Andrew Kinsey explains the basics of foreign currency trading.

The foreign exchange market is the largest asset class in the world with some US$6 trillion traded each day. The majority of this trade is conducted by the ten largest banking institutions in the world that have developed a vast corporate franchise while investing billions of dollars on systems, people and state-of-the-art risk-management systems.

Foreign currency trading is an exercise in evaluating the future strength, or weakness, of one currency’s value against another’s. For instance the current rate of exchange between the Euro and the US Dollar is 1.2850 – that is to say each Euro is worth 1.2850 US Dollars. Should a trader believe that the Euro is going to strengthen against the US Dollar (i.e. the number 1.2850 will increase numerically to say 1.2880) then he will buy Euro, in so doing effectively selling US Dollars.

In the interbank market there will be a physical exchange of Euros for US Dollars. For retail clients who trade currencies on electronic platforms they enter into a synthetic foreign exchange trade where there is no exchange of these principal amounts, but merely estimating how the currency rate will change from one period to another. Typically the currency products offered by electronic retail trading platforms offer their clients enormous leverage. This is achieved by requiring traders to post low cash margins to support their positions.

For example, based on the numbers above of 1.2850 and 1.2880, if a trader enters a position that will generate a R150 000 profit, for such a relatively small exchange-rate movement he may only be required to provide a margin or “deposit” of R20 000. This, together with the round-the-clock trading opportunities that are available in the foreign exchange market, are the primary attractions for traders who wish to take large risks against the prospect of fast, but not-so-easy profit opportunities.

Too much too soon

The prospect of large returns clearly comes with risks. The greatest risks that traders face, in our experience at GT247.com, are self-inflicted. This is because clients have assumed too much risk as a function of their available capital. A trader starts with a capital amount of R100 000 and then commits R50 000 to the first trade they enter into. If it’s a losing trade, then they’ve wiped out half their capital in one fell swoop, and that often proves to be an insurmountable setback from which to recover.

Our advice for novices is to start trading slowly and cautiously, much like learning to drive. If possible, practise on simulated platforms for a period of time and don’t be too proud and ashamed to seek advice. Even the greatest traders have to start somewhere and their skills and profitability take years to perfect. Be aware of taking too large a position and always have a healthy respect for the vicissitudes of the foreign market that punish the unprepared and the arrogant.

Andrew Kinsey is head of Product Design and Educational Research at GT247.com