This article first appeared on tradingwithrayner.com.
In the early days, the foreign exchange was accessed only by big institutions and corporations to facilitate hedging purposes. But given the advancement in technology, forex trading has been open up to retail traders like you and me in recent times not only for hedging, but speculation as well.
But what is forex trading? Forex trading is simply the buying and selling of currencies. When someone says Eurusd is trading at 1.3500, it means 1 Euro cost 1.3500 Usd. Thus if you want to long the Eurusd. you will be buying 1 Euro and selling 1.3500 Usd.
But before you get all excited to start trading the forex markets, there are 5 things you must know before opening your forex trading account.
1) Transaction Cost
If you have ever traded stocks, you will have to pay a commission as well as the spread on it. The spread being the difference between the bid and offer. If you want to buy Keppel Corp today and you are being quoted $10.10, this is called the offer. And if you want to sell Keppel Corp today and you are being quoted $10.00, this is called the bid. So the spread for Keppel Corp is 10 cents.
So in order to trade stocks you have 2 transaction cost to cover, the commission and the spread.But what about forex? In forex trading, you only have 1 transaction cost to cover which is the spread. You are not charged any commission unless you are trading on ECN (that’s another topic altogether) And this is the reason why forex trading has a lower transaction cost compared to stock trading.
2) You Don’t Own The Physical
When you buy stocks, you are part owner of the company shares you bought. But in forex trading you don’t own anything at all, not even the currencies you buy or sell. Because you are trading in the spot market and it does not take delivery of the currencies, unlike the futures market.
All your orders will be electronically recorded by your broker, with profits & losses reflected according to the current market price. If you made profits, your equity will be added accordingly. Likewise if you sustain losses, your equity will be deducted accordingly.
3) Leverage Instrument
Forex trading is a leveraged instrument. It is not uncommon to see broker offering 1:100 on your capital. This means that if you deposit $1000, you can traded up to $100,000. Yes that’s right, 100 times your capital!
But leverage is a double edged sword. It can either increase your profits or amplify your losses. And this is the reason why you hear stories of traders busting their trading account. They are leveraging excessively relative to their account size, even a small price movement against them is enough to wipe out their trading capital.
E.g. SIA is currently traded at $10. You deposit $1000 and can leverage up to $100,000. You maximize your leverage and buy 10,000 shares of SIA. If SIA drops a mere 10 cents, it is enough to wipe out your $1000 capital. (0.1 * 10,000 = $1000)
4) Carry Trade
In forex trading, there is something called the carry trade. When you have a positive carry trade, it means that the currency you are long pays a higher interest rate than the currency you are short. E.g. You are long Audjpy, this means you are buying the Aussie and selling the Yen. The Aussie currently pays interest of about 2.5% a year and the Yen has interest rate of 0%.
So what you are doing is borrowing the Yen at 0% and depositing it in the Aussie which pays 2.5% a year. Free money? The trade off is the currency risk whereby the Aussie may depreciate more than 2.5% against the Yen, and that’s when you will lose money as the positive carry trade is not sufficient to compensate the capital loss.
5) Not Exchange Traded
Unlike stocks or futures whereby they are traded over a centralized exchange, forex trading is traded over the counter. So there is always a possibility of counter party risk. And for you the retail trader, your counter party risk is usually your broker.
Your transaction size in the forex market is too small to even reach the interbank market. So what happens most of the time is your broker would take the opposite side of your trade. After which the broker would pool these retail orders together and hedge it on the interbank market. (the interbank market is where banks and institutions trade with one another)
If your broker somehow fails to hedge and price moves adversely against your broker’s net position, it could possible cause it to go bankrupt. An example would be the recent SNB intervention which caused brokers like FXCM and Alpari to suffer heavy losses.
Forex trading may seem attractive at first glance, but do understand that it is vastly different from traditional stock investing. It comes with greater leverage and counterparty risk but at the same time, it has lower transaction cost and could earn you a positive carry trade.
Image from Masters of Money. Used with appreciation.
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