Why Trade Foreign Currency?
Foreign exchange is the world’s largest and most active market. It’s where banks and dealers exchange large amounts of foreign currency, mostly to facilitate trade and investment between countries. It’s open all day and night – except at weekends – and its volume amounts to around $US4 trillion a day.
High liquidity means there is always someone to trade with, and there is very little risk of a single player being able to move the price, as can happen in other markets.
The foreign exchange market also offers the ability to profit from a large position in the market for a small upfront cost, known as the initial margin. This is called leverage, which in the foreign exchange market is a ratio of at least 100:1. In order to buy $A10,000 worth of US dollars, for example, you only have to pay $100 to enter the trade. But leverage goes hand in hand with risk, which means it’s essential to have a strict risk management plan and to follow it without fail. Leverage can be dangerous for investors, but for traders it’s a useful tool when used with caution and understanding.
Provided you have learned how to trade like a professional – using sound risk management principals and using the tools of analysis that give you a trading edge – and provided you can keep to the rules you will learn here or in a more advanced study course – the foreign exchange market has the potential to allow you the freedom of earning a living from home.
With experience and persistence, and with the right guidance from courses and trained coaches or mentors, you may even be able to build your capital to the point where trading offers you the opportunity to become independently wealthy.
Easy to understand
Dividends, price-earnings ratios, takeovers, quality of corporate management, deciding which shares are likely to move in which direction – the learning curve in the sharemarket is fairly steep and the amount of analysis required can be daunting.
By comparison, foreign exchange is relatively straightforward. You take a currency you’re familiar with (say, the Australian dollar) and you look at its value against just one other currency at first (for example, the US dollar). This is known as a currency pair – one currency valued in terms of another. There are only a few major currencies that lend themselves to forex trading. You don’t have to pick stocks and then follow their fortunes individually.
This guide will help you learn what influences movements in a currency pair and, just as importantly, show you how the most successful traders use technical analysis such as price charts and technical indicators to improve their chances of success.
Trade at home or on the move in your own time
One of the features of foreign exchange trading that makes it so popular is that markets are open 24 hours a day and you can trade directly from your desk, or even while sitting in your favourite cafe with your laptop and a wireless internet connection. Some traders even take it a step further by trading on their mobile phone.
This flexibility means you can trade after work, early in the morning, during lunch or even overnight – whenever it suits you. Foreign exchange providers give you more or less direct access to the markets. This means you can do your analysis, make your trading decisions, set a stop-loss order to help protect yourself against big losses and execute the trade without ever needing more than your computer and a broadband connection.
World’s biggest market – no waiting
Because the foreign exchange market is global and includes all of the world’s largest banks, you can be sure that there’s always someone to trade with – unlike the share market where you might want to buy a particular share, but no one wants to sell (or vice versa).This ability to trade at any time is called liquidity. The size of the global market is variously estimated at somewhere around $US4.0 trillion a day – by far the world’s biggest, deepest and most liquid market.
Low transaction costs
The cost of trading in forex varies depending on your provider and whether you are trading the spot forex market or a derivative such as a CFD, option or warrant.
In the forex market, trading directly or through derivatives, the cost of trading currencies is determined by the spread, which is the difference between the price at which traders can buy a particular currency pair and the price at which they can sell. This spread can vary from time to time, depending on market conditions, and is different depending on the currency pair and which provider you use. For most trading purposes, the cost of each trade is not vitally important to its success. The exception is for some intraday strategies which aim to capture small profits.
On a trade size of $10,000, for which you need an initial margin of $100, the spread will usually average around three pips or approximately $A3.00. (A pip is the smallest move in the forex market; see How Foreign Exchange Prices Work). The spread can vary from as low as one pip for high volume major currencies to five or more pips for minor currencies.
If you hold a position for longer than 24 hours, there may be a small interest charge, depending on the interest rate differentials between the two currencies. At other times you may be paid a small amount of interest on your position. This interest amount is credited or debited as your position is rolled over to the next day, and is made so that you can keep the position open without actually taking delivery of the currency.
Higher leverage than shares
Leverage is the ability to pay only a small amount of the value of a currency as an initial payment to open a trade. Leverage can be a double-edged sword, as using the maximum leverage can give you the maximum possible profit on a winning trade – or the maximum loss on a losing trade. The maximum leverage in the share market is usually 20:1, which means your contract is for 20 times the initial margin (deposit) you pay. In contrast, the foreign exchange market offers leverage from 100:1 and up to 400:1 with some providers. With 100:1 leverage , to enter a trade involving $A100,000 worth of US dollars, you need only pay an initial margin of $A1000.
With this amount of leverage, even very small moves in the value of a currency can result in quite large gains and losses. You will need to learn how to place stop-loss and stop-limit orders (that is, orders to close a position when the price reaches a set level) and the basic rules of risk management to trade safely in the market. This guide will get you started, but unless you are an experienced trader you will need to take some time to learn about trading plans, risk-reward ratios, money management, position sizing, fundamental analysis and technical analysis before you begin.
To show you the kind of returns this level of leverage can offer, suppose you buy Australian dollars and the Australian dollar’s value rises from $US0.90 to $US0.92. A currency can move by this amount, or more, in a matter of a few days when markets are moving swiftly. It represents a change of 2.2 percent, but since you have leverage of 100:1, your profit on the upward move will be 100 times 2.2, or 220 percent, based on the initial amount you pay.
To put it another way, if you were trading one lot, your original $US90,000 is now worth $92,000, an increase (profit) of $US2000, which is worth $A2200 This is the profit you made on your $1,000 initial margin. Our simplified example does not take into account the spread or costs to carry your transaction. For a more detailed example and typical costs of trading see How Trading Works.
High leverage also brings with it a large level of risk compared to ordinary trading. We give you some pointers in how top traders manage this risk in Your Forex Trading Plan.
Need to know
- Foreign exchange trading can be extremely risky yet highly rewarding because of leverage.
- It’s easier to begin trading forex than shares, but you still need to do some homework before you start.
Thank you to Knowledge to Action for providing this information.
