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Many investors have heard of “forex” trading. But how does it work and what are the risks associated with it? The purpose of this post is to provide the reader with a general discussion relating thereto. This discussion is not designed to be complete in all material respects. Thus, it is being provided for educational purposes. It should not be relied upon as legal or investment advice. If you have any questions concerning the contents of this post, please contact a qualified legal or investment professional.
Individual investors who are considering participating in the foreign currency exchange (or forex) market need to understand fully the market and its unique characteristics. Forex trading can be very risky and is not appropriate for all investors. It is common in most forex trading strategies to employ leverage. Leverage entails using a relatively small amount of capital to buy currency worth many times the value of that capital. Leverage magnifies minor fluctuations in currency markets in order to increase potential gains and losses. By using leverage to trade forex, you risk losing all of your initial capital and may lose even more money than the amount of your initial capital. You should carefully consider your own financial situation, consult a financial adviser knowledgeable in forex trading, and investigate any firms offering to trade forex for you before making any investment decisions.Background: Foreign Currency Exchange Rates, Quotes and Pricing
A foreign currency exchange rate is a price that represents how much it costs to buy the currency of one country using the currency of another country. Currency traders buy and sell currencies through forex transactions based on how they expect currency exchange rates will fluctuate. When the value of one currency rises relative to another, traders will earn profits if they purchased the appreciating currency, or suffer losses if they sold the appreciating currency. As discussed below, there are also other factors that can reduce a trader’s profits even if that trader “picked” the right currency.
Currencies are identified by three-letter abbreviations. For example, USD is the designation for the U.S. dollar, EUR is the designation for the Euro, GBP is the designation for the British pound, and JPY is the designation for the Japanese yen. Forex transactions are quoted in pairs of currencies ( e.g., GBP/USD) because you are purchasing one currency with another currency. Sometimes purchases and sales are done relative to the U.S. dollar, similar to the way that many stocks and bonds are priced in U.S. dollars. For example, you might buy Euros using U.S. dollars. In other types of forex transactions, one foreign currency might be purchased using another foreign currency. An example of this would be to buy Euros using British pounds — that is, trading both the Euro and the pound in a single transaction. For investors whose local currency is the U.S. dollar ( i.e., investors who mostly hold assets denominated in U.S. dollars), the first example generally represents a single, positive bet on the Euro (an expectation that the Euro will rise in value), whereas the second example represents a positive bet on the Euro and a negative bet on the British pound (an expectation that the Euro will rise in value relative to the British pound).
There are different quoting conventions for exchange rates depending on the currency, the market and sometimes even the system that is displaying the quote. For some investors, these differences can be a source of confusion and might even lead to placing unintended trades.
For example, it is often the case that the Euro exchange rates are quoted in terms of U.S. dollars. A quote for EUR of 1.4123 then means that 1,000 Euros can be bought for approximately 1,412 U.S. dollars. In contrast, Japanese yen are often quoted in terms of the number of yen that can be purchased with a single U.S. dollar. A quote for JPY of 79.1515 then means that 1,000 U.S. dollars can be bought for approximately 79,152 yen. In these examples, if you bought the Euro and the EUR quote increases from 1.4123 to 1.5123, you would be making money. But if you bought the yen and the JPY quote increases from 79.1515 to 89.1515, you would actually be losing money because, in this example, the yen would be depreciating relative to the U.S. dollar ( i.e., it would take more yen to buy a single U.S. dollar).
Before you attempt to trade currencies, you should have a firm understanding of currency quoting conventions, how forex transactions are priced, and the mathematical formulae required to convert one currency into another.
Currency exchange rates are usually quoted using a pair of prices representing a “bid” and an “ask.” Similar to the manner in which stocks might be quoted, the “ask” is a price that represents how much you will need to spend in order to purchase a currency, and the “bid” is a price that represents the (lower) amount that you will receive if you sell the currency. The difference between the bid and ask prices is known as the “bid-ask spread,” and it represents an inherent cost of trading — the wider the bid-ask spread, the more it costs to buy and sell a given currency, apart from any other commissions or transaction charges.Generally Speaking, There are Three Ways to Trade Foreign Currency Exchange Rates
The forex market is a large, global and generally liquid financial market. Banks, insurance companies and other financial institutions, as well as large corporations, use the forex markets to manage the risks associated with fluctuations in currency rates.
The risk of loss for individual investors who trade forex contracts can be substantial. The only funds that you should put at risk when speculating in foreign currency are those funds that you can afford to lose entirely, and you should always be aware that certain strategies may result in your losing even more money than the amount of your initial investment. Some of the key risks involved include:
As described above, forex trading, in general, presents significant risks to individual investors that require careful consideration. Off-exchange forex trading poses additional risks, including:
The Commodity Exchange Act permits persons regulated by a federal regulatory agency to engage in off-exchange forex transactions with individual investors only pursuant to rules of that federal regulatory agency. Keep in mind that there may be different requirements or treatment for forex transactions depending on which rules and regulations might apply in different circumstances (for example, with respect to bankruptcy protection or leverage limitations).
You should also be aware that, for brokers and dealers, many of the rules and regulations that apply to securities transactions may not apply to forex transactions.