Foreign Currency Trading

Traders in the foreign exchange market make thousands of trades daily, buying and selling currencies while exchanging market information. The $1.2 trillion that is traded everyday may be used for varied purposes:

For the import and export needs of companies and individuals

For direct foreign investment

To profit from the short-term fluctuations in exchange rates

To manage existing positions or

To purchase foreign financial instruments

In the volatile FX market, traders constantly try to predict the behavior of other market participants. If they correctly anticipate their opponents’ strategies, they can act first and beat the competition.

Traders make money by purchasing currency and selling it later at a higher price, or, anticipating the market is heading down, selling at a high price and buying back at a lower price later.Trader purchases a lot of currency è long on the currency (e.g. long dollar, long yen)

Trader sells a lot of a currency è short on the currency (e.g. short sterling)

To predict the movements of currencies, traders often try to determine whether the currency’s price reflects its fundamental value in terms of current economic conditions. Examining inflation, interest rates, and the relative strength of the country’s economy helps them make a determination.Currency under priced è price will go up

Currency overpriced è price will go down

Currency Trading Between Banks

Banks are a major force in the FX market and employ a large number of traders. Trading between banks is done in two ways—through a broker or directly with each other.

Brokers: If a U.S. bank trades with another bank, a FX broker may be used as an intermediary. The broker arranges the transaction, matching the buyer and seller without ever taking a position and charges a commission to both the buyer and seller. About a third of transactions are arranged in this way.

Direct: Mostly banks deal with each other directly. A trader "makes a market" for another by quoting a two-way price i.e. he is willing to buy or sell the currency. The difference between the two price quotes (the spread) is usually no more than 10 pips, or hundredths, of a currency unit.

Most currencies are quoted in terms of how many units of that currency would equal $1. However, the British pound, New Zealand dollar, Australian dollar, Irish punt and the Euro are quoted in terms of how many U.S. dollars would equal one unit of those currencies.

The currencies of the world’s large, industrialized economies, or hard currencies, are always in demand and are actively traded. In terms of trading volumes, the FX market is dominated by four currencies: the U.S. dollar, the euro, the Japanese yen and the British pound. Together these account for over 80 percent of the market.

It is not always easy to find a market for all currencies. The demand for currencies of less developed countries, soft currencies, is a lot less than for the hard currencies. Weak demand internationally along with exchange controls may make these currencies difficult to convert.