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Currency
Trading in South Africa
and internationally
Common Questions About Currency Trading
by Boris Schlossberg, Senior Currency Strategist, FXCM
Although forex is the largest financial market in the world, it is
relatively unfamiliar terrain to retail traders. Until the
popularization of internet trading a few years ago, FX was primarily the
domain of large financial institutions, multinational corporations and
secretive hedge funds. But times have changed, and individual investors
are hungry for information on this fascinating market. Whether you are
an FX novice or just need a refresher course on the basics of currency
trading, read on to find the answers to the most frequently asked
questions about the forex market.
Be careful when choosing an
online FX trading program.
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How does this market differ from other markets?
Unlike the trading of stocks, futures or options, currency trading does
not take place on a regulated exchange. It is not controlled by any
central governing body, there are no clearing houses to guarantee the
trades and there is no arbitration panel to adjudicate disputes. All
members trade with each other based upon credit agreements. Essentially,
business in the largest, most liquid market in the world depends on
nothing more than a metaphorical handshake.
At first glance, this ad-hoc arrangement must seem bewildering to
investors who are used to structured exchanges such as the NYSE or CME.
(To learn more, see Getting To Know Stock Exchanges.) However, this
arrangement works exceedingly well in practice: because participants in
FX must both compete and cooperate with each other, self regulation
provides very effective control over the market. Furthermore, reputable
retail FX dealers in the United States become members of the National
Futures Association (NFA), and by doing so they agree to binding
arbitration in the event of any dispute. Therefore, it is critical that
any retail customer who contemplates trading currencies do so only
through an NFA member firm. |
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The FX market is different from other markets in some other key ways
that are sure to raise eyebrows. Think that the EUR/USD is going to
spiral downward? Feel free to short the pair at will. There is no uptick
rule in FX as there is in stocks. There are also no limits on the size
of your position (as there are in futures); so, in theory, you could
sell $100 billion worth of currency if you had the capital to do it. If
your biggest Japanese client, who also happens to golf with Toshihiko
Fukui, the Governor of the Bank of Japan, told you on the golf course
that BOJ is planning to raise rates at its next meeting, you could go
right ahead and buy as much yen as you like. No one will ever prosecute
you for insider trading should your bet pay off. There is no such thing
as insider trading in FX; in fact, European economic data, such as
German employment figures, are often leaked days before they are
officially released.
Before we leave you with the impression that FX is the Wild West of
finance, we should note that this is the most liquid and fluid market in
the world. It trades 24 hours a day, from 5pm EST Sunday to 4pm EST
Friday, and it rarely has any gaps in price. Its sheer size (it trades
nearly US$2 trillion each day) and scope (from Asia to Europe to North
America) makes the currency market the most accessible market in the
world.
Where is the commission in FX?
Investors who trade stocks, futures or options typically use a broker,
who acts as an agent in the transaction. The broker takes the order to
an exchange and attempts to execute it as per the customer's
instructions. For providing this service, the broker is paid a
commission when the customer buys and sells the tradable instrument.
(For further reading, see our Brokers And Online Trading tutorial.)
The FX market does not have commissions. Unlike exchange-based markets,
FX is a principals-only market. FX firms are dealers, not brokers. This
is a critical distinction that all investors must understand. Unlike
brokers, dealers assume market risk by serving as a counterparty to the
investor's trade. They do not charge commission; instead, they make
their money through the bid-ask spread.
In FX, the investor cannot attempt to buy on the bid or sell at the
offer like in exchange-based markets. On the other hand, once the price
clears the cost of the spread, there are no additional fees or
commissions. Every single penny gain is pure profit to the investor.
Nevertheless, the fact that traders must always overcome the bid/ask
spread makes scalping much more difficult in FX. (To learn more, see
Scalping: Small Quick Profits Can Add Up.)
What is a pip?
Pip stands for "percentage in point" and is the smallest increment of
trade in FX. In the FX market, prices are quoted to the fourth decimal
point. For example, if a bar of soap in the drugstore was priced at
$1.20, in the FX market the same bar of soap would be quoted at 1.2000.
The change in that fourth decimal point is called 1 pip and is typically
equal to 1/100th of 1%. Among the major currencies, the only exception
to that rule is the Japanese yen. Because the Japanese yen has never
been revalued since the Second World War, 1 yen is now worth
approximately US$0.08; so, in the USD/JPY pair, the quotation is only
taken out to two decimal points (i.e. to 1/100th of yen, as opposed to
1/1000th with other major currencies).
  
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