FX Trading basics: Know the differences, understand the risks, and choose your forex broker wisely
This post is written in collaboration with Saxo Markets.
Stock markets down? Economic data looking bleak? At times like these, investors often turn to another market for investment opportunities: the foreign exchange or forex market.
In fact, this scenario is playing out right now. Investors are drawn to safe haven currencies (like the USD) during bear markets and periods of extreme volatility, and seek refuge through USD-crossed currency pairs.
What is forex?
Forex – or foreign exchange – involves the exchange of one foreign currency for another. Forex always involves two currencies, the one you wish to buy or sell, and the other with which you use to purchase or receive proceeds from. These are known as currency pairs.
Unlike the stock market, forex is not traded through a platform or an exchange, but through market participants who communicate via phone calls and Electronic Communications Networks (ECN). These transactions can occur all over the world, at almost any time of the day or night.
That explains why the forex market is the largest financial market in the world, with daily volumes reaching $6.6 trillion as of 2019. Major currency pairs like the EUR/USD, GBP/USD, USD/JPY, and the AUD/USD are also highly liquid. That means they can be purchased and sold in larger quantities easily.
The forex market is open 24 hours a day, 5 days a week, with the biggest volumes occurring during the overlap between the New York and London trading hours.
Ways to trade Forex
There are a number of instruments with which investors can trade forex, including spot forex, forwards contracts, futures contracts, and swaps. Here’s the difference between them.
In the spot forex market, two currencies are directly exchanged for the other, at the current market price – or the spot exchange rate. When you head to a money changer to exchange currencies, you are participating in the spot forex market.
Spot forex transactions are mostly used for the purposes of import and export payments, short term and long term investments, loans, and hedging. As such, these transactions are typically undertaken by banks, financial institutions, large corporations, and even government linked entities. Most spot forex transactions are settled two business days after the transaction date (T+2), though some currency pairs – like the USD/CAD – are settled on T+1.
A currency forward is a binding contract that locks the exchange rate for the sale or purchase of a currency on a specified future date. Its terms can be customised to any notional amount and for any specified period, and it does not require an upfront margin payment. They can also be cash settled or delivery settled.
As such, forward contracts are typically used to hedge large transactions that involve different currencies and have longer repayment terms.
Currency futures are a type of exchange-traded futures contract where a currency can be bought or sold on a stipulated date at a set exchange rate. These contracts are standardised, binding and deliveries must be made upon expiry.
Currency futures differ from currency forwards in that the latter is traded over the counter (OTC), though both can be used for hedging currency risks. Futures contracts are also more commonly used for speculation on currency price movements.
A currency swap – or FX swap – is an agreement between two parties to exchange the principal and interest payments of a loan in one currency for the principal and interest payments of an equivalent loan in a second currency.
There are two main types of currency swaps: fixed-for-fixed currency swaps and fixed-for-floating swaps.
Swaps are typically used to secure a foreign currency loan at more favourable interest rates as compared to borrowing directly in a foreign market.
Retail forex investors are less interested in taking delivery on a forex trade, or hedging a foreign exchange transaction, and more interested in investing in the price movements of the currency pairs.
To do that, retail investors can trade forex pairs through market maker forex brokers or ECN brokers. Saxo Markets, which offers multi-asset trading and investment with access to global capital markets, offer both market maker and ECN access when it comes to trading forex.
Common FX pairs offered by retail FX brokers include the major pairs, minor pairs, while some might even offer exotic pairs.
Key risks in forex trading
Forex trading is not without its risks, so it is important you go in with a clear understanding of the risks involved:
Interest Rate risk – Changes in interest rates impact fund flows in and out of the country, which affects exchange rates and can cause currency prices to rise and fall suddenly.
Transaction risk – Exchange rates can change between the time a contract is entered into and the time it is settled. The longer the time difference, the higher the transaction risk.
Counterparty risk – The counterparty of a forex trade is the company that provides the asset to the investor, and the risk is that the company or broker defaults on the transaction.
Country risk – This is the risk of a country facing a currency crisis that leads to the devaluation of its currency. As such, forex traders should always evaluate the stability and structure of the issuing country before investing in its currency.
Leverage risk – Leverage allows the use of a small initial investment, known as margin, to trade larger positions. The use of leverage can magnify returns on small price movements, but they can also magnify losses which far exceed your initial investment.
What makes a good forex broker?
A good forex broker would provide you with a wide range of currency pairs to trade, such as the 182 forex pairs – including major, minor, and exotic pairs – offered by Saxo Markets. That is far more pairs than any other leading broker in Singapore
Your forex broker should also provide robust trading platforms that offer comprehensive technical analysis charting tools and regular news updates to help you make better investing decisions more quickly. The platforms should also provide a wide range of order types to cater to your trading strategy and preferences.
Your forex broker should also provide you with the appropriate risk management tools to protect you from slippage, gapping and minimise unforeseen losses. A common strategy to manage risk is the 2% rule. The 2% rule means never putting more than 2% of your equity at risk at any one time. Learn more about this and other risk management strategies here.
Saxo Markets even provides tools like stops, trailing stops, limits, as well as its proprietary Account Shield to automatically close your positions at the best possible prices when it is triggered.
Most importantly, keeping your trading costs low is crucial towards maximising your trading returns. You can be assured that Saxo Markets’ transparent, market-leading pricing on FX pairs, with low spreads and no commission across majors, minors and other trading products, will help you with that.
Now that you are ready to trade, start with Saxo Markets.