Introduction to Foreign Exchange
Foreign Exchange (FX or FOREX) is the cornerstone of all international capital transactions and surpasses the huge American domestic money markets in terms of liquidity and depth; even the futures and stock markets are insignificant in comparison.
The majority of Foreign Exchange transactions are neither directly related to international trade nor to international settlements but are in fact speculative in nature. For every trade-related transaction in the FOREX Market, there are about 7 to 9 speculative ones. Foreign Exchange is the world's fastest growing industry today and its growth can be attributed to its substantial liquidity and to the orderly manner in which it functions.
Spot FX, unlike stocks and futures instruments, is not traded on an exchange. Through technological advances in the electronic and telecommunications fields, networks of banks and brokers have gained access to a virtually instantaneous system of global transfers of information, data and funds. With the aid of such developments, spot FX has gained a significant advantage over other financial products that are limited to certain time zones and have to endure the erratic strains and confusion of trading floors.
Banks and brokers these days operate on screen based systems were two-way prices are continuously fed in and dealt on by participants. These systems guarantee greater transparency and instantaneous access to price information anywhere in the world.
Currencies are always priced in pairs; therefore all trades result in the simultaneous buying of one currency and the selling of another. The objective of FX trading is to exchange one currency for another in the expectation that the market price will change so that the currency bought will increase in value relative to the one sold.
When a trader buys a currency that later appreciates in value, the trader must sell the currency back in order to lock in the profit. An open trade or open position is one in which a trader has either bought/sold one currency pair and has not sold/bought back the equivalent amount to effectively close the position.
With all financial products, 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 the ask prices is referred to as the spread.
In the wholesale market, currencies are quoted using five 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 a favorable currency move in the market.
By quoting both the bid and ask in real time, ICM Brokers 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.
Central Banks in most countries have the ultimate control over money supply and interest rates. 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 that quote two-way spot FX prices that are continuously changed so as to allow them to 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 serve just as an indication, but are the prices at which they are willing to deal, usually for an accepted marketable amount.
Corporations traditionally have been entering into currency transaction in order to hedge (cover) their foreign currency exposures so as to minimize risks. Corporations today are increasingly adopting more aggressive policies and actively take positions in currencies. Large multi-national corporations even have their own in-house dealing rooms and credit control departments, but the majority of corporations still conduct their currency transactions through brokers.
Many smaller investors today are purchasing shares in mutual funds. Some of these funds have in excess of US$ 1 billion in assets and are managed by one or more fund managers. Depending on the liquidity, trading strategy and overall policy of the fund, the fund managers would invest a certain percentage of these funds in the Foreign Exchange market. Today, the transaction size and volume of some funds exceed that of some Central Banks.
These institutions are not very active market participants, but in certain circumstances, they can inject large funds into the foreign exchange markets; this is mostly carried out by developing countries where import and export business is channeled through government monopolies.
The Individual Investor
The volume and the number of transactions entered into by individuals has been increasing rapidly. Today, a growing number of individual investors are trading in spot currencies and the futures markets by depositing collateral into margin accounts with brokers such as ICM Brokers. 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
The spot FX market is one of the most popular markets for speculation due to its enormous size, liquidity and tendency for currencies to move in strong trends. An enticing aspect of trading currencies is the high degree of leverage available. ICM Brokers allows positions to be leveraged, in some cases, up to 400:1. Without proper risk management, this high degree of leverage can lead to enormous swings between profit and loss. Knowing that even seasoned traders sometimes suffer losses, speculation in the spot FX should only be conducted with risk capital funds that if lost, will not significantly affect one's personal financial well- being.