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The Forex Essentials
- If a trader buys a currency pair such as GBPUSD, they effectively buy British Pounds and sell US Dollars; if the trader sells GBPUSD, they sell British Pounds and buy USD dollars.
- You buy a currency pair if you expect the exchange rates to increase in value; you sell a currency pair if you expect the exchange rates to fall in value.
- With Forex you trade in lots
- Mini lots typically start at $10,000 and increment by $10,000 typically up to $100,000
- Maxi lots are based on $100,000 increments
- To buy and sell lots, you need a percentage of the lot size as a cash deposit to cover the margin requirements.
- When you buy and sell a currency pair, you need a minimum margin requirement typically between 1% and 2.5% of the lot size e.g. $10,000 requires $100 cash deposit at a margin rate of 1%.
- Even though you only require a small percentage to trade a Forex lot, you realistically need a cash deposit of between 5% and 10% of the lot size to cover volatility and avoid a margin call on open positions held over days or weeks. A margin call is where the broker will ask you to deposit more money to cover the margin on a losing position.
- With Spread betting, you typically bet on exchange rates increasing or decreasing with a minimum bet of £1 per 0.0001 movement; for some currencies the unit size is 0.01.
- Futures and CFD typically require about 5% to 10% of the contract size and are normally cash settled. Forex Options are typically settled by exchanging Forex Futures.
- If you buy a currency you get paid interest; if you sell a currency you have to pay interest. To trade a currency pair you have to buy one currency and then sell another, therefore for long term positions you will receive interest on the currency bought and pay interest on the currency sold. The interest rates on each currency varies; for example if you buy Pound and Sell US Dollars, the interest rate on the Pound is higher than the Dollar therefore you will receive more interest than you have to pay out; this can be used to generate an income on a difference between the two rates.
What investors need to know?
- With a minimum trade on a $10,000 GBPUSD lot you make or lose $1 for every 0.0001 change in the exchange rates; it is essential to understand the inherent leverage that come with varying lot sizes therefore consider carefully your lot size and the associated risk and margin requirement before opening a position.
- With spread betting the minimum bet is typically £1 for every 0.0001 point movement in the exchange rate, therefore if you take recent volatility that saw the pound swing between 1.4300 and 1.4600 against the dollar within 24 hours, it would have resulted in a gain or loss of £300 if a minimum bet of £1 per point was placed.
- The currency markets are ruled by technical analysis with a lot of short term trading activity generated by computerised algorithmic trading platforms. It is essential to have an understanding of Trend Lines and Support Levels plus commonly used technical indicators such as MACD, Stochastic, RSI and Moving Average. Exponential Moving Averages tend to signal a change of trend quicker than normal Moving Average.
- Basic trend line rules are buy at support and sell at resistance. There is a greater probability of a successful trade if the technical indicators are also changing trend when the currency pair is at a point of support or resistance.
- Look for trending currencies that are making swings from highs to lows. Range bound sideways trading kills technical analysis indicators as you get false buy and sell signals.
- Longer term exchange rate trends change gradually over time driven by economic factors such as Interest Rates, Gross Domestic Product, Employment, Consumer Sentiment
- Forex trading can be a very effective way of locking in gains on overseas investments that have been generated by favourable changes in the exchange rate. Consider the following example:
- 18 months ago an investor moves £5,000 into a US Dollar trading account at an exchange rate of 2.0000 and receives $10,000. The $10,000 is invested in some US stocks.
- Today the investor’s US investments are still worth $10,000 however the exchange rate is now 1.4500. If the investor was to sell their US investments and transfer the money back to British Pounds, the $10,000 would be worth $£6,896, which is a currency gain of £1,896.
- The investor doesn’t want to sell their US investments, but does want to lock in the currency gain as they think the Pound is going to rally against the Dollar.
- The investor buys a $10,000 lot of GBPUSD (i.e. buys British Pounds and sells US Dollars) via a Forex trade. The money deposited to cover the Forex margin would currently generate income as the British Pound is paying out a higher level of interest than the US Dollar, but this can change over time.
- If the exchange rate moves from 1.4500 to 2.0000 over the coming months, then the Forex trade will generate a profit, while the US investments worth in British pounds will fall in value; the net effect is that any gains on the Forex trade offset the currency losses on the US investments. Vice versa, if the exchange rate falls, then the Forex trade will loss money, while the US investments increase in value. The investor is therefore hedged at an exchange rate of 1.4500 regardless of which way the currency moves; makes for a better nights sleep.
- When creating a Forex hedge against over seas investments, the objective is to take a Forex position that will generate an equal and opposite gain or loss to the overseas investment worth in British Pounds.
Longer term exchange rate trends change gradually over time driven by economic factors such as Interest Rates, Gross Domestic Product, Employment, Consumer Sentiment.
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