The foreign exchange market (forex) represents a way to exchange one nation's currency for that of another. More than $6 trillion of currency changes hands every day, and because exchange rates are based on nations' interest rates, economics, and geopolitical conditions, rates are always fluctuating. Forex represents a dynamic, global market.
While forex trading offers potential for profit, it's also subject to unique risks and not all accounts qualify to trade forex.
Forex trading venues
In general, retail clients have two choices for trading currencies:
- The futures market. A futures contract is an agreement to buy or sell a predetermined amount of a commodity or financial instrument at a certain price on a stipulated date. Such contracts are traded on exchanges, and volume is typically limited to the major currencies.
- The forex market. Most foreign exchange trading takes place among institutional players—banks, dealers, and large intermediaries—in what's known as the interbank market. Retail forex brokers like Charles Schwab Futures and Forex, use this information to post competitive bids and offers (called the bid/ask spread) against which retail traders may sell or buy currencies in specific increments.
To trade both futures and forex, a trader needs to have a qualified account. It's possible to apply to trade futures and forex through a client's Schwab.com account.
Understanding the quote
Trading the forex market involves trading two different currencies against each other. The ratio of the two is what's known as a currency pair. The quote for a forex currency pair references what it costs to convert one currency into the other. For example, if the U.S. dollar (USD) and Canadian dollar (CAD) pair is trading at 1.33, $1 USD is equal to $1.33 CAD. To find out how much it'd cost to buy a Canadian dollar, a trader would invert it: $1/1.33 = $0.7519. In this example, it costs a little more than $0.75 to buy a Canadian dollar.
Here are some common terms a trader needs to know before trading forex:
- Pip. A pip is the minimum price fluctuation in a currency pair. For most pairs the pip is 0.0001, except for pairs that involve the Japanese yen (JPY). For JPY pairs, the pip is 0.01. For example, a trader might see a quote in the British pound (GBP) and USD (GBP/USD) pair of 1.4278. This means a pound costs $1.4278.
- Pip value. The value of a pip is determined by the size of the trade. Futures contracts are standardized, and their minimum fluctuation is called a tick. Currency futures have different contract sizes, but usually the size is 100,000 or 125,000. However, GBP/USD futures are 62,500, so the tick value is $6.25 (62,500 x 0.0001 = $6.25). If a trader bought one contract of GBP/USD 1.4343 and sold it at 1.4347, they'd have made 4 x $6.25 = $25, In contrast, trading forex allows for more flexibility. Retail traders can trade in increments as low as 10,000 units, much smaller than a futures contract. When trading on the forex market, a trader might buy 20,000 units of EUR/USD. Each pip would be worth $2 (20,000 x 0.0001 = $2). If a trader bought 20,000 units at 1.2320 and sold them at 1.2312, an 8-pip loss, they'd have lost $16.
- Majors and exotics. Any pair consisting of the following actively traded currencies is known as a major: U.S. dollar (USD), Japanese yen (JPY), euro (EUR), Australian dollar (AUD), Canadian dollar (CAD), British pound (GBP), Swiss franc (CHF), and New Zealand dollar (NZD). All currencies and pairs that involve them are known as exotics.
- Forex spreads. On retail forex brokerages, trade costs are typically paid through the bid/ask spread. Also, bid/ask spreads aren't guaranteed. Major pairs typically have tight spreads throughout the day and night, but exotics generally have less liquidity and wider spreads. It's important to understand liquidity risks before trading forex.
Example of forex quote in thinkorswim®
Source: thinkorswim platform
For illustrative purposes only.
Leverage in forex trading
Forex trading involves leverage, which means a trader can establish a position in a large investment with a relatively small amount of money. When a trader buys or sells retail forex or foreign exchange futures, they don't use the entire notional value when trading. Instead, a trader posts an initial margin requirement—essentially a "good faith" deposit. In forex, margin requirements vary as a percentage of the notional amount. Margin requirements are typically between 3% to 5% of the notional value. However, certain pairs can be as low as 2%. Leverage is a double-edged sword because it can magnify both profits and losses. A small amount of market movement can have a large effect—positive or negative—on the account's total profit and loss.
Forex traders should consider their risk tolerance before getting qualified to trade the foreign exchange market or the futures market.
Carrying a forex position into the next day
Forex rates are based on interest rate differentials between the pair's currencies. Forex traders enter positions that are essentially "long" one currency and "short" the other. When a forex trader carries a position from one day to the next, they earn interest on the currency they're long on and pay interest on the currency they're shorting. The differential between the two interest rates is considered the "net financing rate."
Some forex traders ensure they've closed out of their positions before the end of their own trading day to avoid the risk of losses due to the net financing rate. Traders choosing to carry a position into the next day should consider potential losses and understand how financing rates work.
Trade currencies with paperMoney®
Beginners wanting to test out trading forex in a simulated trading environment can try out their strategies on the paperMoney platform on thinkorswim. This simulated platform allows traders to practice, test strategies, and learn the dynamics of forex without risking a dollar, pound, yen, or euro.
