Forex FAQ's (page 2)
How can I trade foreign currency exchange rates?
As you can see from the example, currency exchange rates fluctuate. As the value of one currency rises or falls relative to another, traders decide to buy or sell currencies to make profits. Retail customers also participate in the forex market, generally as speculators who are hoping to profit from changes in currency rates.
How does the off-exchange currency market work?
The off-exchange forex market is a large, growing and liquid financial market that operates 24 hours a day. It is not a market in the traditional sense because there is no central trading location or "exchange." Most of the trading is conducted by telephone or through electronic trading networks.
The primary market for currencies is the "interbank market" where banks, insurance companies, large corporations and other large financial institutions manage the risks associated with fluctuations in currency rates. The true interbank market is only available to institutions that trade in large quantities and have a very high net worth.
In recent years, a secondary OTC market has developed that permits retail investors to participate in forex transactions. While this secondary market does not provide the same prices as the interbank market, it does have many of the same characteristics. How are foreign currencies quoted and priced? Currencies are designated by three letter symbols. The standard symbols for some of the most commonly traded currencies are:
- EUR - Euros
- USD - United States dollar
- CAD - Canadian dollar
- GBP - British pound
- JPY - Japanese yen
- AUD - Australian dollar
- CHF - Swiss franc
Forex transactions are quoted in pairs because you are buying one currency while selling another. The first currency is the base currency and the second currency is the quote currency. The price, or rate, that is quoted is the amount of the second currency required to purchase one unit of the first currency. For example, if EUR/USD has an ask price of 1.2178, you can buy one Euro for 1.2178 US dollars.
Currency pairs are often quoted as bid-ask spreads. The first part of the quote is the amount of the quote currency you will receive in exchange for one unit of the base currency (the bid price) and the second part of the quote is the amount of the quote currency you must spend for one unit of the base currency (the ask or offer price). In other words, a EUR/USD spread of 1.2170/1.2178 means that you can sell one Euro for $1.2170 and buy one Euro for $1.2178.
A dealer may not quote the full exchange rate for both sides of the spread. For example, the EUR/USD spread discussed above could be quoted as 1.2170/78. The customer should understand that the first three numbers are the same for both sides of the spread.
What transaction costs will I pay?
Although dealers who are regulated by NFA must disclose their charges to retail customers, there are no rules about how a dealer charges a customer for the services the dealer provides or that limit how much the dealer can charge. Before opening an account, you should check with several dealers and compare their charges as well as their services. If you were solicited by or place your trades through someone other than the dealer, or if your account is managed by someone, you may be charged a separate amount for the third party's services.
Some firms charge a per trade commission, while other firms charge a mark-up by widening the spread between the bid and ask prices they give their customers. In the earlier example, assume that the dealer can get a EUR/USD spread of 1.2173/75 from a bank. If the dealer widens the spread to 1.2170/78 for its customers, the dealer has marked up the spread by .0003 on each side. Some firms may charge both a commission and a mark-up. Firms may also charge a different mark-up for buying the base currency than for selling it. You should read your agreement with the dealer carefully and be sure you understand how the firm will charge you for your trades.
Why is the Spot Currency Market Attractive to Investors?
Professional investors for individual accounts have dramatically increased their level of participation in the cash Forex markets in recent years. Add to this the growing use of cash Forex by individual investors and you have a rapidly growing investment arena. The following summarizes the many reasons professional investors have flocked to this market.
Liquidity This market can absorb trading volumes and per trade sizes that dwarf the capacity of any other market. On the simplest level, liquidity is a powerful attraction to any investor as it suggests the freedom to open or close a position at will. Access a substantial attraction for participants in the Forex market is the 24-hour nature of the market. In Forex, a participant need not wait to react to a news event, as is the case in most markets.
Flexible Settlement Many professional investment managers have a particular time horizon in mind when they establish a position. In the Forex market, a position can be established for a specific period of time which the investor desires.
How do I close out a trade?
Retail forex transactions are normally closed out by entering into an equal but opposite transaction with the dealer. For example, if you bought Euros with U.S. dollars, you would close out the trade by selling Euros for U.S. dollars. This is also called an offsetting or liquidating transaction.
Most retail forex transactions have a settlement date when the currencies are due to be delivered. If you want to keep your posi- tion open beyond the settlement date, you must roll the position over to the next settlement date. Some dealers roll open positions over automatically, while other dealers may require you to request the rollover. Most dealers charge a rollover fee based upon the interest rate differential between the two currencies in the pair. You should check your agreement with the dealer to see what, if anything, you must do to roll a position over and what fees you will pay for the rollover.
How do I calculate profits and losses?
When you close out a trade, you can calculate your profits and losses using the following formula:
Price (exchange rate) when selling the base currency - price when buying the base currency X transaction size = profit or loss
Assume you buy Euros (EUR/USD) at 1.2178 and sell Euros at 1.2188. If the transaction size is 100,000 Euros, you will have a $100 profit.
($1.2188 - $1.2178) X 100,000 = $.001 X 100,000 = $100
Similarly, if you sell Euros (EUR/USD) at 1.2170 and buy Euros at 1.2180, you will have a $100 loss.
($1.2170 - $1.2180) X 100,000 = - $.001 X 100,000 = - $100
You can also calculate your unrealized profits and losses on open positions. Just substitute the current bid or ask rate for the action you will take when closing out the position. For example, if you bought Euros at 1.2178 and the current bid rate is 1.2173, you have an unrealized loss of $50.
($1.2173 - $1.2178) X 100,000 = - $.0005 X 100,000 = - $50
Similarly, if you sold Euros at 1.2170 and the current ask rate is 1.2165, you have an unrealized profit of $50.
($1.2170 - $1.2165) X 100,000 = $.0005 X 100,000 = $50
If the quote currency is not in US dollars, you will have to con- vert the profit or loss to US dollars at the dealer's rate. Further, if the dealer charges commissions or other fees, you must subtract those commissions and fees from your profits and add them to your losses to determine your true profits and losses.
Is trading at night as good as day, or week ends?
The Forex market is not open on weekends, but is open 24 hours a day from Sunday evening to Friday afternoon. While the Forex market is open, trades can and do happen at all times and on every currency pair. The manuals suggest some times when trades might happen a little more frequently, but you can find them any time. Even the techniques related to news announcements can be traded around your current schedule.
How much money do I need to trade forex?
Forex dealers can set their own minimum account sizes, so you will have to ask the dealer how much money you must put up to begin trading. Most dealers will also require you to have a certain amount of money in your account for each transaction. This security deposit, sometimes called margin, is a percentage of the transaction value and may be different for different currencies. A security deposit acts as a performance bond and is not a down payment or partial payment for the transaction.
Dealers who are regulated by NFA are required to calculate and collect security deposits that equal or exceed the percentage set by NFA rules. Although the percentage of the security deposit remains constant, the dollar amount of the security deposit will change with changes in the value of the currency being traded.
The formula for calculating the security deposit is:
Current price of base currency X transaction size X security deposit % = security deposit requirement given in quote currency
Returning to our Euro example with an initial price of $1.2178 for each Euro and a transaction size of 100,000 Euros, a 1% security deposit would be $1,217.80.
$1.2178 X 100,000 X .01 = $1,217.80
Security deposits allow customers to control transactions with a value many times larger than the funds in their accounts. In this example, $1,217.80 would control $121,780 worth of Euros.
Value of Euros = $1.2178 X 100,000 = $121,780
This ability to control a large amount of one currency, in this case the Euro, using a very small percentage of its value is called leverage or gearing. In our example, the leverage is 100:1 because the security deposit controls Euros worth 100 times the amount of the deposit.
Since leverage allows you to control large amounts of currency for a very small amount, it magnifies the percentage amount of your profits and losses. A profit or loss of $1,217.80 on the Euro trans- action is 1% of the full price (with leverage of 1:1) but is 100% of the 1% security deposit. The dollar amount of profits and losses does not change with leverage, however. The profit or loss is $1,217.80 whether the leverage is 100:1 or 25:1 or 1:1.
The higher the leverage, the more likely you are to lose your entire investment if exchange rates go down when you expect them to go up (or go up when you expect them to go down). Leverage of 100:1 means that you will lose your initial invest- ment when the currency loses (or gains) 1% of its value, and you will lose more than your initial investment if the currency loses (or gains) more than 1% of its value. If you want to keep the position open, you may have to deposit additional funds to maintain a 1% security deposit.
Some dealers guarantee that you will not lose more than you invest, which includes both the initial deposit and any subse- quent deposits to keep the position open. Other dealers may charge you for losses that are greater than that amount. You should check your agreement with the dealer to see if the agree- ment limits your losses.