To trade foreign currencies, one must understand the forex market, forex trading orders, including the different types of orders, how to calculate the required margin deposit for forex transactions, and how to use the trading platform that is generally supplied by the forex broker.
The global FX market is composed of several separate electronic currency networks (ECNs) that connect banks, institutions, and speculators. Forex brokers that provide direct access to an ECN are non-dealing desk brokers, who offer price competition for the customers' orders by broadcasting the orders to other ECN participants. On the other hand, a dealing-desk broker is the only counterparty to the retail customers that it serves, so those customers do not actually participate in the worldwide ECN market. Instead, the forex broker serves as the counterparty to the retail customer. The retail customer of a dealing desk broker only sees the bid and offer prices set by the broker – the retail customer's order is not broadcast to other market participants, not even to the broker's other clients, so there is no price competition for the customer's order. Consequently, forex brokers that advertise that more than $4 trillion of currencies are traded daily, implying that the FX market is the most liquid market, are misleading. Not only is the FX market highly fractured, but most FX transactions are through forwards, futures, and swaps, which do not have a direct effect on bid and offer prices in the spot market. Furthermore, most retail customers are trading with a dealing-desk broker, so the spread actually offered by the broker is determined by the broker, not by the market.
Forex trading, as in futures trading, usually means exchanging liabilities incurred through agreements. Only the agreement to make or take delivery of a foreign currency at a specified time for a specified amount is exchanged, not the actual currencies. Thus, the trader does not need to own a currency before agreeing to sell it. Moreover, most forex traders do not make or take delivery of currency, since they are only exchanging the agreements to speculate for profits. Nonetheless, it is traditional — and probably easier to learn and to discuss — to think of forex trading as the exchange of currencies, so the following discussion will continue to use that metaphor.
Understanding Forex Orders
One thing that you must understand about orders is that when you buy or sell short, you are simply exchanging 1 currency for another. For instance, consider the Euro/dollar currency pair, expressed as EUR/USD (Short tutorial: Currency Quotes). EUR is the base currency (aka primary currency) and USD is the quote currency (aka secondary currency, counter currency). Since this is the most actively traded currency pair, most brokers allow you to trade it. When you buy EUR/USD, you are exchanging United States dollars for Euros (buying Euros with dollars), and when you sell this pair, you are doing the opposite—exchanging Euros for dollars (selling Euros for dollars). Note that buying EUR/USD is the same as selling USD/EUR, and vice versa. (You do not have to worry about having Euros in your account to buy dollars—the broker will take care of this for you automatically.)
- Buy EUR/USD ≡ Sell USD/EUR ≡Exchange Dollars for Euros
- Sell EUR/USD ≡ Buy USD/EUR ≡Exchange Euros for Dollars
To reduce confusion and simplify the handling of forex quotes, the major currencies are assigned a priority, so that the higher priority currency is always displayed as the base currency in a forex quote, so currency pairs will always be displayed in the same way. For instance, a quote for the euro and the US dollar will always be displayed as EUR/USD, not as USD/EUR.
If you initiate a transaction by buying, then you are going long in the quote currency and short on the base currency. If you initiate an order by selling the currency, then you are going short the quote currency and long on the base currency. Therefore, perforce, if you are long in 1 currency, you must be short in the other.
To close a position, you must reverse the transaction that opened your position: selling the currency you bought, or buying the currency you sold short. The complete cycle of buying or selling, then reversing that transaction is referred to as a round turn.
Required Margin Deposit for Forex Transactions
Most FX brokers display client balances in USD using the exchange rate from the New York FX market at the close at 5 PM EST. Every forex dealer requires a margin deposit, or security deposit, which is the balance or equity that the trader must have on deposit to open or maintain a position in a forex trade. The required margin deposit can be calculated as follows:
Margin Deposit = Purchase Currency Amount × Sell Currency Exchange Rate × Required Margin Percentage
For more information, see How to Calculate Leverage, Margin, and Pip Values in Forex, with Examples.
Example — Calculating Required Margin
If you wanted to buy €1,000 with United States dollars and your forex broker requires a 2% deposit, and EUR/USD = 1.25, what is your required deposit?
Since you are buying €1,000 and each Euro costs $1.25, you need 1,000 × 1.25 = $1,250 to make your purchase. In other words, you are selling $1,250 for €1,000.
Required Margin Deposit = 1,000 × 1.25 × 0.02 = $25
Note that a 2% margin requirement is equal to a leverage ratio of 50:1. If the leverage ratio was 25:1, then, 1/25 = 0.04 = 4%. Therefore, the required margin for the above example would be doubled to $50.
Most, if not all, brokers provide for basic order types that are similar to orders for stocks.
The most common order is the market order, which is to buy or sell at market. Actually, what this means is that you are buying the quote currency at the brokers ask price or you are selling short at the brokers bid price, which is always lower than the ask price. This is how most brokers make their money, and why they do not need to charge commissions. The spread is the difference between the bid and ask prices. In most cases, the most actively traded pairs will have the smallest spreads, and less actively traded currency pairs will have larger spreads. Spreads also increase when there is increased volatility in the market, even for frequently traded currency pairs.
As soon as you buy or sell short, the spread is immediately subtracted from your equity, because if you immediately closed the transaction even before there are any price changes, then you will lose the amount of the spread.
The problem with the over the counter (OTC) market is that there is no market price that is the same for all brokers, because there is no central exchange where bid/ask prices can be compared. Most brokers average the quotes from several large banks, but these quotes can differ depending on the bank. The forex dealer then widens the spread for their own profit. This is the "market price" that your broker quotes. This is true even for those brokerages that are advertising a no-dealing desk, where your quote, supposedly, is seen directly by the participating banks. However, the forex dealer is still widening the spread, for that is how brokers make their profits.
Another problem with market orders is that some dealers may give a trader a very unfavorable price that could be 10 pips or more removed from what the trader could see using the broker's software, and then see the price go right back to where it was. Sometimes, the broker will even requote the price, giving you a different price from what you thought you bought it at. This doesn't happen often, but if it does, you should find another broker.
Entry Limit Orders
An entry limit order is an order for a currency pair that is away from your broker's bid/ask price. In other words, your limit order to buy is not your broker's ask price, or your order to sell is not your broker's bid price.
Your order does not compete with any other orders. Only your broker sees your order—no one else. So there is little point in trying to place an order inside the spread, where the transaction price—either a buy or a sell—is between the bid/ask price. Many trading platforms do not even allow such an order to be entered, but even if they did, the broker probably won't complete the transaction unless the market moves enough in the direction of your order.
There are some forex brokers who are advertising a no dealing desk, where your order is shown to some banks that are in the broker's network, and, in these cases, the trading platform does allow you to place an entry limit order inside the spread, but even this is not really effective, because only a few big banks see your order, and if it is a small order, they probably won't have much interest. This is in contrast to an American stock exchange, where the best bid/ask prices from all participants are displayed in the system, allowing any market participant to see those stock prices.
Closing Limit Order
There is another type of limit order that closes a transaction—the closing limit order—and, often, it is listed simply as a limit order by the trading platform, but this is an order to close a transaction that has already been initiated. If the initial transaction was a buy, then the closing limit order will be a sell, and vice versa. It is not necessary to specify whether to buy or sell, since this will be determined by the initial transaction. It is only necessary to specify the price.
Closing limit orders are set to take profits, so if the quote currency was purchased, then the limit order will be higher than the purchase price; if the quote currency was sold, then the limit order will be less than the sale price. If the broker's relevant bid or ask price never reaches your limit order, then no transaction will be triggered, and your position will remain open until you change the limit price or change it to a market order.
Stop-loss orders are set to be triggered by adverse prices, so as to close open positions to limit losses, useful when losses become too great at times when the trader either is not watching the market or cannot reach the broker to execute an order. It is very difficult to predict currency prices or monitor a 24-hour market, and so brokers offer the stop-loss order type as a way for traders to prevent major losses by being able to set a limit at an unfavorable price to close an open position before the losses become too great. Because stop-loss orders are placed to prevent more losses, they are set on the other side of the limit order to take profits. Thus, a stop-loss order for a purchase transaction to sell is set below the purchase price, and a stop-loss order to buy for a short transaction is set above the sell price. Most trading platforms allow setting both limit and stop-loss orders with the initial order, whether it be a market or an entry limit order.
Because of the spread, a stop-loss order for a purchase transaction must be placed below the dealer's bid quote, which is lower than the purchase price at the time of the transaction. In fact, it should be placed low enough so that the random walk of market prices will not trigger the stop-loss order before the limit order. Some unethical dealing desk brokers may even try to harvest the stops by spiking prices through the stop loss orders, which they can do since they — not the market — set the prices. Many traders try to avoid this by not setting a stop-loss order, but then they must accept greater risk.
Stop-Loss Orders May Increase Rather than Limit Losses
The forex market is often advertised as being the largest and most liquid financial market in the world. True, it is the largest market in the world — as an aggregate market; but it is not the most liquid market because it is not 1 connected market, it is many fragmented markets. It may be liquid for Goldman Sachs, but for most retail forex traders, the market is very illiquid. Indeed, for those traders using a dealing desk broker, they are only dealing with one counterparty — the broker. Even the ECNs that some brokers use tend to be small. Liquidity depends on a number of counterparties to any trader's order. For dealing desk brokers, the number of counterparties is exactly one — the broker.
Without liquidity, stop-loss orders are not very effective in preventing losses — indeed, they can magnify losses. Stop-loss orders do not work if there is no one on the other side to take the trade. This is particularly true for forex markets, which are much smaller than the markets major banks use or the stock market, for instance. When major news breaks out, such as when the Swiss National Bank unpegged the Swiss franc from the euro in early 2015, the price of the Swiss franc rose dramatically against many currencies, triggering many stop-loss orders for those who were short on the Swiss franc, all buying at the same time, quickly raising the market price. When the price finally topped out, sellers rushed in to take advantage of the top prices, so that the new equilibrium price moved to a lower level, higher than what it was, but still lower than the maximum after all the buying had stopped. However, traders will not benefit from this bounce, because they will have already been stopped out. After the Swiss franc debacle, as an example, one trader thought that he had limited his losses to $900 because of his stop-loss order, but when he checked his account, it turned out to be a loss of $22,800, more than 25 times higher! (See link at the end of this article.)
Forex brokers allowed an unusual type of hedging that is not allowed in other types of securities. For instance, if you bought a futures contract, then sold the contract, then the trader would be neutral in the position, since the sold contract offset the previously purchased contract. In forex trading, it was possible to buy a currency pair and sell the same currency pair without closing the previous position, so that the trader would be both long and short in the currency pair. As long as the 2 currency pairs were held, losses would not be incurred but neither would any gains be earned. Traders did this because they wanted to close each position at different times, depending on which way the market moved. However, traders can achieve the same objective by 1st opening and closing 1 position, then doing the same again with the other position. Hence, being long and short on the same currency pair does not offer any trading advantages. Forex brokers allowed this because they earned commissions on the 2 trades. However, the National Futures Association (NFA) has issued Compliance Rule 2-43(b), referred to as the FIFO rule., where positions must be offset on a first-in, first-out basis, thus eliminating FX hedging. However, some hedging can still be maintained if the contracts are of different sizes.
FX Trading Platform
The way to actually trade with most forex brokers is over the Internet using their software—the trading platform. The mechanics of trading and what currency pairs you may trade is determined by the software. In addition to trades, the software usually provides other information about your account, such as your balance, how much margin you have used, and how much you have left. It shows all open positions along with any stops or limits for those orders, and any entry limit orders to initiate a transaction. The software may also have windows for news and messages, and may provide a chat service so that you can get help.
The best way to learn the software is to use it to manage a practice account, where the broker allows you to trade using real market data, but without using real money. Good software should prevent you from making at least some mistakes, such as accidently entering a buy price that is higher than the market price, for instance, with similar constraints in setting limit and stop orders. Otherwise, mistyping something, or misusing the software can be a costly mistake.
In the stock market, you can set time limits on orders, such as good till canceled (GTC), or day orders, which are good for the day. However, because the forex market is a 24-hour market from Sunday afternoon until Friday afternoon, most orders placed with brokers are GTC orders.
Before you start trading with real money, you should practice with a practice account first. This is the best way to ensure that you not only understand the trading platform, but also understand forex transactions. Otherwise, you could end up with large losses. You should also trade long enough to see how well you do. Don't jump into it just because you did so well with a practice account in your 1st week. You were probably just lucky. Although forex is very popular nowadays, and there is a great deal of advertising promoting it, the fact is, it is very difficult to make money trading currency—unless you're a broker!
Consider this example on the real risks of forex trading: On January 15, 2015, the Swiss National Bank unpegged its currency, the Swiss franc, from the Euro, allowing it to rise 30% shortly thereafter against the Euro. Consequently, many forex retail traders suffered horrendous losses. Although 30% is a pretty hefty loss by itself, multiply that by the leverage ratio that traders typically use in forex trades. In the US, the maximum ratio is 50 to 1, which means that a trader could be short $10,000 worth of Swiss francs for a margin of only $200. If the Swiss franc rises 30% in 1 day, then the value of those Swiss francs will increase to $13,000, a loss of $3,000 — 15 times the posted margin — in a single day. Moreover, because the sell orders greatly outnumbered the buy orders, stop-loss orders were executed at much lower prices than their set prices. Here are some reported examples of actual losses:
- A loss from 1 stop-loss order should have been about $900 but instead turned out to be $22,800.
- Another trader thought that his total losses would be €1000, which is what his trading platform reported when he 1st looked at it. Later, his forex broker requoted the price so that his total loss was increased to €3000.
Additional Ways to Invest in Currency
There are other ways of investing in currency besides buying the currency itself. Some banks have introduced new products to take advantage of the currency market. Barclays PLC, for instance, has 3 exchange-traded notes (ETNs) that offer investment opportunities in the Euro, yen, and the pound.
Other ways to invest in foreign currency is to buy foreign bonds or stocks, or to invest in currency mutual funds, or bond funds, or to invest in trusts that hold bank deposits in foreign countries, such as the CurrencyShares Euro Trust from Rydex Investments. However, some of these investments may have more risk than the currency alone, since some investments are using leverage, futures, or other derivatives to increase returns, which also increases potential losses.
Other investment vehicles are trying to benefit from the risky carry trade, where futures are bought in countries with a high interest rate and sold in countries with a low interest rate.