There are some significant differences between Forex and other markets like the equity markets or futures. While a good trader may be able to handle any market, structural differences in Forex can force a different approach. Moreover many of the so called "advantages" bring some inherent risks with them.
Superior Liquidity
With such a tremendous daily trading volume, the Forex market can absorb trading sizes that dwarf the capacity of any other market. This means a lot of trading liquidity and flexibility specially at London time, New York and Tokyo (in this descending order).
There are always participants willing to buy or sell currencies in the Forex markets. Its liquidity, particularly in major currencies, helps ensure price stability and market efficiency. Traders can almost always open or close a position at a fair market price.
While it is true that currency markets have superior liquidity, it is also a fact that there are periods when liquidity dries up. This can happen during very volatile times or periods of market uncertainty. A volatile movement in price does not necessary mean a lot of volume, it can be just the opposite: fewer traders in the market means a thiner liquidity, which can lead to a big imbalance between buyers and sellers, resulting in a quick price movement in form of a spike or gap.
Because of the lower trade volume during the Asian session or even more during holiday seasons, investors in the Forex market are also vulnerable to liquidity risk, which results in a wider dealing spread or larger price movements in response to any relatively large transaction happening during these times.
High Leverage
The subject on leverage will thoroughly explained in chapter 3 and you will be taught how to take advantage of it. Leverage trading means, in short, that you are permitted to trade up to 100 times your margin deposit. This is primarily attributed to the higher levels of liquidity explained before.
A leverage of 1:100 means: in order to buy and benefit from one lot of 10,000 US Dollars you only have to commit your 100 Dollars, the rest of the amount is leveraged by the market maker/broker.
While certainly not for everyone, the substantial leverage available with most online retail brokers in the Forex market is an essential attribute of this market. Rather than merely loading up on risk as many people incorrectly assume, leverage is essential in the Forex market. This is because the average daily percentage move of a major currency is less than 1%, whereas a stock can easily have a 10% price move on any given day.
A 100:1 leverage is commonly available from online Forex dealers, and sometimes even higher. This is a both way weapon: on one hand it lets traders profit from a lot size much larger than their investments. But on the other hand, it exposes them to losses of equal magnitude. You can win or lose quicker - that's right - but that's not all: a too small leverage can be equally dangerous as you will learn in chapter 3.
The most effective way to manage the risk associated with leveraged trading (also called margin trading) is to diligently implement a risk management in your trading plan. You have to devise and adhere to a system where your controls kick in when emotion might otherwise take over.
Margin Trading
The Forex market is a 100% margin-based market. This concept is strongly associated with the previous one of leverage. Online Forex brokers offer many opportunities to open smaller accounts than in other markets. That sort of flexibility opens the door to essentially anyone who wants to explore financial trading. This isn't to say that all brokers are that flexible. There are, however, a great many which offer so-called mini-contracts and even smaller accounts traded with micro-lots.
In fact, spot Forex trading is essentially trading a 2-day delivery transaction. This trade involves a cash exchange between two currencies rather than a contract. For that, your broker requires a capital deposit to provide surety against any losses you may incur. How much of a deposit can vary. Some brokers will ask for as little as 0,5%. That is fairly aggressive, though. Expect 1%-2% on the value of the position in most cases.
Note that margin trading does not mean margin loans. Your broker will not be lending you money to trade currencies (at least not the way a stock broker does). As such, there is no margin interest charged. In fact, since you are the one putting money on deposit with your broker, you may earn interest in your margin funds. This is what is referred to as the interest rate carry (or rollover).
When opening a position, one is essentially borrowing a currency, exchanging it for another, and depositing it. This is all done on an overnight basis, so the trader is paying the overnight interest rate on the borrowed currency and at the same time earning the overnight rate on the currency being held.
If you are holding your position longer than one day, your broker rolls you forward into a new position for the next trading day. This is generally done transparently and automatically, but it also means that at the end of each day you will either pay or receive the interest differential on your position.
Some brokers will not apply the day's interest differential value on positions closed out during the trading day. In this case, if you open a position with a negative interest rate differential, but you close it during the same day, the differential is not applied.
Lower Transaction Costs
The over-the-counter structure of the Forex market eliminates exchange and clearing fees, which in turn lowers transaction costs. There are usually no commissions in Forex retail trading because the trader deals directly with a market maker.
You may ask, if Forex brokers don't charge commissions, how do they make money?
The broker makes money from the spread, which is the difference between what he pays for a currency and the higher price at which he sells it. In other words, the spread is the width between the bid and ask prices, which can be quite small in the major currency pairs, ranging between 2 and 5pips.
Because of the currency market round-the-clock liquidity and the competition among market makers, you receive tight, competitive spreads both intra-day and night.
The question if it is more cost-efficient to trade Forex in terms of both commissions and transaction fees depends not only on your broker's conditions but also on your trading style. Forex is more efficient if you know how to balance the number of trades and the earnings ratios. The usual lack of commissions is another factor that, despite being an advantage, has to be well understood to make it work in your benefit.
Profit Potential in Both Rising and Falling Markets
Every open Forex position has two sides because currencies are quoted in terms of their value against each other. This is because currencies are traded in "pairs" (for example, US Dollar vs. Yen or US Dollar vs. Swiss franc), one side of every currency pair is constantly moving in relation to the other.
When a trader is short in one currency he/she is simultaneously long on the other. A short position is one in which the trader sells a currency in anticipation that it will depreciate. This means that potential exists in a rising as well as in a falling market.
some of the equity markets it is much more difficult to establish a short position due to the zero uptick rule, which prevents traders from shorting a stock unless the immediately preceding trade was equal to or lower than the price of the short sale.
This ability to sell currencies without any limitations can be seen as another distinct advantage of the Forex market. You have equal potential to profit in both a rising or falling market, as there is no structural bias to the market. Previous
Superior Liquidity
With such a tremendous daily trading volume, the Forex market can absorb trading sizes that dwarf the capacity of any other market. This means a lot of trading liquidity and flexibility specially at London time, New York and Tokyo (in this descending order).There are always participants willing to buy or sell currencies in the Forex markets. Its liquidity, particularly in major currencies, helps ensure price stability and market efficiency. Traders can almost always open or close a position at a fair market price.
While it is true that currency markets have superior liquidity, it is also a fact that there are periods when liquidity dries up. This can happen during very volatile times or periods of market uncertainty. A volatile movement in price does not necessary mean a lot of volume, it can be just the opposite: fewer traders in the market means a thiner liquidity, which can lead to a big imbalance between buyers and sellers, resulting in a quick price movement in form of a spike or gap.
Because of the lower trade volume during the Asian session or even more during holiday seasons, investors in the Forex market are also vulnerable to liquidity risk, which results in a wider dealing spread or larger price movements in response to any relatively large transaction happening during these times.
High Leverage
The subject on leverage will thoroughly explained in chapter 3 and you will be taught how to take advantage of it. Leverage trading means, in short, that you are permitted to trade up to 100 times your margin deposit. This is primarily attributed to the higher levels of liquidity explained before.
A leverage of 1:100 means: in order to buy and benefit from one lot of 10,000 US Dollars you only have to commit your 100 Dollars, the rest of the amount is leveraged by the market maker/broker.
While certainly not for everyone, the substantial leverage available with most online retail brokers in the Forex market is an essential attribute of this market. Rather than merely loading up on risk as many people incorrectly assume, leverage is essential in the Forex market. This is because the average daily percentage move of a major currency is less than 1%, whereas a stock can easily have a 10% price move on any given day.
A 100:1 leverage is commonly available from online Forex dealers, and sometimes even higher. This is a both way weapon: on one hand it lets traders profit from a lot size much larger than their investments. But on the other hand, it exposes them to losses of equal magnitude. You can win or lose quicker - that's right - but that's not all: a too small leverage can be equally dangerous as you will learn in chapter 3.
The most effective way to manage the risk associated with leveraged trading (also called margin trading) is to diligently implement a risk management in your trading plan. You have to devise and adhere to a system where your controls kick in when emotion might otherwise take over.
Margin Trading
The Forex market is a 100% margin-based market. This concept is strongly associated with the previous one of leverage. Online Forex brokers offer many opportunities to open smaller accounts than in other markets. That sort of flexibility opens the door to essentially anyone who wants to explore financial trading. This isn't to say that all brokers are that flexible. There are, however, a great many which offer so-called mini-contracts and even smaller accounts traded with micro-lots.
In fact, spot Forex trading is essentially trading a 2-day delivery transaction. This trade involves a cash exchange between two currencies rather than a contract. For that, your broker requires a capital deposit to provide surety against any losses you may incur. How much of a deposit can vary. Some brokers will ask for as little as 0,5%. That is fairly aggressive, though. Expect 1%-2% on the value of the position in most cases.
Note that margin trading does not mean margin loans. Your broker will not be lending you money to trade currencies (at least not the way a stock broker does). As such, there is no margin interest charged. In fact, since you are the one putting money on deposit with your broker, you may earn interest in your margin funds. This is what is referred to as the interest rate carry (or rollover).
When opening a position, one is essentially borrowing a currency, exchanging it for another, and depositing it. This is all done on an overnight basis, so the trader is paying the overnight interest rate on the borrowed currency and at the same time earning the overnight rate on the currency being held.
If you are holding your position longer than one day, your broker rolls you forward into a new position for the next trading day. This is generally done transparently and automatically, but it also means that at the end of each day you will either pay or receive the interest differential on your position.
Some brokers will not apply the day's interest differential value on positions closed out during the trading day. In this case, if you open a position with a negative interest rate differential, but you close it during the same day, the differential is not applied.
Lower Transaction Costs
The over-the-counter structure of the Forex market eliminates exchange and clearing fees, which in turn lowers transaction costs. There are usually no commissions in Forex retail trading because the trader deals directly with a market maker.
You may ask, if Forex brokers don't charge commissions, how do they make money?
The broker makes money from the spread, which is the difference between what he pays for a currency and the higher price at which he sells it. In other words, the spread is the width between the bid and ask prices, which can be quite small in the major currency pairs, ranging between 2 and 5pips.
Because of the currency market round-the-clock liquidity and the competition among market makers, you receive tight, competitive spreads both intra-day and night.
The question if it is more cost-efficient to trade Forex in terms of both commissions and transaction fees depends not only on your broker's conditions but also on your trading style. Forex is more efficient if you know how to balance the number of trades and the earnings ratios. The usual lack of commissions is another factor that, despite being an advantage, has to be well understood to make it work in your benefit.
Profit Potential in Both Rising and Falling Markets
Every open Forex position has two sides because currencies are quoted in terms of their value against each other. This is because currencies are traded in "pairs" (for example, US Dollar vs. Yen or US Dollar vs. Swiss franc), one side of every currency pair is constantly moving in relation to the other.
When a trader is short in one currency he/she is simultaneously long on the other. A short position is one in which the trader sells a currency in anticipation that it will depreciate. This means that potential exists in a rising as well as in a falling market.
some of the equity markets it is much more difficult to establish a short position due to the zero uptick rule, which prevents traders from shorting a stock unless the immediately preceding trade was equal to or lower than the price of the short sale.
This ability to sell currencies without any limitations can be seen as another distinct advantage of the Forex market. You have equal potential to profit in both a rising or falling market, as there is no structural bias to the market. Previous