Currency trading involves some risks that could lead to losing capital. However, an investor can have a successful trading journey once they invest in learning, practising, and gaining more experience. Currency trading is conducted in the forex market.
What is Currency Trading? It is the buying and selling of currencies in the forex market. The world’s largest investment market keeps on growing. The market comprises both retail and institutional investors. The trade involves foreign currency exchange and is the leading liquid asset market. Below are some key basics to know.
- In currency trading, the fluctuation of prices depends on the overall individual country’s economic state such as financial/trade flows, instability, and geopolitical risks.
- The currencies are traded in pairs (a pair versus the other) i.e. EUR/USD. The pairs are quoted in pips or points percentage, i.e., 4 decimal places.
- Currency trading is a 24/5 trading affair.
- Despite being the largest market, only a few paired currencies make up most of the trading activities or turnover, unlike the trading of commodities on CFDs where thousands of assets are traded.
In this post, we will expound on the following topics:
- What are the types of currency trading?
- Why you should trade in currencies
- How does currency actually work?
What are the types of Currency Trading?
There are various types of currency trading or markets. Experts derive their functions from the way they operate. Currency trading requires trustworthiness. Some contracts need to be entered and be safeguarded. Here are some types of currency trading including spot, forward, future, option, and swaps.
The spot market is the most known of all. It is the quickest and simplest. Both the buyer and seller get immediate payment as per the prevailing exchange rate. It accounts for 1/3 of all currency trading. The settling of transactions takes between one and two working days. The traders are prone to volatility where there could be price fluctuations regarding the contract and trade. Spot transactions have been on the rise. They come in the following forms: banking transfers and selling /buying currencies.
Spot market accounts for almost 50% of all currency trades; this is according to BIS (Bank of International Settlements). There are several participants in this market segment, including central banks, brokers, dealers, speculators, and arbitrageurs.
The forward market involves two entities who agree to trade at a future date at a specified quantity and price. There is no monetary exchange or security deposit during the signing of the agreement in this type of market. For hedging and speculation, forward contracting is very vital. For example, a wheat farmer forward sells their harvest at a known fixed price to avoid risk. A cake producer forward buys the cake to help in planning the production to avoid price fluctuations. This allows the speculators to come in; they buy in the forward market and wait for a price hike, then sell at high prices. The speculators base their speculation on forecast information or their experience. One of the greatest challenges is the possibility of price movements either way due in the long term. Another good example is trading shares via CFDs, where investors, speculate on the share price movement.
Option refers to a contract that makes an options trader not to be under any obligation to sell or buy the asset at a constant price at a specific date or time. There are two options: call option (grants the buying right), and put option (grants the selling right). For example, the option for buying USD for the Indian rupee (INR) as the base currency, US dollar becomes the call and INR the put. The symbol is as shown USD/INR or USDINR and vice versa.
A currency option is another class of asset for traders that is linked to currency derivatives. It allows a trader to perform a call on exchange rate performing both hedging and investment goals. Several factors affect the prices of currency options such as risk interest rate, exchange rate, volatility, maturity time, and strike price.
Future markets or trading futures give solutions to challenges in the forward trade. However, they seem to work similarly. The contracts have standards with centralised trading. In this one, there are no counterparty risks because the clearing firm guarantees for either side of the transaction/trade. The market has high liquidity because many traders can take part in the same transaction or trade.
Who trades currencies?
Before we talk about why an investor should trade in currencies, it is important to know who trades currencies. The currency trading market involves many diverse players. Let us have a look at them.
Retail or individual investors: this segment is not huge, but it is sprouting. Investors base their trades on a combination of both technical and fundamental factors such as resistance, price patterns, indicators, support, interest rate, inflation rate, or monetary policies.
Hedge Funds and Investment Managers: this cluster takes a considerable portion of the market. It comes second to investment banks and central banks. Investment managers trade for large accounts like endowments, pension funds, and foundations. For example, an investment manager who deals with the international market segment will buy and sell currencies and trade foreign securities. The managers can also perform speculative trades. Hedge funds do the same, to strategise on their currency trading.
Central Banks: these represent governments and are very crucial currency trading players. A combination of interest and OMO (Open Market Operations) guidelines by central banks influences the interest rates. Central banks also regulate their native currency pricing on forex. The banks get into forex trading to stabilise and speed up the competitiveness of the country’s economy. Central banks can suppress their currency by the creation of more supply especially during long deflationary trends. It prompts buying of foreign currency. The act deflates the local currency, which triggers exports’ competitiveness globally.
Multinational corporations: Corporations that import or export do currency trading to pay for services and goods. For example, a German producer of metal products imports trading metals from the US then sells the metal products to China. Once the last sale is executed, the Chinese Yuan that the metal producer received must be converted into Euros. The EUR will then be exchanged into USD to buy more components that are metallic. The firms also trade forex to hedge risks that come with currency transactions. It also offers safety for offshore investments.
Investment and Commercial Bank: Interbank Market carries the greatest currency trading volume. Banks trade currency directly or through electronic platforms. The banks facilitate transactions for customers and conduct speculative trades on their trading desks. When the banks are acting on behalf of customers, the bid-ask spread represents their profits.
Why you should trade in Currencies
Having understood who trades currencies, let us turn to “Why you should trade in Currencies”.
The collaboration between various types of currency traders stabilises the global market by injecting more liquidity, resulting in a major business impact globally. How the exchange rates move influences the balance of payments, inflation, and global corporate earnings.
For example, the carry trade that is executed by various types of investors has a direct influence on how exchange rates behave, and therefore, the global economy experiences the spillover effects. The carry trade is executed to confine variations in yields among currencies through borrowing low-yield currencies, then selling them to buy high-yield currencies. For example, where JPY has a low yield, the traders can sell it and buy a high-yield currency.
As time goes by, interest rates for high-yield countries fall towards lower-yield countries. Once again, the carry trade unwinds, allowing traders to sell the higher-yield investments. An unwinding of JPY can force huge Japanese firms to return to the local economy as the spread between domestic and foreign yields narrows. The action can trigger a huge global equity price decrease.
There are other reasons you should trade in currencies:
You can start trading with a minimal amount where the cost of the transaction is very considerable.
The market is free for all: nobody controls it. It comprises several key players. If one is a beginner, there is no need to worry because there are brokers who offer reliable resources to enable beginner traders to start their currency-trading journey.
Currency trading is a 24/5 affair, hence it offers the liquidity for retail investors to buy and sell their assets with little worry about their net value. The liquidity also minimises the currency trading risks. The market is not limited by time or location, because for 5 days there will always be a region operating.
The brokers allow a retail trader to borrow liquidity in order to open a higher position, which might result in more profits or losses depending on the market’s outcome. The process is known as leverage. There are also demo accounts that, as a newcomer, you can use to gain some confidence in trading currency.
The market allows you to interact with other traders globally, where you can share or borrow some tips on currency trading. A trader can enjoy many other benefits from this expansive market. Now let us understand how currency trading works.
How does Currency Actually Work?
Currency trading is a 24-hour operation from Sunday evening to Friday evening. It has 3 sessions, i.e. US, European, and Asian trading sessions. Despite some session overlaps, each market’s major trade mostly follows the set market hours. Certain currencies pairs will trade more during particular sessions. For traders with USD-based currency pairs, they find trading volumes in the United States trading sessions. The same trend happens in the other two trading sessions. Below are some basics of currency trading you should understand if you want to succeed in this risky but profitable investment.
Currency Pairs and Pips
As opposed to the stock market, where you can trade a single stock, currency trading is traded in pairs. You purchase one currency and then sell another one in the foreign exchange market. Currency pricing mostly follows a four-decimal point. However, all currency pairs where JPY (Japanese Yen) is the quote currency use two decimal places, with each pip being represented by the 2nd decimal point.
Pip is the smallest percentage increment of trade, i.e. 1/100 equals one pip (1%).
Another key aspect of currency trading is the fact that currencies are traded in lots. Lots come in different sizes, such as a standard lot (100,000 units), mini lot (10,000 units), and a micro lot representing 1000 units, especially where USD is the base currency.
Most currency trading beginners use micro-lots that have the lowest pip unit-10 cent price move. They do this for obvious reasons, to help manage risks or losses in case a trade backfires. Remember, some currency pairs move to almost 100+ pips in one trading session, which makes them more prone to making huge losses. Starting small is key and then you can increase your trading volume as you gain more exposure and experience.
With the many currency pairs out there, the biggest part of the currency trading volume revolves around 18 currencies, unlike the many stocks that are traded in the equity markets globally. The most traded pairs are the USD, CAD, EUR, GBP, CHF, NZD, AUD, & JPY. As most of us know, currency trading is not magic but hard work and patience, coupled with a lot of learning. Therefore, trading in a few currency pairs enables traders to manage their trading portfolio.
The Currency Movers
More and more stock traders are gravitating towards the currency markets because currency movers also influence the stock markets. This means there are some similarities.
Of course, currencies move because of obvious reasons. The major contributor to this move is the supply and demand curve. As the demand for more dollars globally increases, the dollar value increases. Similarly, when the dollar supply is too much in the market, its value decreases.
There are other currency drivers, such as geopolitical tensions, emerging economic data from the largest economies, inflation, and interest rates.
As it is with other investment markets, the various learning resources available out there make currency trading easy to understand. However, finding a reliable and winning trading formula requires more practice and patience. There are forex brokers who will offer free demo accounts that give you the practice and experience needed to kick start your currency trading.
This information is not considered as investment advice or an investment recommendation, but instead a marketing communication. FXCess is not responsible for any data or information provided by third parties referenced, or hyperlinked, in this communication