Opportunities to profit from FX trading
THE forex market records about US$5 trillion (S$6.4 trillion) in currency transactions worldwide daily.
This is many times higher than the average daily US$84 billion traded in the global stock markets, testifying to the importance of foreign currency trading or foreign exchange (FX) trading.
Currencies need to be exchanged to facilitate foreign trade and business.
Usually done on a spot basis, FX trading is the buying and selling of one currency against another at an agreed rate. Spot FX is normally done over-the-counter, meaning there is no central exchange.
FX trading is conducted electronically over-the-counter with transactions via computer networks between dealers in major financial hubs around the world.
As the market is open 51/2 days a week and there are different time zones between Asia, Europe and America, there are opportunities to make money round the clock.
Many people do forex trading on a small scale with money changers. Travellers exchanging domestic currency for a foreign one perform currency trading.
Upon their return, some may want to sell the foreign currency still in hand, but they will notice there is a difference in the price being quoted.
This difference between the buy price and the sell price is known as the spread.
Typically, the spread would favour the money changer.
Price fluctuations of currencies are measured in terms of pips. One pip is 0.0001 and is the smallest price change in the value of a currency.
Spot FX trading works in the same way except that the transactions are much bigger. A regular contract is pegged at a value of 100,000 units of a currency pair but a trader does not need that much capital to take a position.
Depending on the currency pair involved, the trader can get leverage from 15 to 50 times - which makes currency trading attractive.
As minimum capital is needed because of high leverage extended, it bodes well if a trader's position - whether buying long or selling short - on the relevant currency pair goes the right way.
However, the volatility of the FX market can lead to heavier losses than a trader can bear, making it essential to have a stop-loss order as part of the strategy.
For example, price fluctuations of 100 to 150 pips in a day are considered normal. This can result in a loss or profit of $1,000 to $1,500, depending on the trader's position.
Buying a higher interest currency versus a lower interest one is another way in which investors looking for long-term gains can benefit from the difference in the interest.
For example, the Australian dollar interbank rate is 2.5 per cent a year whereas the United States dollar is 0.25 per cent.
When buying the FX pair, a person need only pay an initial margin of US$1,800 to receive the difference of 2.25 per cent interest which is based on the standard 100,000 contract. This kind of investment is called a carry trade.
FX traders need to familiarise themselves with a few currency pairs in contrast to thousands of listed companies in the equities market.
The prices of currencies are determined by various factors, including current interest rates, supply and demand, economic performance, sentiments about geopolitics and perception of the future performance of one currency against another.
The ways that currencies are administered by central banks also have a bearing on the extent of price fluctuations.
To this end, currencies are grouped into three categories: Those left to be determined by market forces, those fixed by the national central banks and those pegged to a basket of currencies.
Major currencies such as the euro, US dollar, pound sterling, Australian dollar and Swiss franc are floating currencies.
They are in the first category and prices are determined by market supply and demand.
Traded in very large volumes, the huge market depth and liquidity protect them from being manipulated by market makers and traders.
In the case of China, its yuan is in the second category - based on rates determined by the country's central bank.
The bank is active in terms of market intervention and capital control, including taking measures to restrict the selling and buying of the yuan.
Although China recently permitted the setting up of offshore yuan centres, the consensus is that rates are influenced by the official fixing.
For the third category, the central banks adopt a mixture of policies adopted by both floating and fixed currency administrations.
An example is the Singapore dollar, which has a nominal effective exchange rate tied to a basket of currencies of selected trade partners.
The trade-weighted exchange rate is maintained broadly within an undisclosed target band with the central bank having the option to intervene should there be excessive price fluctuations.
It takes time to understand the FX market. Seminars and training sessions for both beginners and experienced traders are provided by some industry players.
Like any investment, the FX market offers opportunities to make money, but it is important to have patience, take time to educate oneself and adopt a methodical approach.