Forex trading has become one of the most popular ways to speculate and generating income in the capital markets for a retail investor. Not only are the markets open 24-hours a day, 6-days a week, but the liquidity provided makes currency trading one of the best ways to take a global view of the world. It is not difficult to learn forex trading, but to be successful you will need to understand some of the nuances of currency trading.
When you transact in the forex markets you are trading a currency pair which is the relative value of one currency to another. The rate is called the exchange rate, and this determines how much of one currency another currency will cost. The most liquid currency pairs are referred to as the major currency pairs. This security always has the U.S. dollar as one of the two currencies that are exchanged. When the dollar is not involved in a currency pair, the security traded is referred to as a cross currency pair. Forex traders will also trade emerging market currency pairs, which are currencies from developing countries traded versus the dollar.
Bid and Offer
When you purchase a currency pair from a broker or a dealer you are buying where your broker will sell which is referred to as the offer price. When looking at this price it is the right side of the quote. For example the offer side to the quote 1.3510 / 1.3511, is 1.3511. If you are selling a currency pair you are selling where others will buy which is the bid side of a quote, which is the left side of the quote or 1.3510.
Each currency pair has a base and a counter currency which tells traders which currency is purchased and which is sold. It’s important to learn this information so you won’t transact and then find out you purchase the wrong currency. For example, the Euro and U.S. dollar are always quoted as EUR/USD. If you plan on purchasing this currency pair you would buy it on the offer side which is the right side of the quote. This currency pair tells you how many dollars you need to pay per Euro. There are rules such as direct and indirect quoting help you determine which currency is the base and which is the counter currency.
Spot and Forward Trades
The most common settlement period for currency transactions is the spot. This means that the delivery of each currency to the counterparties in the transaction will occur in 2-business days. The currency market has evolved to the point where deliveries rarely occur, but they are still the foundation of currency trading. If you decide you do not want to take deliver and want to hold your currency position beyond spot, you will enter the world of the currency forward transaction. A forward transaction is made up of the forward rate which incorporates the spot rate and the forward rate. The forward rate of a currency pair is calculated by adding or subtracting the interest rates of the two countries’ currencies. This interest rate differential makes up the forward points.
Forex trading can be lucrative, challenging and enjoyable. It’s important to learn about some of the nuances of the process before diving in, including the spot and forward rate, about the bid and offer, and direct and indirect quoting.