How to trade in the forex markets

published 16 October 2013

What's the world's most-traded asset? US shares? US government debt (Treasuries)? Crude oil? Nope not even close. It's currencies.

Foreign-exchange trading also known as forex, or FX is by far the most active market out there, with an estimated daily turnover of $4trn. By comparison, the New York Stock Exchange turns over about $50bn per day.

FX is attractive to traders, for two main reasons. The first is that money never sleeps (at least during the week): currencies are traded around the clock, with activity passing from Asia to Europe to North America and back to Asia.

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The second is that it is extremely fast-paced and highly liquid, presenting plenty of trading opportunities.

So how does FX trading work? The key point is that currencies come in pairs. If you are betting on the US dollar, it has to be against another currency, such as sterling. Pairs are written in the form GBP/USD. The opening position is based on the currency on the left so long GBP/USD' is a bet that sterling will strengthen against the dollar, while short EUR/JPY' is a bet that the euro will weaken against the yen.

Currency quotes usually run to four decimal places (except pairs involving the yen, which run to two). The last digit is referred to as one pip, or one tick. So if sterling is quoted at 1.6038 and it moves to 1.6035, that's three pips.

FX quotes are provided with a bid-ask spread, just like with spread betting. So if the GBP/USD is currently 1.6038, the spread might be 1.6037-1.6039. Pairs that involve the US dollar have the tightest spreads, reflecting the fact that the dollar is the world's most actively traded currency (around 80%-85% of currency trades involve it).

You can place FX trades in two main ways, depending on the provider you use. With a spread-betting firm you will usually place a trade in terms of pounds per point, where one point equals one pip. Alternatively, if you use an FX broker, you will trade a notional amount for example £10,000.

In the example above with a spread of 1.6037-1.6039, a £10,000 bet would gives you long GBP exposure of $16,039. If GBP/USD then weakens 30 pips to 1.6007-1.6009, your position is worth $16,007, a loss of $32.

As you can see, a single pip is a very tiny move. But currencies usually don't move 5% or so in a day unlike stocks so providers often grant relatively high leverage. Margin of 5% of the face value of your position ie, leverage of 20:1 is common. Some will grant margin of 0.25%, amounting to leverage of 400:1.

However, high leverage must be used with great care: one exceptionally volatile day's trading could easily wipe your margin and cause your broker to close out your positions at a loss. Always employ stop-losses and begin with far less leverage than your provider may allow.

FX trades are often opened and closed within a day, but can be rolled over if you choose. Each night your account will be debited or credited to reflect the interest rate differential between the two currencies in your trade.

If you have bought a higher-yielding currency versus a lower-yielding one, you will receive interest, while if you are long a lower-yielding currency versus a higher-yielding one, you will be charged interest.

Some providers also offer forward contracts in which you bet on the price of the currency three months or more ahead. These can offer a cheaper way to take longer-term positions.

What drives currencies?

Economic data: countries with strong, stable economies tend to be viewed more favourably by traders. The release of statistics on growth (GDP), unemployment levels and retail sales can cause a currency to rally or sell off against its peers when data is stronger or weaker than expected.

Interest rates: investors prefer to borrow in countries where money is cheap, and put it to work where rates are high. So higher and rising interest rates and the expectation of rate rises often cause a currency to strengthen. As a result, central-bank interest-rate moves are major events for FX traders.

Trade balances: there will usually be higher demand for currencies of countries that run trade surpluses than for those that run deficits.

Inflation: high inflation erodes the value of a currency. This could make it less attractive but it may also increase expectations for an interest-rate rise, which would imply a stronger currency.

Risk: political risk, financial risk and factors such as military action can have a huge impact on FX. Safe haven' currencies, such as the Japanese yen and the Swiss franc, have tended to rise in recent years when investors are especially fearful.