Forex trading: The basics

Until the early 1970s, although it seems hard to believe, the world got by on a system of fixed exchange rates. Occasional devaluations and revaluations were all the adjustments that were made.

Then exchange rates were allowed to float more or less freely. At that time, professional foreign exchange dealers were little more than back office staff. Virtually overnight an industry was created based around currency speculation and FX dealers suddenly became the highly paid stars of the City, and were usually washed up and burnt out by the time they were 35.

Long hours, high pressure, and early burnout are now commonplace in the City, but foreign exchange (FX) trading remains one of the most liquid markets there is. There is underlying demand for currency exchange from the corporate sector, and from travellers, but this accounts for only a fraction of the daily turnover of more than $2,000 billion in the global foreign exchange market.

The vast bulk of this trading is now conducted between the dealing rooms of banks in major financial centres around the world. It is probably best characterised as an elaborate multiplayer computer game, played with real money, with profits and losses recorded every second of every trading day. And the 'spot' foreign exchange market - the market for real currency transactions, is of course dwarfed by trading in FX futures.

Spreading the bets

The existence of FX futures means that, while you might not want to stump up the large ante that gambling on a professional-sized futures contract might entail, you can play the FX market through the medium of spread betting. Outside of the share market, spread bets tend to exist where there is a futures market around which to base a price. Most spread betting firms worth their salt offer bets in currencies as part of the range of products they offer. Most of them focus on the most popular currency 'pairs', namely the permutations of the US dollar, yen and euro as well as 'cable' (the $:£ relationship), and the rate between sterling and the euro.

Unfortunately, this isn't simply betting on discrete movements in, say, 'cable' between $2.00 and $2.05.

FX prices are usually quoted to four decimal points and the unit you are betting on, in this case, is a 'pip', in other words the fourth figure to the right of the decimal point. So, if you are buying at $2.0345 and the price moves to $2.0395, that is a movement of 50 pips. Put another way, each one cent movement in the rate is 100 pips.

You typically need to have £200 in your account for every £1 a point you bet. The spread is typically around 20 pips and a guaranteed stop-loss - an essential for this type of trading - might cost you a further five or six pips.

The other requirements before you even contemplate embarking on this type of trading is an awareness of the fundamental factors that move currency markets - interest rates, economic data, monetary conditions, politics - and an ability to use real-time charts to judge the timing of buying and selling prices and appropriate levels for stop-losses. FX trading is ultra short term, so the other requirement is a willingness to watch the trades you might make like a hawk on a second-by-second basis.

Peter says

The advantage of FX trading is that you can take a view and bet on it. It is an easy proposition to understand. There are no company fundamentals, management issues, or accounting minutiae to worry about. The product is a simple one.

The drawback is there are thousands of professionals trading the market in competition with you. They have access to highly sophisticated computerised analysis and charting packages and access to trading capital beyond your wildest dreams. They are paid to watch their trading screen every second of every trading day. You might want a life.

The underlying point is that FX is as close to what economists call perfect competition as it's possible to get. There are large numbers of buyers and sellers and ready access by all of the players in the market to all of the information they need to make their decisions.

For a more in-depth look into the pros and cons of trading currencies, be sure to visit our guide on how to trade forex. You can also open a free demo account with us to practise your trading.