How to trade the forex markets

What happened to the Japanese yen following the earthquake and tsunami shows just how far and fast a currency can react to global markets. Here’s what you need to know about trading currencies, plus some key points on what drives currency movements.

It's been quite a month for the Japanese yen. Following the earthquake and tsunami, the currency briefly shot up to record highs against the US dollar. It then retreated sharply as the Japanese central bank intervened (helped by the G7 countries) with a new round of quantitative easing.

This kind of event and currency movement is extreme. But it shows just how far and fast a currency can react to global events. So how should you approach the global currency markets (also known as the foreign exchange, or FX, markets) as a novice? Here we look at what you need to know about trading currencies, and in the box below, we look at some of the drivers of currency movements.

Currencies never sleep

The global market for currencies is vast daily turnover can easily exceed equity markets by ten times. They are traded round the clock in the bigger financial centres such as New York, London and Tokyo. This means the choice of currencies available to a spread better is huge and prices can move fast. So this is a market where you should definitely consider stop-losses.

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Currencies come in pairs

When you buy, say, BP shares, your broker won't ask you which firm you are simultaneously betting against. But with currency trades you always bet on a pair. So an up bet on, say, the US dollar, is placed against something else sterling or the yen, or even a basket of other currencies. When you place a trade always have the right pair in mind the key point to note is that your opening position is based on the left-hand currency in a pair. So a 'long GPB/USD' trade is an up bet on sterling versus the dollar. A 'short EUR/USD' trade is a down bet on the euro against the greenback. And so on.

Beware of bet sizes

Currency quotes can be fiddly, running to five figures or more. A GBP/USD quote might be 1.6242/1.6244. A spread bet based on this is placed for an amount per point where a point is the last digit. You will also hear these referred to as 'ticks' or 'pips'. So, for example, if you place an up bet on sterling, you'll be buying the spread at 1.6244. Don't get carried away on the bet size as a novice. Let's say every time the rate moves up by $0.0001 you make £10. That may seem like a tiny movement, but given how fast currencies move, it can still trigger big gains or losses. If positive GDP or jobs data push the rate to 1.6262/1.6264, for example, you make 18 pips (16262 16244), or £180. Great. But had the currency plummeted instead, you'd have lost £10 per pip and that could get expensive without a stop-loss order in place.

What moves currencies?

A currency is a bellwether for a country's economy. So when UK plc is thriving, the pound will normally rise and vice versa. So economic data releases are important to spread betters. You need to know two things as a minimum when key data is due to be released, and the likely impact on a currency. Here are some key points to watch.

Interest rates

If markets expect interest rates to rise, the currency will usually strengthen. That's because, once implemented, the higher rate available on, say, sterling deposits makes the pound more attractive than its rivals. Any hint that quantitative easing (QE money printing) measures might be reversed should have the same effect, because traders will expect the amount of sterling in circulation to fall. Like any other commodity, if you reduce the amount of a currency available, its price (exchange rate) should rise. Equally, if a rate cut is expected, it will weaken, as will any announcement that a central bank plans to do more QE.

GDP and employment data

Wealthy countries tend to have strong currencies. One key wealth measure is gross domestic product (GDP). By extension a growing economy creates jobs. So when key employment data surprise on the upside, a currency normally jumps. Among the most important employment data releases are the monthly US 'non-farm payrolls' report.

Inflation data

Most central banks are tasked with keeping inflation at or below a target rate (2% in the UK). So if Consumer Price Index (CPI the Bank of England's target measure) or Retail Price Index (RPI) data come in higher than expected, the pound will usually rise, because currency traders expect a rate rise to come that bit faster.

Trade figures

The 'trade balance' is the difference between the value of tangible exports and imports (goods mainly) for a particular country. A surplus suggests exports exceed imports (China is an example) and a deficit the reverse (the UK). Throw in the value of services such as tourism and you get a current account surplus or deficit. These figures can influence a currency too. If a trade surplus shoots up, for example, it suggests overseas customers are buying a country's goods. That in turn creates external demand for the currency to pay for them.