlike exchange-based markets, FX is a principals-only market. FX firms are dealers—not brokers. Unlike brokers, dealers assume market risk by serving as a counterparty to the investor's trade. They do not charge commission; instead, they make their money through the bid-ask spread.

An FX investor can't attempt to buy on the bid or sell at the offer as is the case in exchange-based markets. On the other hand, once the price clears the cost of the spread, there are no additional fees or commissions. Every single penny gained is pure profit to the investor. Nevertheless, the fact that traders must always overcome the bid/ask spread makes scalping much more difficult in FX. 

3. What Is a Pip?

Pip stands for percentage-in-point and is the smallest increment of trade in FX. In the FX market, prices are quoted to the fourth decimal point. For example, if a bar of soap in the drugstore was priced at $1.20, that same bar of soap would be quoted at 1.2000 in the FX market. The change in that fourth decimal point is called 1 pip and is typically equal to 1/100^th of 1%.

Among major currencies, the Japanese yen is sometimes an exception. It is common to see it quoted to two or three decimal places against the dollar rather than four, depending on the website.

4. What Are You Really Trading?

FX traders hope to profit from exchange rate changes between currency pairs. For dollar-denominated accounts, all profits or losses are calculated in dollars and recorded as such on the trader's account.

The FX market helps traders change one currency into another and is used by multinational corporations for things like payroll, the payment for goods and services from foreign vendors, and mergers and acquisitions (M&A). Financial institutions use the FX markets to hedge positions and take directional bets on currency pairs based on fundamental and technical analysis. Individual traders may also trade currencies to speculate on exchange rate moves.

Currencies always trade in pairs, so traders are always long one currency and short the other. For example, if a trader sells one standard lot (equivalent to 100,000 units) of EUR/USD, they exchange euros for dollars and would be short euros and long dollars.

To better understand this dynamic, an individual who purchases a computer from an electronics store for $1,000 exchanges dollars for a computer where:

• The individual is short $1,000 and long one computer
• The store would be long $1,000, but now short one computer in its inventory

The same principle applies to the FX market, except that no physical exchange takes place. While all transactions are computer entries, the consequences are no less real. If demand for this computer increases, the individual could sell it for a higher amount, say $1,100, booking a $100 profit.

5. What Currencies Trade in Forex?

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

• EUR/USD (euro/U.S. dollar)
• USD/JPY (dollar/Japanese yen)
• GBP/USD (British pound/U.S. dollar)
• USD/CHF (dollar/Swiss franc).

The three commodity pairs are also traded:

• AUD/USD (Australian dollar/U.S. dollar)
• USD/CAD (U.S. dollar/Canadian dollar)
• NZD/USD (New Zealand dollar/U.S. dollar)

These seven major currency pairs account for about 85% of all speculative trading in FX. Additional pairs and crosses are traded as well, but there are only so many currencies in the world, and obscure ones don't tend to trade much, if at all, especially between each other. Therefore, the FX market is far more concentrated than the stock market.

6. What Is a Currency Carry Trade?

A carry trade is the most popular in the currency market, practiced by both the largest hedge funds and the smallest retail speculators. It is based on the fact that every currency in the world has an associated interest. These short-term interest rates are set by central banks such as the Federal Reserve, the Bank of Japan in Japan, and the Bank of England (BoE).

The concept of carry is straightforward. The trader goes long on the currency with a high interest rate and finances that purchase with a low interest rate currency. For example, one of the best pairings was the NZD/JPY cross in 2005. Rates rose by 7.25% for New Zealand's economy, which was spurred by China's huge commodity demand and a hot housing market, while Japanese rates remained at 0%. A trader going long on the NZD/JPY could have harvested 725 basis points in yield alone. On a 10:1 leverage basis, the NZD/JPY carry trade could have produced a 72.5% annual return from interest rate differentials without any contribution from capital appreciation. This example illustrates why the carry trade is so popular.

Before pursuing the next high-yield pair, be advised that when the carry trade is unwound, the declines can be rapid and severe. This process is known as the currency carry trade liquidation and occurs when the majority of speculators decide that the carry trade may not have future potential.

For every trader seeking to exit their position at once, bids disappear, and the profits from interest rate differentials are not nearly enough to offset capital losses. Anticipation is the key to success: the best time to position the carry is at the beginning of the rate-tightening cycle allowing the trader to ride the move as interest rate differentials increase.

Common Forex (FX) Jargon

Every discipline has its jargon, and the currency market is no different. Here are some terms that a seasoned currency trader should know:

The Bottom Line

Forex can be a profitable, yet volatile, trading strategy for both inexperienced and experienced investors. While accessing the market—through a broker, for instance—is easier than ever before, the answers to the above six questions will serve as a valuable primer for those diving into FX trading.