What is Foreign Exchange?
Foreign exchange (FOREX), the Global Currency exchange or the FX markets is the largest, most liquid, market in the world. Larger than the equities (Shares) and Futures markets combined, every day five trillion of FOREX transactions is traded globally. In addition to trading for profit – also called speculative trading, FOREX is traded typically to diversify investment portfolios and to hedge against exposures in other assets mostly other currencies. Essentially the Forex markets provides an anchor for the global commerce and transactions. A key difference between FOREX and Equity trading is the size of transactions; FOREX transactions tend to be significantly larger in value and size.
A 24/5, truly global market
FOREX trading begins when Oceania NZ/Australia opens and “follows the sun” across Asia, Europe and the Americas, when the cycle begins again (Excluding weekends Saturday and Sunday. The trading window in each time zone overlaps – Asia with Europe, Europe with US, US with Asia – as such it is possible to trade currencies 24 hours a day.
How does FX trading work?
To properly understand FOREX trading, one needs to know its inner workings. If you’ve ever been to a Currency Exchange Bureaus, you’ve already traded foreign exchange. It means, simply, “exchanging” (buying or selling) one currency for another, for example, selling British Pounds to buy US dollars, or Euros.
FOREX transactions always involve two currencies e.g. the Euro versus the US dollar or EUR/USD, also called currency pairs.
For all currency pairs, there is a bid price – the price at which Sandton Capital Markets will BUY currency from client (in exchange for the other currency) and an offer (or “ask”) price – the price at which Sandton Capital Markets 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/USD1.15 means 1 euro is worth 1.15 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. The difference between a bid and offer price is called a spread. 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 FOREX, a client 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 a client 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 Prime 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/shares transactions, a client 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 a particular FOREX trader expected the euro to strengthen against the dollar they would BUY EUR/USD. Conversely, if they anticipated a market fall, they 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 1:200 margin would mean that a client would need to deposit only U.S $1,000 in order to hold a positions of $200,000; they deposit in to their trading account U.S $1,000 is ‘leveraged’ to allow them trade in much larger size. Margin is a double-edged sword; while it can result in significantly larger gains if the market moves in client’s favor, if it moves against the client’s it can increase their potential losses accordingly.
Example of a FOREX Trade
- A trader deposits $10,000 In Sandton Capital Markets Trading Account. The account is set to 0.5% (Half of a percent) margin or 200:1 Leverage. What this means is that for one lot opened of 100,000 the trader must maintain at least $500 in Margin (100,000×0.5%=$500).
- If the trader expects that Euro is going to rise against the US Dollar, he/she will buy $100,000 or 1 standard lot of the EUR/USD. The market quotes EUR/USD, The investor buys EUR at 1.1517 versus the USD.
- By making this trade, the trader effectively commits to the simultaneous buying of EUR 100,000 (1lot of EUR 100,000) and the selling of $115,170 (100,000 x 1.1517) of U.S dollars, by using $500 as Margin (100,000×0.5%) and borrowing $99,500 from Sandton Capital Markets.