FX Trading 101

  by Kevin Pendley

In the last decade, trading activity in foreign exchange (FX) markets has skyrocketed. If you're curious how to get involved in FX and what trades might be attractive, then you've come to the right place.  

FX markets offer fast-paced action for day traders, and wonderful longer-term trending moves for those with a more patient investing horizon. If you polled a dozen random investors and asked them what the biggest market in the world is, they might come up with the U.S. equities or Treasury markets, or perhaps the mammoth world of credit swaps - but all of those markets are in fact dwarfed by worldwide volume in FX. Daily turnover in FX markets is estimated at $3.2 trillion, or nearly $200 dollars a day for every human being on the planet. Incredibly, trading in FX markets has nearly tripled in the past seven years, and should continue to swell as markets like China become more volatile and open to investment opportunity.

What's more, one could easily argue that the greatest trade ever executed in any marketplace took place in FX…when hedge fund genius George Soros took on the Bank of England's fixed band for the pound and won that battle - raking in an estimated $1 billion back in 1992. A billion bucks is a lot of money now, and it was a ton of money 16 years ago. 

Even if you are a seasoned stock market investor, FX is a different animal, and there is more than one viable approach to dip your toes in the water of currency trading. The two most common avenues are to open up an account with an investment bank or to trade FX derivatives, such as futures on foreign currencies. 

If you opt for trading with a bank - called the "cash" or "interbank" market - then there are no direct commission charges, but you will pay a price by giving up basis points on the bid/ask spread. These basis points are called "pips" by FX traders. Having an account with a bank in the cash market also provides the ability to customize the size of the trade and to venture into exotic currency crosses that might not be readily available or as liquid in the derivatives arena. 

If you approach FX trading through futures or options, you will pay a commission rate on each contract traded. These commissions typically range from $20 to $90 dollars per contract, depending on whether you are executing orders through a discount or full service broker. 

"If someone lacks experience trading FX, or they are a small investor, I would urge them to consider starting in the futures business because they will get all the help and education they need to understand the process," says Dominic Boyle, market strategist with Lind-Waldock, one of the largest futures brokerage firms in the world. 

In addition, Boyle noted that someone trading a futures account would not have to be concerned about the cash "roll," which involves interest rate payment or credit, depending on the yield ratios of the currencies that are being traded. Simply put, high yield currencies accrue interest rate carry, while low yielders pay out interest on many FX crosses. 

Be careful when opening up a new FX account. Stick to reputable firms that focus on interbank or futures transactions. There are a bevy of Internet FX trading firms out there in cyberspace, and while many are reputable, there have been numerous fraudulent scams in recent years accompanying the explosion in FX trading interest. If in doubt, check the National Futures Association (NFA) website to see if a firm you are thinking about opening an account with is listed as under regulatory authority by the NFA. 

From a trading perspective, foreign exchange rates are impacted by all kinds of events, including balance of payment trends between various nations, long-term business cycles, political changes, interest rates and investment patterns, which means that there are a never-ending supply of dynamic developments taking place all over the globe that can impact currency valuation. 

I mentioned earlier that FX markets are a wonderful trading vehicle for short-term trades, and also for long-term investment opportunities. As an example, it's not uncommon for the most actively traded FX market - euro/dollar - to see daily ranges in the 125 pip zone. For a futures account, a 125-pip move on a full-sized contract is worth $1,562.50 per contract, which is clearly a huge bang for the trading buck. And I'm sure most of you have heard that the euro is at all-time highs against the dollar; what this means for longer-term trades is that this has been a great trending market if you have been on the correct side of the move.  

In fact, currencies are a broad reflection of the relative strength of one economy vs. another. Economic trends play out over time, and the same is true of currency patterns…changing the course of a trend in FX markets is very much like the old axiom of trying to turn around an aircraft carrier…it takes time! Point in case: the euro has been rising against the U.S. dollar for more than seven years. 

Now that we've attacked the basics of trading FX markets, each coming week we'll isolate various crosses and explore what the charts, the fundamentals and the experts have to say about where currency markets are headed and how we can try to take advantage of those moves.

Kevin Pendley has been involved in financial and commodity markets for two decades, including more than 15 years with Knight-Ridder Financial News/BridgeNews.  In addition to his work at 4xAdviser.com, he is a contributor at SmallCapInvestor.com, where he writes a weekly technical analysis column on the Russell 2000.

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