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A Primer on Forex Trading





Forex trading refers to trading currency of one country against another; forex is an acronym for Foreign Exchange. When a trader (or an investor for the purpose of buying US exchange listed stocks) buys US dollars by selling an equivalent amount of Canadian dollars as dictated by the foreign exchange rate, they are said to be trading currency.

Forex trading is the most liquid market in the world and forms an essential constituent of today’s global business environment. However, there is no centralized marketplace for currency trading and transactions between interested parties from all over the world occur through computer networks. The international reach of foreign exchange ensures that there are traders, somewhere in the world, asking and bidding for a particular currency at any given time. Hence, currency trading is done 24 hours a day, five days a week.

As most investors/traders would be aware, the Canadian Dollar (CAD) has been on an upswing when compared to the US Dollar (USD) over the last year.

forex

A US trader who bought CAD for 95 US cents in July 2010 could have sold them for 1.05 USD in May 2011 for a decent profit. However, the chart above shows the wholesale rate reserved for large transactions in the order of millions. A small investment of $10,000 US in July 2010 would have received a different exchange rate depending on the broker used (same goes for the sale in May 2011). The retail rate provided by a specific bank or discount broker will be lesser based on market conditions and amount involved and never match the exchange rates available to foreign currency transactions among big players like banks and commercial institutions.

Forex Dealer Compensation

Forex trading is usually conducted through a broker or market maker. For stock trading, the broker takes a trade order to the stock exchange, ensures the execution assuming market conditions offer an avenue, and charges a commission for their service. But, the forex market does not charge commissions. The reason is that institutions involved in foreign exchange trading are dealers and not brokers. Such dealers take on market risk by acting as the counter party to a trade. In the absence of commission-based compensation, they take their cut through the bid-ask spread.

Bid-Ask Spread

The bid-ask (or bid-offer) spread is the difference between the lowest price a seller is willing to accept for a security and the highest price a buyer is willing to pay for the same instrument. The size of the spread varies based on the liquidity and transparency in the market. The higher the number of buyers and sellers in the market at a given time, then the lower the bid-ask spreads. Since the forex market is highly liquid, the spreads are small. Such small price movements are measured in pips.

Pip (percentage in point)

A pip refers to the smallest price movement in currency trading, where prices are quoted to the fourth decimal (except for the Japanese Yen). E.g. Consider EUR/USD at 1.4091; if the sell price were to decrease to 1.4085, then the price has dropped by 6 pips. If the price rises to 1.4191 (from 1.4091), then the increase is worth 100 pips. For this example of EUR/USD, one pip is equal to 1/100th of a (US) cent.

Do you trade in the forex market? How has your experience been? What is your view on currency speculation?

About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.





11 Comments, Comment or Ping

  1. Forex trading? Holy cow. The big money on forex trading is made from offering courses and software on how to do forex trading.

    There’s a saying, something about there’s a sucker at every poker table, look around if you don’t see them………

  2. I haven’t traded currency before, but I can only assume that it involves a massive amount of leverage as the price movements are so small.

  3. 3. John

    Yup, it seems the only thing advertised more on the internet than Forex training courses are enhancers to the “you know where” and pills for “you know what”.

    I did quite a bit of research on Forex a couple of years ago and it seemed that the only people that were making money were the corporate investors moving large sums of money and actually influencing the currency’s value at the miniscule pip scale. These were the day traders that are looking at four computer monitors and following the minute by minute motion of the pips. Who wants to compete with those guys? Not something the average investor reading this blog is capable of. The other Forex strategy that seemed somewhat reasonable was more of a long term 1-3 year approach based less on technical analysis and more on the fundamentals underlying the currencies. I then realized that there are economists that get paid a salary many times more than mine to figure this out and still get it wrong. This is not my type of investment.

  4. 4. DanP

    I did some forex trading awhile ago. I was trying to learn more about trading on techicals and i figured i’d take it more serious if i was using real money. To make any sort of real cash, you are leverage 10x upto a 100x. Its an incredible world but doesnt feel much different than gambling at that point. I couldn’t make any money. I traded every day for a month before giving up. The only way i felt like i had a chance at making any sort of gains was to long CAD, than short CAD at the same time. Than put stop losses on both ends and hope that one broke through strong enough that it would end up making me money. I was sucessfull a few times, but the gains just weren’t worth the large amounts of risk one takes.

    Tough world….

  5. 5. Clark

    DanP: Thanks for the insight.

  6. 6. MB

    A word of caution about the forex brokers.

    You do not want to trade in a bucketshop where your broker is also the market maker. Look for a broker that offers the ECN type market. This is where the liquidity providers are the interbanks (not your broker). The spread gets tighter as more of them participate.

    There will be trading costs, but it is the best way to go. Typically the fee will be smaller than the cost of the spread and you would not have to worry about any manipulation by your broker.

    It is a good idea to stick to the major pairs as they have tighter spreads. Just be careful trading during the economic announcements. The spread does widen dramatically. However, the usual spread should be 1 to 1.5 pips. The decent brokers do provide quotes in 0.00005 increment for the major pairs.

    Forex is just like any other market. It moves up and down and sideways. Only difference is that it offers much higher leverage – thus gains and losses are magnified. Trading (any market) consistently takes lots of skills.

    MB

  7. 7. Ed Rempel

    Hi Clark,

    My view is that Forex is like any futures or options trading – in the long run, nearly everyone loses money. That is because it is a “zero-sum game” with costs.

    It is not like the stock market, which goes up over time. If one trader makes $958.73, then another trader lost $958.73. Plus both paid some costs and bid/ask spread.

    It is like a poker game where after every hand, the house takes a bit of the pot. After a while, nearly all the players are down.

    Ed

  8. 8. Sarlock

    Tough world to play in unless you have a few million to put on the table and have a real firm understanding of technicals in order to take advantage of small price moves and multiply them in to big gains.

  9. 9. Clark

    Appreciate the input from all comers!

  10. 10. Steve Winters

    If you follow your charts and and trade during peak Forex times (US and Europe overlaps I find to be the best) you can be profitable. Forex trading is not really meant to be for long term holds (although you certainly can in nice trending markets – EUR/USD nice up trend from mid Feb to May)

    It’s certainly not for everyone but if you follow the charts like you would any other stock, and enter/exit on key levels you will see some nice results.

    I highly recommend following the EUR/USD pair even if you do not trade forex. You can really see some real nice correlations between the Euro and the way the US market moves.

  11. 11. SixesAndSevens

    Hi there, I did extensive forex trading a couple of years ago.
    With several online brokers, using the MT4 platform.
    I even used automated trading tools (called “Experts”).

    Net result : a lot of time and energy and stress spent, no money made (in fact lost some), lots paid in consulting fees and experts license.
    i guess you could say that the only thing i got out of it was the experience.

    as someone said it’s a zero-sum game.
    you will win some trades and you’ll lose some.
    the automated experts are no more experts than you or i are.
    there are layers and layers of complicated “systems” and “models” and “strategies” but the fact is at the end of the day none of them can see the future.
    and in forex trading it’s very small movements that produce large gains and losses because of the leverage.
    i used over 20 bots at various points in time.
    each of those worked for some time and then stopped working.
    then there would be a new set of bots and the process went on and on for months.

    if anyone is interested, i can explain in more technical terms why forex trading can never work as a money making strategy for anyone, short term or long term.

    among all the different ways of making money in financial markets, i will rank forex trading as the last.
    my list would be:
    stocks
    bonds
    options
    commodities incl. futures
    forex

    my suggestion is save your time and money and go do something else.

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