I don’t know about you, but I am a beginner when it comes to currency trading. The potential to make money trading currencies seems great, but if you’ve never done it before, there are probably some things you should know.
First, I was surprised to learn that foreign exchange (FX) trading does not take place on a regulated exchange like the New York Stock Exchange (NYSE), the National Association of Securities Dealers Automated Quotations (NASDQ) or the Chicago Board of Options Exchange (CBOE) that we are all familiar with. Instead, currencies are traded based on credit agreements between the parties.
“Hmm,” you say: “What if I have a problem with a transaction? Who can I turn to for help?” And those are certainly, very good questions. There must be some mechanism that individual investors can rely on, and there is. Reputable U.S. retail dealers in foreign exchange belong to the National Futures Association (NFA). As NFA members, the dealers are required to agree to binding arbitration in the event of a dispute. And now, with new legislation passed in 2008, the U.S. Commodities Futures Trading Commission (CFTC) has jurisdiction to enforce rules. So, if you make sure to trade through an NFA member firm, you’ll have some recourse if you run into a problem.
Before the internet, foreign exchange was primarily traded by financial institutions, large companies and sophisticated investors. Multi-national corporations still comprise a large part of the market as they move funds between currencies to cover payroll, and buy raw materials and services globally.
Today, the foreign exchange market is one of the most liquid markets in the world and many individual investors are finding profitable opportunities. Trades are made 24 hours a day, from Sunday at 5 p.m. Eastern Standard Time through to 4 p.m. Eastern Standard time on Friday.
I’ve looked at foreign exchange quotes and I wasn’t quite sure what I was looking at. I found out that foreign exchange prices are generally quoted to the fourth decimal point (1 euro=$1.4291). The exception is the Japanese Yen which is quoted to the second decimal point (1 dollar=84.99 yen). All trades are settled on a net basis, and most retail brokers will automatically translate any foreign currency profit or loss resulting from trades into the denomination of your account. So, if you’re like me and have a U.S. dollar account, you’re going to see dollar profits or losses applied to your account.
And here’s something else you need to know: Currencies trade in pairs. Trades consist of the simultaneous purchase of one currency with the sale of another. It’s a lot different than trading stock because you have to think about both sides of the transaction in relation to each other. For instance, you would buy a currency only if you expect it to increase in value compared to its paired currency. Once you’ve made a trade purchasing or selling a currency pair, you have an open position until you complete an equivalent opposite transaction to close the position. You will not lock in your profit or loss until the position is closed.
There are numerous currency pairs that are traded. The four most actively traded pairs are:
- EUR/USD (Euro/U.S. Dollar)
- GBP/USD (British Pound/U.S. Dollar)
- USD/CHF (U.S. Dollar/Swiss Franc)
This is not as confusing as it looks. The first currency in the pair is the base currency and the second is called the counter currency (also called the quote currency). When U.S. Dollars are the base currency (i.e., USD/JPY), a price quote tells you what one U.S. Dollar is worth in the other currency.
And if you’re used to trading stock, you’re used to paying commissions to your broker. But in the FX market, foreign exchange firms are dealers (not brokers) and they act as principals in the transaction. That means that instead of charging commission, dealers actually act as the counterparty in a trade. By doing that, the dealer is exposed to market risk and they make money on the difference between the bid price and the asking price which is called the spread. In other words, you can’t buy at the bid price or sell at the asking price; you have to transact above or below those levels so the dealer firm will pick up the price differential. That’s how they make money instead of charging commission. And for you, the investor, to make money, you first have to recover that cost.
Now, I know a little bit more about currency trading, and I hope you do too. But what I know is definitely not enough to make me comfortable trading independently. I bet you feel the same way. I’ll continue to pass along information about currency trading as I learn. Unfortunately, I’m afraid I’ll miss some great opportunities in the market while I’m learning, and I don’t want to do that.
There is an answer for folks like us. Bryan Rich, Weiss Research currency analyst, has a wealth of knowledge, great insight and he spends a lot of time doing in-depth analysis of the currency markets. Moreover, he shows you ways to participate in currency moves with new, innovative exchange traded funds (ETFs). These ETFs track global currencies and trade just like a stock in your normal stock brokerage account.
I’m going to check out Bryan’s World Currency Trader so I can get in on the action, while I’m learning. You might want to consider that too!