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Knowing the answers to some of these top questions about currency trading will not only help you to better understand this market but will ultimately help you to become a successful forex trader.
Every market and industry have their own vocabulary and the foreign exchange market really is no different. Below are some popular terms that will make you sound like a professional in just about no time:
- Base currency: first currency cited in a pair
- Authorised dealer: institution approved to work in the foreign exchange market
- High/Low: daily traded price
- Spot price: current market value
At first glance, forex trading may seem like an ad-hoc arrangement, especially compared to those structured exchanges such as the NYSE. While bewildering, forex trading actually works exceedingly well. Why? Participants in FX must compete and cooperate with each other. This self-regulation drives effective control over the market. But not to worry, as reputable U.S. FX dealers become a member of the National Futures Association (NFA) which means they agree to binding arbitration in the event of a dispute.
Being the most prevalent type of trade in the forex market, the carry trade is based upon the principle that every currency has an interest rate.
Put simply, the trader invests in the currency with the high-interest rate and finances it with the currency with the low-interest rate. Depending on the marketplace and timing of investment, the yearly return from the difference in interest rates between the respective currencies could be extremely high and yield very little appreciation.
While you might be inclined to run out and buy the next high-yielding pair, it’s important to be cautious as the carry trade can have severe and rapid declines. Known as the carry trade liquidation, this occurs when it’s decided upon that the carry trade won’t have any future potential. Once this is called, every trader and investor starts to seek his/her exit strategy. Then bids will start to disappear, and ultimately profits from the difference in interest rates aren’t nearly enough to cover all the capital losses. Essentially for the carry trade strategy to successfully work, anticipation is key.
Yes, all currencies are always traded in pairs. Knowing this, traders always know that he/she will always have “more” of one currency and “less” of the other. For example, when trading from EUR/USD, the exchange of euros to dollars would mean that the trader has “less” euros and “more” dollars. Despite the fact that there is no physical interchange in FX trading, the principle and consequences are very much just as real as any.
Speaking Of Currencies, What Currencies Are Typically Traded In The Foreign Exchange Marketplace?
While some dealers may trade in exotic currencies, the forex market typically trades with the seven most liquid currency pairs in the world:
- Euro to US Dollar
- US Dollar to Japanese Yen
- British Pound to Dollar
- Dollar to Swiss Franc
- Australian Dollar to US Dollar
- US Dollar to Canadian Dollar
- New Zealand Dollar to US Dollar
These currency pairs along with various combinations of the above, such as the Euro to the New Zealand Dollar, make up a high percentage of all FX trading.
Nothing. In the retail forex trading market, there is no tangible exchange ever. All FX trades exist virtually in a computer and are computed out per market price.
So why then does the FX market even exist? To simplify the day-to-day exchange of one currency into another for large organisations that continuously trade in the foreign market. More often than not, the main reason that FX markets exist is so that these multi-billion institutions can “express” their opinions on day-to-day fiscal and political events occurring in the world. This “trading” is, of course, purely speculative.
Standing for percentage in point, pip is the smallest increment or price change that can occur in exchange. In this market, prices are typically cited to this fourth decimal place (1/100th of 1%) and the pip is equal to exactly that. To give an example, a bottle of shampoo at a drugstore would be priced at $3.50 and in the FX market, it would be priced at $3.5000.
To put it simply, no. Unlike the stock market that you’re probably used to, forex trading is a principals-only market. And unlike these exchange and physical-based markets, here firms are called dealers and not brokers. Dealers accept market risk by being the contra party to the investing trade. While brokers charge commission, dealers make their compensation via the bid-ask spread.
What exactly is the bid-ask spread? This spread is the difference in the amount of the ask price and the bid. Often, the ask price surpasses the bid. In this rule, every gain (or profit from the difference) down to the very last penny is considered to be a profit and given to the investor. However, this bid-ask spread is quite tough to overcome and makes scalping in this marketplace that much more difficult.
Currency trading doesn’t take place on a regulated platform like with stocks nor is it controlled by an overarching governing organisation. There are also no clearing houses to assure legitimate trades or an arbitration panel for disputes. All trades are based upon credit agreements. This business which is housed in the biggest, most liquid worldwide market is finalised via a mutual understanding and virtual handshake.
But that’s not the only way in which the forex market differs from others. Some other ways include:
- Uptick rule doesn’t exist like it does in stocks
- No limits on trade size. If you have the capital, you can trade it
- Insider trading is nonexistent. In fact, European financial data is often leaked way before it’s officially released.
While forex trading might seem like the wild wild west right about now, it can be conquered. Like we mentioned above it is the most liquid and fluid market in the world. Encompassing countries in all continents, the sheer size and scope make this market the most readily available in the world. Trading occurs 24 hours a day Sunday through Friday, and there are rarely gaps in prices.
Your margin requirement equals the units of the base currency divided by your leverage.
Example 1: trade of 1 lot on GBPUSD with leverage of 1:100 1 lot = 100,000 units of base currency, in this case GBP100,000 100,000 / 100 = GBP 1,000 margin requirement.
Example 2: A trade of 1 lot on GBPUSD with leverage of 1:500 1 lot = 100,000 units of base currency, in this case GBP100,000 100,000 / 500 = GBP200 margin requirement.
A buy/sell limit order is an instruction to deal if the price moves to a more favorable level than where it’s in the market now.
That’s why these orders are sometimes called improvement orders.
A limit order is a request to buy at a price lower than the current price or request to sell at a price higher than the current price.
If the current offer in GBPUSD is 1.61086, you might leave a limit order to buy at 1.61070.
If the current bid in GBPUSD is 1.61086, you might leave a limit order to sell at 1.61099.
A buy/sell stop order is an instruction to deal if the price moves to a less favorable level than where it’s in the market now (remember: it’s less favorable to buy at higher prices and to sell at lower prices).
A stop order is a request to buy at a price higher than the current price or a request to sell at a price lower than the current price.
If the current price of spot EURUSD is 1.38985, you might leave a stop order to buy at 1.38998.
If the current price of spot EURUSD is 1.38985, you might leave a stop order to sell at 1.38975.