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Foreign exchange trading – what you need to know

09:24, 14 August 2018

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The old saying that says anyone thinking about dealing in commodities ought to lie down until the feeling passes could equally be applied to someone contemplating a spot of foreign exchange trading.

Foreign exchange (Forex) is a market whose riptides can pull a trader under in very short order. Trading currencies is not for the faint-hearted.

Yet it can be an exciting and rewarding activity, for those prepared to do their research and form strong and coherent views with which to inform their Forex trading strategies. Contracts for difference (CFDs) offer a cost-effective and straightforward entry into this market, and are especially suited to high-conviction foreign exchange trading.

A zero-sum market

More on that in a moment. First, a look at the Forex market as a whole.

Currencies are an asset class like no other. For a start, they are the means by which all other assets are priced, yet have a price of their own, one that can change second by second.

In addition, this is a zero-sum market, meaning that for every gain for one currency there must be a loss for another. While it is quite possible for all shares or all commodities to rise simultaneously, currencies are priced only in reference to each other, so, for example, a rise in the dollar value of the euro means a decline in the euro value of the dollar.

The only monetary asset against which all currencies can rise of fall at the same time is gold.

This takes us to a third key feature of the foreign-exchange market, which is that the well-informed trader will need to distinguish between one currency’s strength and another’s weakness. For example, in early 1985 sterling reached an all-time low against the dollar never seen before or since, $1.06 – close to parity.

Politically sensitive

On the face of it, this was odd, because the British economy was pulling out of the downturn of the early Eighties and Margaret Thatcher’s second administration was well-regarded internationally. A well-briefed trader would have recognised that the story here was one of dollar strength, not sterling weakness.

By contrast, sterling’s strong performance against the dollar in the mid-2000s was very much a vote of confidence in the British economy.

Fourth, currencies are highly politically sensitive, which is hardly surprising as they are manufactured and managed by political appointees in the world’s various central banks. Even when these central banks are supposedly independent of direct political control, comments by senior politicians can send currencies skidding up or down as traders read perhaps too much into these remarks.

One example from the UK a few years ago illustrates this perfectly. A Treasury official said, off the cuff, that ministers would support the Bank of England in the monetary policy decisions that it took. A statement of the obvious, perhaps, but this was seen as implying the next decision would be unpopular – in other words, a rise in interest rates, and the markets reacted accordingly.

Talk of monetary policy takes us to the key influences on a currency’s exchange rate, of which interest rates are the most important. A rise in rates ought, all things being equal, to make the currency concerned more attractive to traders and investors, because the returns on holding it have risen.

This is the chief reason that a rise in rates is a usual response to a “run” on a currency, with the central bank seeking to stem and then reverse the tide of selling. But aside from improved returns, there are other reasons why a rate rise may favourably impress currency traders.

Should the country – or countries, in the case of the euro – in question be suffering from inflation, the rate hike should bear down on this, slowing the rate at which the currency’s internal value is being eroded.

Furthermore, by dampening domestic consumption, a rate rise may release resources for exports, to the benefit of the national economy as a whole.

Finally, a rise may indicate political strength and confidence. On rare occasions, it could also indicate the opposite, take for example the time the British Government raised rates twice on “Black Wednesday” –16 September 1992 – first from 10% to 12% and later to 15%, to try to keep the sterling within Europe’s Exchange-Rate Mechanism.

Currency markets simply did not believe that this 50% rise in borrowing costs would stick, and continued to sell the pound. Britain left the ERM that evening and the rate rises were cancelled. The markets had been proved right.

Key role of the dollar

The balance of payments is another influence of exchange rates. A country that is running a large deficit on its trade and investments with the outside world is vulnerable to a lack of market support for its currency simply because it will need constantly to borrow abroad.

This is especially the case should a sizeable deficit be combined with domestic political instability, a combination known as “fragility”.

Even when a country is running a healthy balance of payments surplus, its currency can be affected by fears of restrictions on trade, as seen in President Donald Trump’s imposition of tariffs.

Finally, currencies are critically affected by what happens to the dollar. This is a currency like no other, being both the unit in which about two-thirds of world trade is denominated and the “middle currency” between those world denominations that do not have a direct exchange rate between them but which do have a rate against the dollar.

So, you have researched the market and want to trade. How? These days you will almost certainly be online currency trading. The days of pit traders waving their arms in the air and yelling at each other are almost entirely in the past.

As mentioned above, Forex is a zero-sum game, which makes it particularly well-suited to CFD trading. One currency, such as the yen, can either rise or fall against another currency, such as the New Zealand dollar, but they cannot both rise and fall against each other.

Once the trader has taken a view, they enter a contract with a CFD provider in which they back this view and the provider backs the alternative outcome in terms of gainer and loser. Only one view can be right – the very essence of Forex trading.

Capital Com is an execution-only service provider. The material provided on this website is for information purposes only and should not be understood as an investment advice. Any opinion that may be provided on this page does not constitute a recommendation by Capital Com or its agents. We do not make any representations or warranty on the accuracy or completeness of the information that is provided on this page. If you rely on the information on this page then you do so entirely on your own risk.

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