How The Forex Market Trades Fiat Currency
Currency trading involves the strategic buying, selling, and exchange of different foreign currencies. The market in which currency trading occurs is known as the forex (FX) market. Investors have been known to turn significant profits by speculating on major trends in currency valuation, which mainly center around economic and political events.
If you’ve ever traveled internationally, you’ve likely seen firsthand how much the exchange prices of currencies can move. There are many levers and pulleys tightening or slackening the strength of one currency over another. But there is also a market that trades on the daily and even hourly swings in exchange prices; that market is the forex market.
Currency Trading Is Booming
The global foreign-exchange market is valued at roughly $6.6 trillion per day according to the Bank for International Settlements, as reported by Bloomberg last September. That’s up from $5.1 trillion just three years prior. To put that in perspective, the average daily volume of the entire U.S. stock market is roughly $270 billion to $380 billion, or roughly 1/17th the size of forex.
The vast majority of forex trading takes place between banks and institutional investors. But with new platforms and increased availability, the retail portion of forex trading has recently boomed. There are a couple of factors for why that’s the case.
- High risk but high reward – First, as has been argued several times in this period, forex can appear to be similar to gambling. Both can be high stakes and offer potential high rewards.
- Fast pace seen firsthand – The other reason, which could be argued is the main one, is that just a short decade ago, individual investors saw just how quickly currencies can move, fall apart, and strengthen compared to one another. Following the Great Recession, we saw several sovereign debt crises in Europe and elsewhere. Even the U.S. lost its Standard & Poor’s AAA credit rating back in 2011.
Currencies can be traded both inside specialized brokerage accounts as well as in select IRAs, where tax benefits can be leveraged. While a forex broker would need to be involved, these can even be traded alongside the likes of gold and silver in a Precious Metals IRA. This is because forex trading in an IRA, like buying precious metals in an IRA, requires a self-directed IRA (SDIRA).
But before you start piling money into this market, it’s helpful to know the mechanics of forex and how it moves.
How Does Currency Trading Work?
All trades involve both the purchase of something and the selling of something else. When you go out and buy a stock, you purchase shares. But you also sell the currency you used to buy them.
With currency trading, that transaction is much more apparent.
Going Long or Short
Each currency trade involves at least one pair of currencies. The most common pair is the EUR/USD—or the euro/dollar—trade. Here, traders are either buying the euro and selling the dollar or vice versa.
When a U.S. investor takes dollars into a trade like this, they are said to be “going long” the euro. This means that they believe that either some specific economic event is going to favor the strength of the euro, or that the dollar is due for something unfortunate. For any currency pair, one currency is always increasing in value (“long”) while the other is reducing in value (“short”).
Technical Patterns Can Signal Potential Opportunities
Forex is more often traded based on technical patterns, or historical movements that can point out upcoming ones. Various forex platforms offer charting tools to assist in finding technical patterns. This, too, is one of the major reasons why the retail side of this market has boomed over the last dozen years; retail forex has acquired some of the same tools that only institutional investors and banks had at the start of the century. Through technical analysis, forex trading can be made more strategic.
Now, if you have traveled and exchanged currencies, you likely know that generally the price movement between two currencies isn’t huge. How, then, is the forex market so lucrative and why is it compared to gambling?
Margins Allow Investors to Profit
Margin is the name of the game when it comes to forex trading. Investors of all sizes leverage their trades so that even fractions of a penny can turn into hundreds or thousands of dollars in gains or losses.
Buying on margin to leverage a trade means borrowing money to place a bigger trade than you could otherwise afford. First you put down a good faith deposit, which is usually a certain percentage of the total amount of money that you then get to trade.
The amount of margin varies according to the forex broker with whom you work, but 1% margin is relatively common; in this scenario, a good faith deposit of $1,000 offers control of $100,000 of currency. The size of your forex trade can be enormous compared to the actual amount you have in your account.
Buying on margin is also known as trading on leverage. Individual forex brokers can directly answer any questions you might have on how this could impact any forex trading you perform through them.
Transactions Defined by Lots and Pips
The other important mechanic you definitely need to be aware of before going in is “lot sizes” and their corresponding “pips.” These concepts are crucial to understanding the day-to-day mechanics behind how the forex market works.
Lots are the specific volumes of currency in which forex trading occurs. There are four lot sizes: 100,000 units (standard), 10,000 units (mini), 1,000 units (micro), and 100 units (nano). Each lot unit is worth one unit of the base currency; for example, in euro-based trades, one unit can equal one euro. As the market itself grew, brokers started breaking up tradable lots into smaller sizes. Originally, standard and mini lots were the only ones you could trade; micro and nano lots were added over time to expand the trading power.
The changes in currency values are measured in units known as pips. A pip stands for “percentage in point.” Basically, this is the unit of currency broken out to the fourth decimal place of a currency pair (1/100th of 1%, or a basis point). So, a EUR/USD trade’s lowest price change can be $0.0001. That’s a single pip. This may seem like a very small unit—and it is—but given the scale at which forex traders operate, even a change of a single pip can lead to huge profit or loss.
Factors Affecting Currency Trading
Currencies, like stocks or precious metals, move primarily because of supply and demand. If the majority of the world sees the U.S. dollar as a safer store of wealth than any other currency, the dollar’s strength will go up—and so will its price in comparison to other currencies.
Of course, it’s not always easy to know when these ebbs and flows into and out of a single currency will occur; after all, there are hundreds if not thousands of factors at play. As we saw in the sovereign debt crisis a decade ago, when certain governments take on too much debt or threaten to not make interest payments, currency prices can go haywire. However, forex trading generally relies on macro trends in currency valuation. Understanding more details may simply add a bit more nuance to your trading.
Other factors that affect currency trading include trends in commodities. Oil, for instance, is still purchased globally through U.S. dollars; this means that trade into and out of dollars accompany trades into and out of oil.
The largest factor affecting currency trading is economic strength and forecasted economic strength. For example, over the last several years, the U.S. economy has grown faster than European economies; this, in turn, has strengthened the dollar compared to the euro.
Since 2014, the EUR/USD has fallen from $1.38 to $1.10. This means that while it used to take $1.38 dollars to buy one euro, it now takes $1.10. That might not sound like a lot. But when you consider 100:1 leverage and trades being measured in 1/100th of a cent, the gains rapidly add up.
Because of all these big factors at play, you can see why some claim forex is like gambling. There are quite a number of variables you need to be aware of when trading currencies. Still, it is the largest market in the world based on average daily trading value. When you hear most people talk about investing or markets, they are referring to stocks; keep in mind that there is one that is 17 times larger: forex.
Currency Trading Terms
While we defined lot size and pips above, they aren’t the only two forex-specific terms. Here are the main ones you won’t likely see in other markets:
- Currency Pairs — The matching of currencies in an actual currency trade. A common example of currency pairs is EUR/USD. The first part is the “base currency” in a trade (EUR in this example). The second is the “quote currency” (USD, here).
- Major pair – The most commonly traded pairs include the US dollar and one of the seven major global currencies (AUD, CAD, CHF, EUR, GBP, JPY, NZD), and they usually have the lowest transaction costs. These make major currency pairs some of the best pairs with which to get started in trading.
- Exchange Rate — This is the current price of a currency pair. If the EUR/USD is listed as $1.1056, that means that to purchase one euro, it takes $1.1056 USD.
- Lot — The basic volume of currency units (or dollars, euros, yen, or other specific currency) each trade is based on. This refers to the base currency of the currency pair. Trading three micro lots of EUR/USD would be worth 3,000 euros.
- Lot Size – Lots being traded come in one of four lot sizes: 100,000 units (standard), 10,000 units (mini), 1,000 units (micro), and 100 units (nano). These lot sizes have become optimized over time to align with common trading volumes and currency value fluctuations.
- Pip — This is technically a fraction of a currency, so you can see even more detail about a currency pair’s price changes. Pips are only ever really used to describe the price movement of a currency pair. If the EUR/USD moves from $1.1056 to $1.1060, that’s a movement of four pips. These are almost always taken to the fourth decimal place of a currency. The Japanese Yen is the exception; a pip on a Yen-based trade would be the movement of each second decimal place.
- Bid/Ask price – The bid price is the price at which buyers want to buy, while the ask price is the price at which sellers want to sell.
- Spread – The difference between the bid and ask price. The closer these are, the less cost for buyers; therefore, buyers are interested in minimizing spread.
As you monitor the performance of your Precious Metals IRA, you’ll likely keep an eye on gold and silver prices. Odds are you will encounter forex markets and currency trading mentioned alongside this price reporting; and if you read any commentary about trends in precious metals like gold, they will likely be explained in parallel to trends in major currencies like the dollar.
Understanding what currency trading entails can help round out your financial knowledge and empower you to better understand the trends affecting your retirement savings, providing better context on currency trends alongside the performance of your precious metals.