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.
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.
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.