Foreign Exchange CFDs

There is lots of knowledge and interest out there about FOREX trading. FOREX (Foreign Exchange) is simply purchasing a currency at one price and selling it at another price to make a profit. Currency markets are well known around the world, and your average Joe will have exposure to them when you go travelling to Europe or Asia as you will need to change your currency to be able to purchase things in the new country. You also may have exposure to foreign exchange markets if you ever made a purchase from overseas and had to calculate what the cost of the product was in your local currency.

Trading foreign exchange (also commonly known as FX or Forex) is fast becoming the world’s most popular trading instrument for retail traders. Over the Counter (OTC) FX is commonly traded through CFD providers. The FX market is the world’s most liquid market and with daily turnover in the Trillions of dollars  makes it the largest market in the world! The major reason for its size is attributable to its major traders such as large global banks, central banks, institutional investors, hedge funds, governments, retails investors and many more. For this reason FX is vast becoming a part of all traders strategies.

The major use of FX for retail investors is for speculation. Majority of traders combine their Technical Analysis techniques along with Macroeconomic fundamentals to apply it to an extremely liquid market making for a profitable combination. Traders can gain probably the best leverage in the OTC world with some providers offering leverage of up to 400/1 with most offering around 100/1. FX markets are also traded 24 hours, starting from 20.15 GMT trading through till 22.00 GMT Friday only resting weekends for traders. Other traders use FX for hedging large currency sums they have overseas or investments that are held in foreign currencies. In this case traders use FX to lock in currency risk.

When we talk about FX providers there are two price feeds you can get.  A DMA feed straight into the Inter Bank market or a market maker feed! Market Makers will use the interbank market feed to derive their prices then add a spread to cover commissions even though they say its ‘commission free’. DMA providers will give you depth and much tighter spreads. In this instance a commission will be payable.

The way Foreign Exchange works is there are two parts to a position. The base currency and the counter/quote currency! When trading FX you always trade a pair. You are speculating on the value of one currency against another. Let’s take an example of AUD/USD. In this case the base currency is the Australian Dollar and the quote currency is the US Dollar. If you thought the Aussie dollar was going to strengthen against the US Dollar then you would buy the pair AUD/USD. The trader then Has to decide what value they would like to trade ie $100,000AUD. If this was the case then technically the trader is long $100,000 AUD and short the equivalent in USD. As the value of the AUD goes up the trader profits and if the value of the USD was to strengthen against the AUD then the trader loses money. If the trader thought the USD was going to strengthen against the AUD then they should sell the pair AUD/USD.

There are many providers out there that let you trade FOREX. You can simply open an account and say you want to purchase x amount of dollars and sell x amount of Euros and hey presto, it all happens automatically.

Contracts for difference (CFDs) work as a form of financial derivative that creates a contract between two parties that states that one party will have to pay the other the difference in the value of the underlying asset that the contract was made on.

What this means is that you can make a contract saying you will buy the USD at $1.10 Canadian Dollars, and if it is higher than that (say $1.20 Canadian Dollars) at the time you decide to sell it, the other party will have to pay you the difference, but if it is lower (say $1.00) you will have to pay them the difference. This is basically the same as trading the currency its self.

FOREX trading accounts will also allow you to purchase on leverage (borrow to make bigger purchases than the actual amount of cash you have). CFD accounts also let you do this.

Due to the Fact FX is an OTC market and covers a range of global currencies traders should be aware that trading FX can be extremely volatile and with the leverage available in these markets should be traded with caution. FX is traded all around the world and unlike an equities market there are so many more influencing factors on FX prices than many other markets. I briefly want to go through many thing on more of a macroeconomic level to show you what FX traders look for when trading.

Economic Factors

The value of an country’s currency can weigh heavily on economic policy conditions which are generally revealed through many economic indicators.

When looking at economic policy we should always consider both fiscal policy and monetary policy. Announcements surrounding government budget surpluses and deficits are always important as the impact is always reflected in the value of a country’s currency. Inflation also has a multitude of effects on a currency and these figures globally are monitored closely.

Economic growth and health is of utmost importance and is covered by a number of economic indicators such as GDP, employment level, retails sales, nonfarm payroll, housing prices and many more will indicate the level of an economies growth and therefore the strength of its currency.

Political Conditions

Politics will always play a role in the value of a country’s currency. Political instability or even upheaval can have devastating effects on the value of a currency. Even anticipations about new ruling political parties can create instability in a currency’s value. The announcement of political policies and budgets are closely monitored as this can affect the strength of an economy or a forecast of the direction it will be heading and therefore determining the value of its currency!

Technical Trading

As in any tradable products on the market these day there are always technical traders. FX markets being so liquid and volatile, with an abundance of leverage, means technical traders love FX. Most will use technical analysis along with these fundamental points we just mentioned so that they are not caught unaware when large announcements or data on economic indicators is revealed.

Unexpected Events

So called black swan events need to be factored in. Extremely tight risk management systems are vital as events such as war, political unrest, terrorist attacks and natural disasters have adverse effects on the economic state of countries and therefore the value of their currency. Take recent events close to home such as the Floods in Queensland and the earthquake in New Zealand.

There are many types of Foreign Exchange CFDs. All are slightly different but here are the most common;

Spot FX

This is as it is names and effectively is an ‘on the spot’ transaction. Rollover will occur daily or every second day depending on the pair. It tracks the price of the currency pair at that moment in time and is the most common and popular type of FX CFD trade.

Forward

This is when you trade an FX pair with an agreed upon date at some stage in the future. Future dates can be selected by traders and the cost of carry, or financing, of the position is usually factored in.

Future

There are some currency futures that can be traded like a normal futures contact. In this case the value is pre determined and expiry is similar to that of a futures product, usually every 3 months.

As you can see, CFD accounts allow you to do almost everything that a standard FOREX account could do, but they also offer so much more. Like the ability to trade shares in almost any market, the ability to trade indices, commodities and many other different options.