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The FX market is large, liquid and more accessible than ever for private
investors, who can make large returns on relatively small moves. David
Jones explains how the system works
The foreign exchange market is
the biggest in the world bar
none - trading in excess of a
trillion dollars a day, it is bigger
than any stock or commodity
market. This can be a difficult number to get
your head around but as one expert put it: 'If
you take the next largest traded product -
bonds - it would take 28 days of volume to
equal the volume traded in the FX market
every day'. FX is a 24-hour market, starting off
in Australia and the Far East, then on to
Europe, and finally to New York before the
whole cycle starts again.
The major players in the market are the
large international banks and corporations.
For example, if you are XYZ company based in
the UK and you need to buy in for $100 million
worth of widgets from the USA at the
beginning of next year, you have a currency
risk. Let.s say you do the vast majority of your
banking and business in pounds. The
exchange rate when you place the order is 1.80
- i.e. one pound is worth 1.8 dollars. Your $100
million order will cost you £55.55 million. By
the time it comes to pay for
the goods, let's assume there
has been an adverse move in
the exchange rate and the
pound has weakened by 10%,
making the exchange rate
1.62. Your $100 million order
is now going to cost you
£61.7 million. The various
movements of currency
markets can have a serious
affect on the bottom line of
international companies. One
of the main reasons that FX markets exist is to
help companies .hedge. these risks and insure
themselves against such movements.
Large and liquid
The fact that the market is so big makes it an
ideal one from the point of view of investors
and traders. Because of the size of the market
it is very liquid - the bid/offer spread is very
tight and private investors can now get the
same rates as the institutions (this was not
the case as recently as a few years back, when
the private trader usually incurred wider
spreads).
Like any market the objective of currency
trading is to buy cheap and sell expensive, or
for the short-sellers, sell expensive and buy
cheap. It really is no different to buying and
selling shares in this respect. One currency
does not rise or fall in isolation - the big news
over the past few years has been the weakness
of the dollar - but if one currency is falling, it
means another is rising.
You always buy or sell one currency against
another in the expectation that the market
rate or price will change in your favour. For
example if you thought the pound would rise
against the dollar, you 'buy' pounds and 'sell'
dollars. If you think the dollar will rise against
the euro you would 'sell' euros and 'buy'
dollars. This can be a bit confusing as it looks
like you need to perform two transactions. In
reality, it is not and a couple of examples
should illustrate how it works in reality.
Small moves, big returns
Spread betting is one way to trade FX - all
spread betting companies offer currency
trading. Using spread betting for the first
example, our trader may decide that the
pound is going to rise against the dollar and
calls her spread betting company. As with all
markets there is a bid/offer spread - a price you
buy at and a price you sell at. The spread
betting company quotes 1.7796/1.7800. If she
wants to buy, she will be buying at 1.7800. She
decides to buy £1 per point at 1.7800. Three
days later the pound has strengthened (so
consequently the dollar has fallen) and the
exchange rate has moved to 1.8000/1.8004.
At this point a lot of people will be
wondering how it is possible to make any
decent returns on what is a relatively small
move. The easiest way to explain it is with
currency trading you forget the decimal. So
the example above - in which GBP/USD
moved from 1.7800 to buy to 1.8000 to sell - is
in fact a 200-point move. Our trader decides to
take profits and sells £1 per point to close the
trade. Her profit is 200 times £1, or £200.
Another example will be used to illustrate
short-selling. This time our investor thinks
the recent rally in the euro is overdone and it
due a slide. He calls for a quote in EUR/USD
(euro vs US dollar) and is told '1.2400/1.2404'.
As well as ignoring the decimal point, the
important thing to remember in trading
currencies is when you place the trade it is the
first quoted currency you are buying or
selling. He thinks the euro is going to fall so
he sells £10 per point at 1.2400. A week later he
calls up and is told it is 1.2146/1.2150. The euro
has slid 250 points against the dollar and he
closes the trade netting a £2,500 profit (250
points times the £10 bet size).
Spread betting is not the only way to
participate in the FX markets. You can trade
through normal brokers and there are also
futures contracts available on the major
currencies e.g. euro, yen, sterling - which can
be traded through futures brokers.
With brokers you do not bet £x per point,
but buy or sell so much currency. As an
example, if you thought the euro was going to
rise and did a $10,000 trade, every one point
movement in the exchange rate translates
into a $1 profit or loss; a $100,000 position
translates into $10 per point etc. The futures
markets work in a similar way, with each
single contract covering a fixed dollar amount
of exposure.
It is a different market from the stock
market but the active trader or investor
should not over-complicate it and be put off
from dipping in a toe. 'It is an interesting
market to learn about in addition to your
normal trading or investing portfolio,' says
one insider. 'There are far fewer areas to focus
on - there are really only a dozen or so
currencies that are considered the majors and
there is plenty of information about them'.
Another added: 'The key is the transparency
of the FX market. If the investor has general
experience of financial or investment tools
then I don't think the transition should be
too difficult'.
A double-edged sword
Even during relatively quiet days, the various
FX crosses can move around 30.50 points -
another reason why these markets should be
considered by active traders. And the margin
or leverage available is several degrees larger
than other products such as equity Contracts
for Differences (CFDs) - but as ever this is a
double-edged sword. 'Margin can be
disastrous for traders who are not disciplined
but it is a wonderful thing for people who
trade sensibly,' says one commentator. 'It's
there to give you the opportunity to gear your
position up but should not be used as an
excuse to take on over-large positions'.
Margin coupled with the daily volatility
make currencies the ideal short to mediumterm
speculators. markets, but participants
should always try to minimise their risk as
much as possible. You do not want to find
yourself on the wrong side of a major move in
the markets, and thankfully all of the
companies which offer trading in this area let
you set stop losses, which can stay in place
around the clock so you do not need to worry
about losing your shirt at three in the
morning as the euro plunges.
The easiest way to understand the FX
markets, as with a lot of things, is to just get
on and do it. The mechanics are nowhere near
as complicated as they may appear at first
glance - like all markets it can just go up,
down or sideways and all of the companies
allow you to start off by trading small to
ensure your risk is kept to manageable levels.
When it comes to trading and investing
strategies it could be argued that FX is the
'purest' market out there. The euro is not
going to come out with a profits warning;
no director is going to sell a chunk of
stock; and any analyst.s downgrade is going
to be like a flea on the back of an elephant.
FX does occasionally experience extreme
shock moves - usually as result of, for
example, employment figures, interest rate
announcements etc - but as currencies are
bigger economically than any individual
share, in theory it should make analyses a bit
less fraught.
Certainly from a charting and technical
analysis point of view, the FX markets 'play by
the rules'. There are fantastic longer-term
trends for the investors and lots of bounces
and breakout over all sorts of time frames,
setting up plenty of low risk and potential
high reward opportunities.
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