FOREX is short for “foreign exchange” and is often abbreviated further to “FX”. It is also known as currency trading.
What is Forex Trading?
The vast majority of currency trading takes place outside of a regulated exchange. There is no price for a particular currency pair at any one time and no unified or centrally cleared market for the majority of trades. However, this should not imply that the FX market is some sort of Wild West where anything goes. Instead banks and other financial intermediaries act as market makers by offering up their own dealing spreads on different currency pairs. This leads to fierce competition and price transparency and the opportunities for arbitrage generally mean that dealing spreads aggregated from different sources tend to be very tight.
What is a CFD?
CFD stands for Contract for Difference and is a type of derivatives product. A CFD has specific characteristics which allow it to be traded on margin. Typically you only need to put up a modest percentage of the value of the underlying contract to control a large amount of it. In other words you are trading on leverage which means that potential profits, and losses, are magnified. Another characteristic of a CFD is that it is just as easy to sell as to buy. Consequently it is possible to speculate on a specific financial instrument (such as an individual equity, commodity or stock index) falling in value as well as rising.
Forex Trading Statistics
- Foreign exchange is the biggest trading market in the world. According to the 2016 Triennial Central Bank Survey by the Bank for International Settlements (BIS) trading in foreign exchange (FX) markets averaged $5.1 trillion per day in April 2016.
- The most heavily traded bilateral currency pair on the spot market was the Euro/US dollar which accounted for 23% of volumes, followed by the US dollar/Japanese yen (17.7%) and British pound/US dollar (9.2%).
- The US dollar was involved in over 40% of all transactions.
How Does Forex Trading Work?
For many people their first experience of leveraged or margined trade is on FX products. This is despite the fact that dealing in FX can be slightly more complicated than trading on other financial instruments.
FX trading has a few peculiarities which need to be understood. For a start, currencies are always traded in pairs. What is being considered is how one currency fares relative to another. This may seem obvious, but consider trading a commodity such as crude oil. Now, the vast majority of exchange-traded commodities are valued in dollars. When you buy or sell oil you’re backing your judgement over whether the price in dollars is set to rise or fall. Once you know how much you stand to make or lose per point movement, then calculating your potential profit or loss given a specific move is straightforward. But with a currency pair you not only need to know how much one point (or tick) is worth, but also what currency your profit or loss will be in, and in addition which way round you need to trade on a particular currency pair to back your view appropriately.
First off, let’s deal with getting the trade the right way round. Obviously, with a currency pair you back how one currency will perform against another. But let’s consider a trade of the euro against sterling. You may expect sterling to rise and the euro to fall, but do you buy the currency pair or sell it? And what is the currency pair telling you? In trading convention it’s usual to see this pair expressed as what one euro is worth in terms of sterling. But we often hear this exchange rate expressed as what the pound is worth in euro terms. So let’s consider some popular currency pairs and their abbreviations.
|Base Currency||Counter currency||Abbreviation|
|US dollar||Japanese yen||USDJPY|
|US dollar||Swiss franc||USDCHF|
|US dollar||Canadian dollar||USDCAD|
|Australian dollar||US dollar||AUDUSD|
|Australian dollar||Japanese yen||AUDJPY|
Forex Trading Example
The table above shows a selection of currency pairs expressed according to market convention. The easiest way to understand FX pairs is to think in terms of the first-named, or “base”, currency. Staying with the EURGBP as an example, the EUR is the base currency while the GBP is the counter currency, and this is typically the form you will find the pair expressed in on trading platforms. If you expect the euro to rise against sterling then you “buy” the EURGBP currency pair. In contrast, if you expect sterling to go up (and the euro fall) then you would “sell” the EURGBP currency pair.
Now let’s consider the price itself. When trading CFDs on any financial product it’s vitally important to know precisely what a point, or tick, means. You need to know this to work out how much risk you’re taking on a particular trade. You also need to know this in order to calculate your eventual profit or loss on a trade.
At Spread Co we help you to understand this in the way we display our FX prices. Here’s a deal ticket for the EURGBP which will help to illustrate this:
Looking at the “buy” price in green, we can see it runs to five decimal places 0.86496. Here at Spread Co it is the last big digit of the price which is the significant point or tick. In the above example, the “trade per” isn’t applied to the fifth decimal place (which is expressed in a smaller font size than the other digits), but the one just to the left of it - the bigger one. So if the EURGBP goes from 0.86496 to 0.86506 that is one full point - not 10.
Here’s another example using a deal ticket for the British pound against the Japanese yen (GBPJPY):
Looking at the “buy” price of 139.617, this time the price is calculated to three decimal places. Yet the “trade per” isn’t applied to the last digit in the price (which is also written in a smaller font size than the other digits), but the one just to the left of it - the bigger one. So if the GBPJPY goes from 139.617 to 139.627 that is one whole point.
Now we know what one point relates to for the EURGBP and GBPJPY, let’s see how this relates to different trade sizes, margin requirements and eventually profit and loss.
At Spread Co we offer three account types: spread bet, CFD or plain FX. There’s no difference in terms of the underlying market that you’re trading or betting on, but there is a fundamental difference in the way you decide on your bet, or trade, size. This trading guide is about CFDs, so let’s look at an example using the EURGBP again.
Here’s the dealing ticket from before. As you can see there is a “sell” tab in red and a “buy” tab in green. As you can see from the dealing ticket above, you “sell” at the lower bid price of 0.86476, or “buy” at the higher offer (or “ask”) price of 0.86496. The difference between the lower (sell) price and the higher (buy) price is 0.0002 (0.86496 minus 0.86476 = 0.0002) and this is the dealing spread.
When dealing in FX it helps to think in terms of the first-named currency. For example, if you expect the euro to fall against sterling you would sell the EURGBP at the lower end of the spread. If you think the EURGBP will rise (the euro is set to go up relative to the British pound) you would “buy” at the higher end of the spread.
If you look at any of the deal tickets so far you will see that there is a box saying “quantity” which has been auto-filled with 10,000 and has “+” and “-“ either side. This is where you control the number of CFDs that you buy or sell on the currency pair. The more you buy, the more you stand to win or lose. Let’s take the example above and assume you bought 10,000 CFDs of EURGBP. What does this mean? In this instance 1 CFD is equivalent to €1, as the euro is the first-named currency in the pair. So it means you have bought 10,000 euros-worth of sterling which has cost you £8,649.60 (10,000 x 0.86496).
Let’s assume that the euro now goes up in price relative to sterling and that you sell your 10,000 CFDs at 0.87860
You will realise a profit which can be calculated in two different ways:
Value of closing trade - £8,786.00
Less: Value of opening trade - £8,649.60
Equals - £136.40 profit
Closing price - 0.87860
Minus Opening price - 0.86496
Equals - 0.01364 per CFD therefore
Profit on 10,000 CFDS = 0.01364 x 10,000 = £136.40
Here’s another example using GBPJPY
Let’s say you pay 139.617 for 10,000 CFDs of GBPJPY
This means you have bought £10,000 of Japanese yen at 139.617 which works out as 1,396,170 JPY (10,000 x 139.617)
Let’s say that this time the trade goes against you and you end up closing it out by selling 10,000 CFDs at 138.503
Again, we can work out the result in a couple of different ways:
Value of closing trade- JPY 1,385,030
Less: Value of opening trade- JPY 1,396,170
Equals a loss of - JPY 11,140
Closing price- 138.503
Minus Opening price - 139.617
Equals -1.114 per CFD therefore
Loss on 10,000 CFDS = 1.114 x 10,000 = 11,140 JPY
If you are actively trading FX on a CFD account you will often have balances in a number of different currencies. This is quite different from spread betting where all your profits and losses are realised in a base currency of your choice. Instead, with a CFD trading account you realise profits and losses in different currencies. These can be converted back into sterling, euros or US dollars at your request, or done automatically once a month. In the GBPJPY example above, the loss of 11,140 JPY would convert to £80.43 using 138.503 to exchange.
Forex Margin Requirements
- Notional Trading Requirement (NTR): the amount of money required in an account before opening a trade.
- Additional Unencumbered Funds: additional funds available in an account to cover unfortunate market movements.
With CFDs you don’t actually buy or sell the underlying asset you want to trade. Instead you take a view on the prices offered by an intermediary, such as Spread Co, as to whether the price will rise or fall. This allows you to trade on “margin.” What this means in practice is that you only have to put up a small percentage of the value of the underlying asset to control a large amount of it. In other words, you are dealing with leverage. As a result, your potential profits are magnified, but so are your losses. For this reason, great care must be taken when trading with CFDs or other leveraged products.
Spread Co requires you to hold a certain amount of money in your account before you can open a trade. For CFDs on currency pairs this is a percentage of the value of the underlying contract. This is typically 0.50% or 1.0%, although there are a couple of counter currencies where the margin requirement is higher, reflecting higher volatility and an occasional lack of liquidity.
Taking the EURGBP from the first example, the margin requirement for this pair is 0.50%. The deposit is worked out as follows:
Number of CFDs x price x 0.5%
So in this case the initial margin works out as:
10,000 x 0.86496 x 0.5/100 = £43.25
So you need to have £43.25 of unencumbered funds (in other words, money not needed for other positions) on your account. But it is important to understand that this is the very minimum requirement. After all, markets are constantly fluctuating - up and down. Consequently, it is important to have additional unencumbered funds available on the account to cover the possibility of adverse market movements. If these resources were exhausted though a negative market move, Spread Co would ask you for additional funds (variation margin) to keep the position open. A full list of our CFD FX pairs, the margin requirements and the currency in which the profit or loss is calculated can be seen on the “Currencies Market Information” page under the “Range of Markets” tab on our website.
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