Topic Cover | Learn Commission, Forex, Trading Guide
Investors who trade stocks, futures or options typically use a broker, who acts as an agent in the transaction. The broker takes the order to an exchange and attempts to execute it as per the customer's instructions. For providing this service, the broker is paid a commission when the customer buys and sells the tradable instrument. (For further reading, see our Brokers And Online Tradingtutorial.)
The FX market does not have commissions. Unlike exchange-based markets, FX is a principals-only market. FX firms are dealers, not brokers. This is a critical distinction that all investors must understand. Unlike brokers, dealers assume market risk by serving as a counterparty to the investor's trade. They do not charge commission; instead, they make their money through the bid-ask spread.
In FX, the investor cannot attempt to buy on the bid or sell at the offer like in exchange-based markets. On the other hand, once the price clears the cost of the spread, there are no additional fees or commissions. Every single penny gain is pure profit to the investor. Nevertheless, the fact that traders must always overcome the bid/ask spread makes scalping much more difficult in FX. (To learn more, see Scalping: Small Quick Profits Can Add Up.)
What is a pip?
Pip stands for "percentage in point" and is the smallest increment of trade in FX. In the FX market, prices are quoted to the fourth decimal point. For example, if a bar of soap in the drugstore was priced at $1.20, in the FX market the same bar of soap would be quoted at 1.2000. The change in that fourth decimal point is called 1 pip and is typically equal to 1/100th of 1%. Among the major currencies, the only exception to that rule is the Japanese yen. One Japanese yen is now worth approximately US$0.01; so, in the USD/JPY pair, the quotation is only taken out to two decimal points (i.e. to 1/100th of yen, as opposed to 1/1000th with other major currencies).
What are you really selling or buying in the currency market?
The short answer is "nothing". The retail FX market is purely a speculative market. No physical exchange of currencies ever takes place. All trades exist simply as computer entries and are netted out depending on market price. For dollar-denominated accounts, all profits or losses are calculated in dollars and recorded as such on the trader's account.
The primary reason the FX market exists is to facilitate the exchange of one currency into another for multinational corporations that need to trade currencies continually (for example, for payroll, payment for costs of goods and services from foreign vendors, and merger and acquisition activity). However, these day-to-day corporate needs comprise only about 20% of the market volume. Fully 80% of trades in the currency market are speculative in nature, put on by large financial institutions, multibillion dollar hedge funds and even individuals who want to express their opinions on the economic and geopolitical events of the day.
Because currencies always trade in pairs, when a trader makes a trade he or she is always long one currency and short the other. For example, if a trader sells one standard lot (equivalent to 100,000 units) of EUR/USD, she would, in essence, have exchanged euros for dollars and would now be "short" euros and "long" dollars. To better understand this dynamic, let's use a concrete example. If you went into an electronics store and purchased a computer for $1,000, what would you be doing?
You would be exchanging your dollars for a computer. You would basically be "short" $1,000 and "long" one computer. The store would be "long" $1,000 but now "short" one computer in its inventory.
The exact same principle applies to the FX market, except that no physical exchange takes place. While all transactions are simply computer entries, the consequences are no less real.
Which currencies are traded in the forex market?
Although some retail dealers trade exotic currencies such as the Thai baht or the Czech koruna, the majority trade the seven most liquid currency pairs in the world, which are the four "majors":
•EUR/USD (euro/dollar)
•USD/JPY (dollar/Japanese yen)
•GBP/USD (British pound/dollar)
•USD/CHF (dollar/Swiss franc)
and the three commodity pairs:
•AUD/USD (Australian dollar/dollar)
•USD/CAD (dollar/Canadian dollar)
•NZD/USD (New Zealand dollar/dollar)
These currency pairs, along with their various combinations (such as EUR/JPY, GBP/JPY and EUR/GBP), account for more than 95% of all speculative trading in FX. Given the small number of trading instruments - only 18 pairs and crosses are actively traded - the FX market is far more concentrated than the stock market. (To read more, check out Popular Forex Currencies.)
What is a currency carry trade?
Carry is the most popular trade in the currency market, practiced by both the largest hedge funds and the smallest retail speculators. The carry trade rests on the fact that every currency in the world has an interest rate attached to it. These short-term interest rates are set by the central banks of these countries: the Federal Reserve in the U.S., the Bank of Japan in Japan and the Bank of England in the U.K.
The idea behind the carry is quite straightforward. The trader goes long the currency with a high interest rate and finances that purchase with a currency with a low interest rate. For example, in 2005, one of the best pairings was the NZD/JPY cross. The New Zealand economy, spurred by huge commodity demand from China and a hot housing market, saw its rates rise to 7.25% and stay there, while Japanese rates remained at 0%. A trader going long the NZD/JPY could have harvested 725 basis points in yield alone. On a 10:1 leverage basis, the carry trade in NZD/JPY could have produced a 72.5% annual return from interest rate differentials, without any contribution from capital appreciation. Now you can understand why the carry trade is so popular!
But before you rush out and buy the next high-yield pair, be aware that when the carry trade is unwound, the declines can be rapid and severe. This process is known as carry trade liquidation and occurs when the majority of speculators decide that the carry trade may not have future potential. With every trader seeking to exit his or her position at once, bids disappear and the profits from interest rate differentials are not nearly enough to offset the capital losses. Anticipation is the key to success: the best time to position in the carry is at the beginning of the rate-tightening cycle, allowing the trader to ride the move as interest rate differentials increase. (To learn more about this type of trade, see Currency Carry Trades 101.)
Forex Market Jargon
Every discipline has its own jargon, and the currency market is no different. Here are some terms to know that will make you sound like a seasoned currency trader:
•Cable, sterling, pound - alternative names for the GBP
•Greenback, buck - nicknames for the U.S. dollar
•Swissie - nickname for the Swiss franc
•Aussie - nickname for the Australian dollar
•Kiwi - nickname for the New Zealand dollar
•Loonie, the little dollar - nicknames for the Canadian dollar
•Figure - FX term connoting a round number like 1.2000
•Yard - a billion units, as in "I sold a couple of yards of sterling."
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