Forex

Yesterday, I wrote about options which can be traded as well as owned like stocks and bonds. Trading itself has many facets, strategies, and markets. Trading has been around since the beginning of time.

You can settle among us; the land is open to you. Live in it, trade in it, and acquire property in it. Genesis 34:10

Today I will discuss forex, or foreign exchange of currency. Every country in the world uses their own version of fiat, or paper money. This money, essentially has no value except what the collective group of people that use it give it in exchange for goods and services. This is called legal tender. It is accepted by meer confidence that it has value. The liquidity or ease of conversion is the reason this is used world wide.

Everyday, foreign currencies are traded around the world, and fluctuate daily. This trading goes on 24 hours a day, 6 days a week. It begins 4pm EST Sunday and ends 4:30pm EST Friday. Some of this trading is result of countries trading back and forth for goods. For example, China sends a shipment of clothing to the US. In China, the yuan is the currency. This has to be converted to dollars for the transaction to be complete. Today, the yuan is equal to 0.1346 US dollars, or about 13 cents.

There are no commissions when currencies are traded. Instead, there is a spread, or difference between what the price of the currency is when bought (bid) or sold (ask). In our example, the yuan is being sold at 0.1350 instead of 0.1346. The 4 hundredths of a cent spread is kept by the broker for the exchange. This is charged for every lot (unit of currency, usually $10,000) traded.

The pip, or price interest point, is used to measure the smallest price change, usually 4 decimal places. In most cases with the US dollar, it is 1/100th of a cent. All forex trading is done in pairs, such as the EUR/USD or Euro versus the US dollar. It will measure how many US dollars it will take to buy one Euro. The Euro is the base currency (always on the left), and the USD is the quoted currency (on the right).

Speculation accounts for about 95% of all trading that takes place, over 2 trillion each day. The forex market is the largest in the world; larger that all stock markets, bond markets, and futures markets combined. Huge sums traded can also mean huge profits on very small price fluctuations. Experienced traders can profit as much as 1% to 10% per day. Leverage is the key. Some brokers offer as much as a 400:1 leverage on small accounts. Medium sized accounts will offer 100:1 leverage. So for every $100 you risk, you can control a $10,000 lot. For example, a one pip movement would equal $1. If the EUR/USD pair moves from $1.4600 to $1.4700, this would mean a 100 pip movement or $100. Now, multiple that by the number of lots traded such as 10, that would equal $1000.

Currency trading is very risky and should only be done with risk capital. This is money that the trader can afford to lose. However, as mentioned, experienced traders do very well and can make huge profits in a short period of time. As discussed in the Asset Allocation post, 10% of your portfolio could be put into higher risk investments. That 10% could double the returns of the whole portfolio.