Foreign exchange (FX or forex) is the cornerstone of all international capital transactions and is the largest financial market in the world. The vast majority of FX transactions are not directly related to international trade and are speculative in nature, although trade-related FX transactions still play an important role. For every trade-related transaction in the FX market, almost 9 times as many are speculative. The FX market continues to expand and its growth can be attributed to the large amounts of liquidity available and to its timely and organised network of systems.
Spot FX, unlike stocks and futures instruments, is not traded on an exchange. Through technological advances in electronic and telecommunications fields, networks of banks and brokers have access to a fast-moving system that transfers data and funds almost instantly around the world. Through this network, Spot FX has gained a significant advantage over competing financial products that are limited to certain time zones and have to endure the erratic strains and confusing nature of trading floors.
Banks and brokers use screen-based systems where two-way prices are analysed, managed and traded. These platforms guarantee greater levels of transparency and instant access to price information anywhere in the world.
Currencies are always priced in pairs, meaning all trades require the buying of one currency and the selling of another. The objective of FX trading is to exchange one currency for another in anticipation of the market price changing, so that the currency being bought will increase in value relative to the one being sold.
When a trader buys a currency that later appreciates in value, they must then sell the currency back in order to lock in the profit. An open trade, or open position, occurs when a trader has either bought or sold one currency pair and has not sold or bought the equivalent amount to effectively close the position.
FX quotes include a ‘bid’ and ‘ask’. The ‘bid’ is the price at which a market maker is willing to buy (clients sell), while the “ask” is where the market maker will sell (clients buy) the currency pair. The difference between the bid and ask price is referred to as the ‘spread’.
In the wholesale market, currencies are quoted using 5 significant numbers, with the last placeholder called a ‘point’ or a ‘pip’. In spot FX, like any traded instrument, there is an immediate cost in establishing a position. For example, EUR/USD may be bid at 1.3150 and ask at 1.3153, this three-pip spread defines the trader’s cost, which can be recovered with favourable currency movement in the market.
By quoting both the bid and ask in real time, ICM ensures that traders always receive a fair price on all transactions.
The concept of margin
Margin is a good faith deposit giving the trader the right to buy or sell the value of the underlying contract of a currency, bullion or derivative instrument. This margin requirement allows the investor to trade a larger amount of money with a relatively small deposit. The small margin payments are one of the main reasons why spot FX has become so attractive for individual investors.
Most central banks have ultimate control over money supply and interest rates within their respective countries. They intervene to regulate market fluctuations for freely convertible currencies by using their foreign currency reserves, or by influencing interest rates through money market operations.
Commercial banks are market makers who quote two-way spot FX prices that are continuously changed so they can balance supply and demand for the currencies. In the currency markets the interbank exchange rate is the wholesale price and the commercial exchange rate is the retail price.
Brokers are intermediaries that convey the market prices received from banks via electronic or telecommunications networks to other market participants. These rates do not only serve as an indication, but are also the prices at which they are willing to deal, usually for an accepted marketable amount.
Corporations traditionally enter into currency transactions to hedge (cover) their foreign currency exposures to minimise risks. Many adopt strong policies and actively take positions in currencies. Some large multi-national corporations even have their own in-house dealing rooms and credit control departments, although most still conduct their currency transactions via brokers.
Many smaller investors purchase shares in mutual funds. Some of these funds have an excess of $1 billion in assets and are managed by multiple fund managers. Depending on the liquidity, trading strategy and overall policy of the fund, these fund managers invest a certain percentage of the funds in the foreign exchange market. In some cases, the transaction size and volume of funds exceed that of some central banks.
Government institutions are rarely active in the markets, although in certain circumstances they can inject large funds into the foreign exchange. However, this usually only occurs in developing countries where import and export business is channelled through government monopolies.
The Individual Investor
The volume of transactions entered into by individual investors continues to increase. A growing number trade in spot currencies and futures markets by depositing collateral into margin accounts with brokers such as ICM. These investors are now gaining in importance and are having short-term influence on exchange rate movements during illiquid market conditions.
What every trader should know
Due to its considerable size, liquidity and tendency for currencies to move in strong trends, the spot FX market is one of the most popular markets for speculative trading. An enticing aspect of trading currencies is the high degree of leverage available. In some instances, ICM allow positions to be leveraged up to 400:1. Without proper risk management in place, this high degree of leverage can lead to large swings between profit and loss.
With the knowledge that even seasoned traders sometimes suffer losses, speculation in the spot FX market should only be conducted with risk capital funds that, if lost, will not significantly affect the individual’s personal financial well-being.