Currency Trading for Profit

Forex Trading and Exchange Rates

The foreign exchange market is a massive global market where trillions of dollars are traded on a daily basis. The market is primarily conducted directly between counterparties rather than through a central clearing house. The market is made up of a wide variety of participants. The market makers, or liquidity providers, are generally banks. The end users include; currency speculators, companies involved in import/export, fund managers with international portfolios and central banks. The market consists of a variety of 'instruments' or contracts but the big four are the 'spot' market, the 'forward' market, the 'swap' market and the 'currency options' market. The spot market is by far the most accessible and popular for private investors.

Forex Trading
The forex trader's goal is to profit from moves in the exchange rate between two currencies. Exchange rates move up and down from minute to minute as buyers and sellers exert their influence over the market.

There are as many different exchange rates as there are combinations of pairs of different currencies, however the majority of trading occurs in the following currencies; Japanese Yen, US Dollar, Euro, British Pound, Australian Dollar and Canadian Dollar. These currencies have significant market depth (liquidity) which ensures very small bid/offer spreads and constant price discovery.

Private investors gain access to forex markets by trading on a leveraged basis on either the spot market or the futures market. The futures market has been overtaken in popularity by brokers offering leveraged foreign exchange via online dealing platforms that offer 24 hour access and very tight spreads.

Margin Trading
Private investors usually trade the forex markets on margin. This means that they lodge an initial deposit to their FX broker usually between 2% and 5% of the amount they wish to trade. If the investor's position starts to lose money the FX broker would normally 'margin' the client which is a request for more funds to cover the unrealised loss on the forex position.

Trading on margin allows the investors to have a much larger exposure to the forex market than would be possible if the investor needed to have the full face value of the amount to be traded. This brings greatly increase risks of significant losses but also makes possible significant profits.

Spot Transactions
A spot contract is an agreement to exchange one currency for another currency at an agreed exchange rate and usually settles within 2 business days. There are some exceptions to this rule such as the Canadian Dollar which settles the next day. Spot transactions make up about 30% of forex market turnover.

Swap Transactions
A currency swap is where a contract is agreed to exchange currencies at a rate at the 'near' date and then exchange them in the other direction at the 'far' date at a different exchange rate. The difference between the exchange rates is principally determined by exchange rate differentials. Currency swaps make up about 60% of turnover in forex markets.

Outright Forward Transactions
These are similar to spot contracts in that it is an agreement to exchange an amount of one currency for an agreed amount of another currency except that the settlement date is greater than the spot date. In practice the vast majority of outright forwards are settled under 12 months, but theoretically there is no limit to how far out the settlement date could be set.

Copyright notice
Copyright 2009 OzForex Pty Ltd ABN 65 092-375-703