Currency Trading Explored
Reading Time: 20 Minutes
What is Currency Trading?
Currency trading represents the buying and selling of international currencies; this activity forms the foreign exchange market, which is commonly abbreviated to ‘forex’ or ‘FX’.
The forex market is the world's largest and most liquid financial marketplace, consisting of global companies, large funds, governments, and individual currency speculators. Interestingly, daily transactions reached $7.5 trillion in April 2022.
Unlike exchange-based markets (a centralised market), the forex market is decentralised. Currency trading operates in the ‘Over the Counter’ (OTC) market, meaning transactions occur through a network of dealers (global computer networks) rather than through one centralised location.
There are many factors which can affect the supply and demand of currencies. Macroeconomic considerations such as interest rate changes, inflation, and unemployment can influence currency prices. Other factors, like political instability, geopolitical conflict, and natural disasters, may also impact trading activity and can sometimes lead to elevated volatility.
The forex market has undergone radical change in recent years due to the development of technology, which has enabled access to millions of traders and investors who were previously unable to tap into the market. For instance, desktop and mobile-based trading platforms offer anyone with an internet connection the ability to trade currency.
How does Currency Trading Work?
Forex trading is formed through currency pairs, two currencies paired against one another that are grouped between Majors, Minors and Exotics. Major currency pairs consist of the most widely traded and liquid currencies and always include the US dollar. Minor currency pairs, on the other hand, are often referred to as ‘cross currency pairs’, and tend not to be as widely traded as the majors. Finally, exotic currency pairs comprise currencies from developing countries, though they can include the US dollar. The main point to be aware of is that minor and exotic currency pairs tend to have larger spreads (differences between the bid/ask price values) than the majors because they’re not as widely traded.
Currencies are bought and sold against another currency. For example, let’s assume that the currency pair EUR/USD trades at $1.0600, meaning 1 unit of the base currency, the euro, is equivalent to $1.06, the quote currency, priced in dollars. The base currency for all pairs is always denoted on the left and is equal to 1 unit, while the quote currency is denoted on the right and informs the amount needed to buy one unit of the base currency.
Buying and Selling
For a trader to generate a return from buying (entering long) currency, the quote price (the currency pair) has to rise. For example, an investor purchases euros (in terms of dollars) using the EUR/USD currency pair at $1.0600. In the following days, the pair’s value rises to $1.0700, representing a gain (100 pips, to be precise). Had the quote price dropped to $1.0500, the investor would have experienced a loss of 100 pips.
To generate a return from selling (shorting) a pair, the quote price must fall. A return would have been realised if the investor had sold units of EUR/USD at $1.0600 and the price dropped to $1.0500. If the quote price had risen to $1.0800, a loss would be registered. The extent of that loss depends on the number of units purchased, which is why learning how to calculate position size correctly is important.
Currency pairs are measured in pips or ‘percentage in point’.
Say the GBP/USD currency pair is trading at $1.25167. The fourth decimal in this quotation represents the pip count. The fifth decimal place relates to what is referred to as a ‘point’, a tenth of one pip.
Most currency pair quotes are priced to four decimal places (pairs including the Japanese yen are quoted to two decimal places). Though it is important to understand that some (many) brokers also price their currency pairs to five decimal places, such as FP Markets.
Calculating pip value depends on the account currency denomination and the traded currency pair. For instance, an account currency denominated in the same currency as the quote currency is straightforward: for a standard lot, the pip value equals 10.00 units, a mini lot amounts to 1 unit and for a micro lot, 0.10 units.
Forex trades are measured in Lots or Units:
- One standard lot is equal to 100,000 units of the base currency of a currency pair
- One mini lot equals 10,000 units of the base currency of a currency pair
- One micro lot equals 1,000 units of the base currency of a currency pair
If a trader purchased one standard lot of EUR/USD at the original rate of $1.0600, it would amount to 106,000 USD without the use of leverage. Fortunately, the retail Forex market allows investors to trade on margin (leverage). Through margin, the aforementioned investor could have controlled a position worth 106,000 USD for much less of a financial commitment: initial margin.
Leverage allows investors to gain exposure greater than one’s account equity. The leverage ratio is a fixed ratio (though it can generally be altered through one’s Client Portal), with FP Markets offering up to 500:1 leverage. It is crucial to understand that while higher leverage can generate larger returns, it can equally produce greater losses, hence the term ‘double-edged sword’ when describing leverage. This is why risk management is important.
The leverage ratio determines the margin percentage for a specific trade, established by dividing the leverage ratio. With 500:1 leverage, for example, the margin requirement is determined by dividing 1 by 500: 0.002 or 0.2% = (1 / 500). A 50:1 leverage ratio, therefore, leads to a margin requirement of 0.02 or 2% of the overall position. As you can see, the leverage ratio and margin have a unique relationship.
A one standard lot position of EUR/USD with a 50:1 leverage ratio (2% margin requirement) equates to an initial margin requirement of $2,120, assuming the account currency is the same as the quote currency: USD. With FP Markets, you can access a dedicated Trading Calculator that will allow you to calculate each trade’s margin requirement.
Spot vs Derivative
Forex trades can be executed in different forms. ‘Spot’ transactions are agreements for currency exchange at current market conditions and prices. These deals occur immediately but are usually settled after two days.
'Derivative' transactions, on the other hand, tend to be based on future market conditions. These forms of transactions can be forex forwards, futures, and options. This form of trading involves an agreement of a determined price, volume and date for exchange.
Options set a price and time when the trader can elect to go through with the trade or not (hence the trader is not obligated and has no commitment), while futures and forwards are an agreement for a later sale. Forward contracts occur in OTC markets, while futures and options generally occur on exchanges.
How to Start Currency Trading?
To begin trading currencies, you must first select a broker. FP Markets has eighteen years of experience as a reliable international forex broker, awarded over forty international awards and is globally regulated.
FP Markets offer a series of trading platforms, including MetaTrader 4 and 5 (MT4/MT5), cTrader and Iress. MT5 is an updated version of the MetaTrader software, including hundreds of tools to assist traders with technical and fundamental analysis. However, MT4 has remained the most popular trading platform for retail traders. cTrader is also a popular platform, containing enhanced charting tools, up-to-date news and real-time market data. All platform options are available through FP Markets to download across Windows, Mac, and Mobile (iOS and Android).
Most professional traders advise beginners to start their careers with a demo account to practise currency trading. The demo account simulates a live trading environment with virtual funds. Users receive digital funds to place trades on live market prices and become familiar with their chosen trading platform.
A demo account gives users time to develop a trading strategy without the stress of trading with real funds. Once confident, traders and investors have the option of setting up a live account.
Once you have established an account with FP Markets and selected and downloaded the trading platform software, you can start trading currency.
Trading platforms can be personalised to suit your preferences, showing chosen currency pair charts in the desired time frame. Multiple technical indicators are available for implementation on charts, helping to generate trading decisions. When you identify a trade, opening a transaction can be done by clicking on ‘New Order’ at the upper part of the platform (F9) to set your trading parameters, including order type, stop-loss and take-profit levels. When you click Buy or Sell, you have officially started currency trading.
However, before you begin opening trades with real funds, certain pitfalls are common among newer traders that you should be aware of.
Currency Trading Mistakes to Avoid
Lack of Research
The first mistake to avoid is not having an established trading plan. Demo accounts are available for traders to develop and trial an approach before committing funds. Users have time to study the cause of price movement through technical and fundamental analysis.
Technical analysis represents the study of price and volume through historical price charts. MT4 and MT5, as well as cTrader and Iress are equipped with numerous technical indicators to assist traders in identifying trading opportunities.
Fundamental analysis is the study of an asset’s intrinsic value. Traders should be acutely aware of the worldwide economic, political, and social events which can impact global currency prices. Economic data such as GDP, inflation, and interest rates can influence global currencies. As such, worldwide economic announcements need to be monitored by forex traders.
Political instability, social unrest, geopolitical conflicts, and natural disasters can also significantly affect investor sentiment, impacting trading behaviour. The international news cycle needs to be monitored to identify countries going through a period of instability, and traders must be well informed on international economic and social news.
Another considerable mistake to avoid is becoming too emotional and lacking patience. The forex market can be unpredictable and volatile. Specific well-researched investments can go against you, leading to unexpected losses. Therefore, learning to maintain emotional control is key to a successful trading career. When traders allow their decision-making process to be motivated by emotions rather than technical or fundamental analysis, this can lead to account ruin.
Traders are recommended to begin investing an amount of money which they can afford to lose. It is also paramount that risk management is employed.
Currency Trading Styles
Day trading is the most common form of trading in the forex market for retail investors. This short-term style looks to open and close 2-4 positions throughout the day, attempting to maximise profit without the risk of holding positions overnight. Day traders open positions for hours (sometimes even minutes), looking for frequent small gains to build their returns. These investors utilise fundamental and technical analysis, paying close attention to the world news cycle and utilising technical indicators on their charts to inform their trading decisions.
Scalping is another form of short-term trading. Unlike day trading, scalpers hold positions for seconds or minutes at most. These traders look for tight spreads and liquid markets. Therefore, most trading is done through major currency pairs (those including the US dollar).
As with day traders, the idea is to generate returns with a large volume of short-term trades. FP Markets offer tight spreads starting from 0.0 pips for this form of investing. Both scalping and day trading also requires a lot of screen time from the investor, analysing charts and news throughout the day to find trading opportunities.
Swing trading on the other hand, involves holding positions for several days, sometimes weeks. Swing traders analyse longer-term price trends through technical indicators and fundamental analysis. This trading style is ideal for investors with less time for analysis. Swing traders use long-term rather than short-term charts to analyse the price movement.
Swing traders will also need to consider the swap fees as they hold positions overnight, a fee charged or paid to an investor for holding a position overnight (business day rollover). The value of the swap depends on the difference between the interest rates of the currencies in the pair and the size of the position. The investor receives a credit if the currency bought has a higher interest rate than the currency sold. In comparison, an investor’s account is debited if the currency bought has a lower interest rate than the one sold.
The final trading style is position trading, which involves holding positions longer than swing traders. Position traders hold positions for weeks, months and even years and ignore short-term price movements. These investors rely on macroeconomic factors, general long-term market trends, and historical price patterns.
This trading style requires even less time monitoring charts than swing trading. Position trading is often called investing due to how long the individuals hold their positions.