Trading in Foreign Exchanges
Before we start thinking about trading in foreign exchanges, it would be useful to remind some main information about ‘Forex’ itself. The proper name is ‘foreign exchange market’ but the shortcut is also generally accepted and – what’s more - being used more often.
From the very beginning – ‘Forex’ enables a new way of executing transactions. Practically, it is a tool facilitating investors, banks and institution buying and selling different currencies. Statement that ‘Forex’ has revolutionized the international trade wouldn’t be wrong. Things changed a lot since foreign exchange market was introduced in 1973. The most significant example is Euro – the new currency common for more and more European countries. French franc, German mark, Spanish peseta and so on stopped existing and – as the consequence – the exchange rates were no longer needed. But that didn’t reduce the meaning of trading in foreign exchanges.
More than thirty years since the beginning were enough for the foreign exchange market to multiply its size and volume.
Converting currencies
Before going into the details, it would be useful to find out the way of converting currencies. Exchange, rates, quotation – all these names appear very often, but what are they exactly concerned about and what’s the rule? At first, the currency pair – like USD/EUR or GBP/PLN (the order of notation matters). It describes what currencies are to be traded. The first is called ‘based’ and second – ‘counter’. After those symbols, there’s hardly ever a number – the exchange rate. For example, USD/EUR=0,6630. That number informs, how many units of the counter (second) currency are needed to by one unit of base (first) currency. Taking the example rate: for one U.S. dollar the trader should be paid €0,66, what also means that for $1 the customer should get €0,66.
There are also two types of quotes (currency price):
- The direct quote means a price of 1 U.S. dollar that needs to be paid in different currency.
- The indirect quote is a price of one unit of different currency in terms of U.S dollars.
What’s worth noticing, the currencies rates are set to four decimal places.
Trading activities
Although all the transactions executed on ‘Forex’ are concerned about exchanging currencies, separate kinds of trading activities (also the financial instruments) may differ.
- The basic type of transaction is called ‘spot’. It is the most often used type of contract that is agreed between the market maker (company or even an individual responsible for quoting sell and buy prices) and the trader. To make the contract rightfully agreed, there are some components needed: the principal amount and the pair of currencies with the exchange rate among them. The main feature of spot transaction is its short time of realization. Usually the realization happens two days after the trade date (that’s the ‘spot value date’). Although this rule obtains for the most currency pairs, there are some exceptions. While swapping U.S. dollars for Canadian dollars (also Russian ruble and Turkish lira), the transaction is realized the next (business) day.
- Forward (also the ‘forward contract’). It looks like a spot transaction, but the time of realization is much longer (depending on parties’ settlements). It may be a day, but also a few months or years. Until that time, no money is transferred.
- Derivatives
Cross rate
Trading in foreign exchanges offers some facilities that might be useful and – what’s often the most important side – help saving time. One of them is ‘cross rate’. As it’s been earlier said, the relationship among two currencies is characterized by rate (how much of a second currency can be bought for one unit of base currency). The cross rate is used when there is more than one currency pair used in transaction. Therefore, instead of trading ‘step by step’, the customer may execute only one transaction. The scheme below illustrates the example of Euro to Baht swap.
Trading in foreign currencies
Buy cheap, sell expensive
The ways of trading in foreign exchanges are clear. But still it’s not specified what’s the point of that.
Surely, there are some coin collectors or maniac changing currencies only for pleasure. But the main reason, common for most of the participants is a will of earning money. The incessantly changing rates make a good possibility of earning profits from their differences – buy cheap, sell expensive. The whole work depends on predicting the rates’ changes. If you suppose that one currency price is going to get higher, it’s reasonable to buy some units when it’s still cheap and then wait for the rate’s change. When the price growth seems to be stopped, it’s good to sell bought units, saving the difference.
For example:
- Day first: EUR/USD=1,5094
Client decides to buy U.S. dollars for €5000.
5000 x 1,5094 = $7547
Paying €5000, client receives $7547.
- Month later: EUR/USD=1,3214
Client decides to sell U.S. dollars.
7547 : 1,3214 = €5711,37
Paying $7547, client receives €5711,37.
It’s more than €700 earned only because of the rate change.
It looks easy and very profitable, but remember about the high risk. Good luck!