Been at the equity markets a little too long? Anxious to trade something new? Well how about buying and selling money. The name of the game is Foreign Exchange or Forex. It’s a global free market for currencies that trade 24/7. It’s responsible for setting the exchange rates that you may take advantage of when you go from country to country. Global travelers know what it's like to watch exchange rates and conversions. Things are a little different as a trader though. When you’re trading currencies, you must consider two prices when you’re buying one currency with another. These are called currency quotes or rates. Essentially, what a currency quote tells you is how much of one currency you can buy with another. Let’s say you have an exchange rate of 1.5 USD/EUR. This means that you can purchase 1.5 euros for 1 US Dollar. See, the numerator of that rate is called the base currency and the denominator of that currency is called the quote currency. The exchange rate is expressed as a fraction and that rate is your price.
There are a ton of advantages to trading currencies that the equity markets can’t quite match. For one thing, Forex markets are open 24/7. The market can do this because currencies are traded all over the planet and so there is always someone awake and willing to buy or sell. Markets are closed from 5pm on Friday to 5pm on Sunday though, so you do get a break during the weekend. The fact you can trade in the evening lets you to take advantage of events that you couldn’t trade on when the US equity markets are closed. The Forex market is also the largest and the most liquid market out there. Daily volume for the market averages around $3.2 trillion USD, but can sometimes peak up to $4 trillion. $1.5 trillion of that trading is spot trading, which is just buying and selling based on the current market price. For comparison, the NYSE trades about $169 billion a day, or about 5% of the Forex market.
Trading currencies is also low cost because you only pay the spread to your broker when you buy and sell. There is still a bid and an ask that traders worry about but there are no commissions. Forex is full of tax advantages though so that's something to look forward to! Short-term capital gains, which are typically defined as when you take profit from an investment made under a year ago, are just taxed at your current tax rate. Long-term capital gains are taxed at only 15%. Interestingly though, the first 40% of your profits are taxed at short-term rates and the remaining 60% are taxed at the long-term rate. That’s a nice little bonus for your bottom line.
It is both a gift and a curse that there are fewer currency pairs that you can trade than there are securities in the US equity markets.
This means that there are more analysts covering each currency and therefore less opportunity to find something that the other guys are missing. This isn’t to say that it’s impossible to make a profit though. Let’s talk a little bit about what currency traders are looking for when they’re about to enter a trade.
Currency inflation rates can predict how a currency will perform. One country with lower inflation rates than the other countries will see an appreciation in the value of their currency. Another thing to watch for is the country’s interest rates for their sovereign debt. Forex rates, interest rates, and inflation rates are all correlated and provide insight into how exchange rates will move. Trade deficits are also a great way of pinpointing opportunity, since spending more on imports than you receive on exports can cause depreciation of your currency. The last big indicator I want to talk about here is something called Terms of Trade. Terms of Trade is the ratio of export prices to import prices. The goal is to have your export prices rise at a greater pace than your import prices, and when they do, that results in an appreciation of the currency.
Foreign exchange moves around in interesting ways. The actual trading takes place in intervals called pips, which stands for Price Interest Point. These pips are essentially equivalent to .0001, or one basis point. Brokers will generally round the price of a transaction up or down to the nearest pip.
Hopefully you have a little bit of a clearer picture of the Forex market. In the next article, I’ll get into some foreign exchange strategies that traders can use to make some money in these markets, but it’s worth reading and learning more about. Forex is often considered one of the craziest markets you can trade in because it’s so large, incredibly complicated, and the rules are a little different than most other markets. Nothing worth it is ever easy, but the profit numbers here are pretty worth it.
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