There are basically three ways:-

  • 1. On an exchange that is regulated by the Commodity Futures Trading Commission (CFTC). For example, the Chicago Mercantile Exchange offers forex futures and options on futures products. Exchange-traded forex futures and options provide their users with a liquid, secondary market for contracts with a set unit size, a fixed expiration date and centralized clearing.
  • 2. On an exchange that is regulated by the Securities and Exchange Commission (SEC). For example, the Philadelphia Stock Exchange offers options on currencies (i.e., the right but not the obligation to buy or sell a currency at a specific rate within a specified time). Exchange-traded options on currencies have characteristics similar to exchange-traded futures and options (e.g., a liquid, secondary market with a set size, a fixed expiration date and centralized clearing).
  • 3. In the off-exchange, also called the over-the-counter (OTC), market. A retail customer trades directly with a counterparty and there is no exchange or central clearing house to support the transaction. Such dealings are dealt with by “Forex Brokers” and enable non-professionals and professionals alike to engage in Forex Currency Trading directly with minimal costs.
  • 4.  Some countries allow Spread Betting. (Notably the UK but excluding USA) This is a bet on the future movement of a currency – the more the price moves in the direction of the bet when placed the more the bet returns in exact proportions to the movement of the currency’s price. In certain countries any gains are tax free.

We are really concerning ourselves here with Option 3.  However, much if not all, of the information following will be just as relavant to the other two methods and for some people the other routes may offer better ways to trade due to their individual circumstances.

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 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 broker 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?

Before opening an account, you should check with several brokers and compare their charges as well as their services. If you were solicited by or place your trades through someone other than the broker, 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. A few firms may also charge a different mark-up for buying the base currency than for selling it.

However with competion over the last few years the “spread” has become the sole means of brokers income.  And the spread has gradually been reduced until it’s now possible to trade some markets with as little as a 1 pip spread (0.0001) and spreads of just 2 or 3 pips or the norm.

Hence trading the Forex currency market is now by far the cheapest in terms of transaction costs. Add to that the fact that Data is freely available as are charting software packages and you have compelling reason why trading Forex is so popular.

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 convert the profit or loss to US dollars at the brokers rate. Further, if the broker 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.

How Much do I need to start Trading?

The price movements in currencies are relatively small. Let’s say you bought $100,000 worth of the Gbp/Usd at 1.5650. An hour later the exchange rate has improved to 1.5680 (a 30 “pip” move 0.0030) and you decide to take your profit. This would be $300.
This represents just 0.3% profit of the $100,000 the transaction cost. Making even meagre profits will be difficult given this scenario.

That’s where LEVERAGE comes in.

Brokers allow traders to just put up a “margin” or deposit against the transaction. These vary but are usually in the 50:1 to 500:1 area.
Taking an example of 100:1 leverage you would only need to put up a deposit of $1000 to do the same trade as above. The $300 profit now represents 30% profit!

However- be warned – the reverse is also true and losses can very quickly eat into the capital allowed for trading.

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