The Process of Currency Trading
A highly evolved marketplace
The logistics behind modern foreign exchange can seem quite complex to the uninitiated. The currency trading marketplace has evolved over several centuries, and is based on a series of conventions which were shaped largely by market participants themselves. Thanks to advances in modern technology, the process of exchanging one currency for another has progressed from a slow, cumbersome, paper-driven endeavor into a dynamic, frenetic, computer-driven marketplace where huge fortunes – and huge losses – can be realized in a matter of mere seconds. Investors must obtain a firm grasp of the basic principles of currency trading in order to profit from spread and arbitrage opportunities, and – perhaps more importantly – to avoid making costly mistakes in the course of placing their trades.
Conventions simplify the market
While there are some 164 different global currencies that can traded today, in practice, the majority of foreign exchange transactions involve a small subset of this group. The International Organization for Standardization (ISO) has established a system of abbreviations for all currencies in order to facilitate efficient trading and to reduce the potential for misunderstandings between parties. Among the most popular ISO codes are: USD for United States dollar; EUR for the European Union euro; GBP for the Great Britain pound; and JPY for the Japanese yen.
Most trades happen on the cash market, where prices are quoted in “pips,” or the last significant decimal of the given exchange rate. Because the number of decimal places can vary by currency, having some familiarization with individual currencies and typical exchange rates can help to minimize the potential for confusion. For example, U.S. dollars are quoted to the fourth decimal place, but Japanese yen are quoted to just the second decimal place. To expedite matters, traders may often verbally quote currency exchange rates using only the last two digits, or the “small figure.” Hence, an exchange rate of 1.1686 may be quoted as simply “86.” If one needs the “large figure”for this exchange rate, it is quoted as “16.”
The two types of trades on the cash market are the spot market and the forward market.
In spot trades, the transactions are considered to be immediate, because the transaction must close within 2 days after the trade is matched. In the forward market, the transaction closes at some point beyond this 2-day window. The close can be as far as a several months away, but the investor must always remember that the longer the close involved, the greater the risk of a currency fluctuation in the interim.
Checking the spread
A “bid” is a request for a price by a buyer. An “offer” or an “ask” is a price presented by a seller. The difference between these two prices is known as the “spread,” and is quoted in pips. When the buyer and seller agree on the terms of the transaction, a trade is executed, and currencies are exchanged. This exchange is not a physical transfer of paper notes and coins, but rather a series of accounting entries made by the two parties which record their new “positions” in the two currencies after the transaction is completed. Much in the same way that a consumer or business might write a check to authorize the transfer of currency from one account to another, representing payment for goods or services, almost all foreign exchange transactions take place without the literal transfer of paper currency.
It’s A Two-Way Street
It is important to remember that every foreign exchange transaction actually involves two elements: buying one currency; and simultaneously selling another currency. To determine the real profit or loss on a transaction, an investor must also consider his or her cost of obtaining the currency that is being sold. Foreign exchange professionals fully realize that not every transaction will be a profitable one when judged in isolation. However, various trades can be utilized to help bolster a trader’s position in the market, setting up new opportunities that arise from constantly fluctuating exchange rates.
Hedging your bets
In a forward transaction, the buyer and seller agree to exchange currencies at specific terms at a particular date in the future, usually 30, 60, or 90 days from the date of the agreement. In a swap forward transaction, the buyer and seller agree to exchange currencies for a set length of time, and to reverse the exchange at a later point in time.
“Futures” are contracts to take delivery of a commodity at a fixed price at a fixed date in the future. In a forward currency trade involving futures, the buyer and seller agree to exchange a certain block of currency – representing a fixed size in number of units – at some date in the future at an agreed-upon rate.
Foreign exchange “options” are opportunities to make or take delivery of a currency at a designated price on or before a set expiration date. The owner of an option purchases the right – though not the obligation – to buy or sell a specified amount of currency at a specified price up until a specified date known as the “expiration.” The owner can either choose to take advantage of the deal terms by exercising the option prior to the expiration date, or to simply allow the option to expire.
The wizards behind the curtain
Due to the number of variables involved in any currency trading transaction, it should be readily apparent that smooth operation of the foreign exchange marketplace requires the constant and instantaneous transfer of massive amounts of data, the interpretation of which is expedited by a system of standards that reduce the need for extraneous communications. Buyers and sellers must be quickly matched, and the details of their deal terms exchanged, recorded, debited and credited to their respective accounts.
The Interbank is a network of banks and dealers that constitute the modern cash currency marketplace. Contrary to popular belief, the Interbank is not a single institution, company or stone edifice with a physical trading floor, but rather it is a virtual entity, made real only via the technology that connects its various member organizations. In everyday parlance, the use of the term Interbank typically means that one of the large international banks is involved in the transaction. About a third of all foreign exchange transactions involve the Interbank’s spot market, and volumes for typical transactions are in the millions of units (i.e. a sale of 30 million British pounds sterling at a price of USD $1.8044 per pound).
The actual means of executing and clearing foreign exchange trades involves two major computer systems that communicate deal terms and generate the transactional records used by various trading firms. The Clearing House Interbank Payment System (CHIPS), is a system owned by several New York-based banks which links more than 100 financial institutions involved in clearing dollar currency transactions. The Society of Worldwide Interbank Financial Telecommunications (SWIFT) is another system which provides a standardized means of transmitting orders and other currency clearing operations.
Improved access for small investors
For many years, participation in the foreign exchange markets was limited to large international banks with the necessary capital reserves and infrastructures to handle this type of intense financial activity. The minimum transaction size was typically $1 million or greater. Thanks to advances in computer technology that allow for the subdividing and independent tracking of larger blocks of currency, commercial banks are now able to offer the average investor access to the foreign exchange markets at a much lower minimum account size.
The mere availability of these new avenues of access shouldn’t necessarily imply that foreign exchange is an appropriate investment vehicle for every consumer. In fact, due to its global nature, currency trading is unlike any other form of investing, posing potential pitfalls which every investor must attempt to avoid.