forex trading basics

The global foreign exchange market is the biggest market in the world.The 3.2 trillion USD daily turnover dwarfs the combined turnover ofall the world's stock and bond markets.
There are many reasons for the popularity of foreign exchange trading,but among the most important are the leverage available, the highliquidity 24 hours a day and the very low dealing costs associatedwith trading.
Of course many commercial organisations participate purely due to thecurrency exposures created by their import and export activities, butthe main part of the turnover is accounted for by financialinstitutions. Investing in foreign exchange remains predominantly thedomain of the big professional players in the market - funds, banksand brokers. Nevertheless, any investor with the necessary knowledgeof the market's functions can benefit from the advantages statedabove.
In the following article, we would like to introduce you to some ofthe basic concepts of foreign exchange trading. If you would like anyfurther information, we suggest that you sign up for a FREE Membershipon this website, where you will be able to exchange views with otherForex traders and get answers to any questions you might have.
Margin Trading
Foreign exchange is normally traded on margin. A relatively smalldeposit can control much larger positions in the market. For tradingthe main currencies, Saxo Bank requires a 1% margin deposit. Thismeans that in order to trade one million dollars, you need to placejust USD 10,000 by way of security.
In other words, you will have obtained a gearing of up to 100 times.This means that a change of, say 2%, in the underlying value of yourtrade will result in a 200% profit or loss on your deposit. See belowfor specific examples. As you can see, this calls for a verydisciplined approach to trading as both profit opportunities andpotential risks are very large indeed. Please refer to our page ForexRates & Conditions for current Spreads, Margins and Conditions.
Base Currency and Variable Currency
When you trade, you will always trade a combination of two currencies.For example, you will buy US dollars and sell euro. Or buy euro andsell Japanese yen, or any other combination of dozens of widely tradedcurrencies. But there is always a long (bought) and a short (sold)side to a trade, which means that you are speculating on the prospectof one of the currencies strengthening in relation to the other.
The trade currency is normally, but not always, the currency with thehighest value. When trading US dollars against Singapore dollars, thenormal way to trade is buying or selling a fixed amount of US dollars,i.e. USD 1,000,000. When closing the position, the opposite trade isdone, again USD 1,000,000. The profit or loss will be apparent in thechange of the amount of SGD credited and debited for the twotransactions. In other words, your profit or loss will be denominatedin SGD, which is known as the price currency. As part of our service,Saxo Bank will automatically exchange your profits and losses intoyour base currency if you require this.
Dealing Spread, but No Commissions
When trading foreign exchange, you are quoted a dealing spreadoffering you a buying and a selling level for your trade. Once youaccept the offered price and receive confirmation from our dealers,the trade is done. There is no need to call an exchange floor. Thereare no other time-consuming delays. This is possible due to livestreaming prices, which are also a great advantage in times offast-moving markets: You can see where the market is trading and youknow whether your orders are filled or not.
The dealing spread is typically 3-5 points in normal marketconditions. This means that you can sell US dollars against the euroat 1.7780 and buy at 1.7785. There are no further costs, commissionsor exchange fees.
This ensures that you can get in and out of your trades at very lowslippage and many traders are therefore active intra-day traders,given that a typical day in USDEUR presents price swings of 150-200points.
Spot and forward trading
When you trade foreign exchange you are normally quoted a spot price.This means that if you take no further steps, your trade will besettled after two business days. This ensures that your trades areundertaken subject to supervision by regulatory authorities for yourown protection and security. If you are a commercial customer, you mayneed to convert the currencies for international payments. If you arean investor, you will normally want to swap your trade forward to alater date. This can be undertaken on a daily basis or for a longerperiod at a time. Often investors will swap their trades forwardanywhere from a week or two up to several months depending on the timeframe of the investment.
Although a forward trade is for a future date, the position can beclosed out at any time - the closing part of the position is thenswapped forward to the same future value date.
Interest Rate Differentials
Different currencies pay different interest rates. This is one of themain driving forces behind foreign exchange trends. It is inherentlyattractive to be a buyer of a currency that pays a high interest ratewhile being short a currency that has a low interest rate.
Although such interest rate differentials may not appear very large,they are of great significance in a highly leveraged position. Forexample, the interest rate differential between the US dollar and theJapanese yen has been approximately 5% for several years. In aposition that can be supported by a 5% margin deposit, this results ina 100% profit on capital per annum when you buy the US dollar. Ofcourse, an even more important factor normally is the relative valueof the currencies, which changed 15% from low to high during 2005 –disregarding the interest rate differential. From a pure interest ratedifferential viewpoint, you have an advantage of 100% per annum inyour favour by being long US dollar and an initial disadvantage of thesame size by being short.Please refer to our page Forex Rates & Conditions for current Spreads,Margins and Conditions!
Such a situation clearly benefits the high interest rate currency andas result, the US dollar was in a strong bull market all through 2005.But it is by no means a certainty that the currency with the higherinterest rate will be strongest. If the reason for the high interestrate is runaway inflation, this may undermine confidence in thecurrency even more than the benefits perceived from the high interestrate.
Stop-loss discipline
As you can see from the description above, there are significantopportunities and risks in foreign exchange markets. Aggressivetraders might experience profit/loss swings of 20-30% daily. Thiscalls for strict stop-loss policies in positions that are movingagainst you.
Fortunately, there are no daily limits on foreign exchange trading andno restrictions on trading hours other than the weekend. This meansthat there will nearly always be an opportunity to react to moves inthe main currency markets and a low risk of getting caught without theopportunity of getting out. Of course, the market can move very fastand a stop-loss order is by no means a guarantee of getting out at thedesired level.
But the main risk is really an event over the weekend, where allmarkets are closed. This happens from time to time as many importantpolitical events, such as G7 meetings, are normally scheduled forweekends.
For speculative trading, we always recommend the placement ofprotective stop-lossorders. With Saxo Bank Internet Trading you caneasily place and change such orders while watching market developmentgraphically on your computer screen.