Forex: Currency Trading for the Small Investor

Forex: Currency Trading for the Small Investor

Key Takeaways

    Currency trading is similar to pairs trading, in that you’re buying one currency and selling another

    Forex trading involves leverage, which can magnify gains as well as losses

    Carrying a currency position from one day to the next requires “rolling” 

Did you know that more than $5 trillion of currency changes hands every day in the foreign exchange market (“forex”)? Currencies are a dynamic, global market open virtually around the clock. And because foreign exchange rates are based on global interest rates as well as macroeconomic and geopolitical conditions, they’re always fluctuating. The good news is, you don’t have to be a big fish to swim in the pool of currency trading. The bad news is that forex trading is most definitely not for everyone. 

Currency trading is a vibrant marketplace. If you haven’t looked at forex yet, perhaps you were afraid of it, or just didn’t quite understand how to trade currency. But you don’t have to be a rocket scientist to figure things out. In fact, if you decide forex is right for you, you can rely on many of the same tools available on the thinkorswim® platform from TD Ameritrade that you may already be using. And if you understand what makes a stock tick, you more than likely understand what makes forex—ahem, pip.

What Makes the Dollar Move?

One way to think of a country’s currency is the same way equity investors think of stocks. Higher stock prices typically reflect investor confidence in a company’s future. Likewise, higher currency values typically reflect investor sentiment in the health of that country’s economy relative to other countries. Much of it has to do with interest rates and interest rate differentials. Lower rates in the United States make the dollar less interesting relative to other currencies. That is, as rates or yields fall, banks and other investors might move money into places that offer higher rates. For instance, if rates are low in the U.S., investors might move money into, say, Australia by investing in what might be higher-yielding Australian bonds.

Capital movements across borders are powerful forces that drive currencies higher and lower. Economic data and interest rates are the key fundamental drivers for this capital movement. As a result, trends can last months or even years and can potentially provide both short- and long-term profit opportunities in the currency markets.

Take a Pair; Mix and Match

Trading forex is essentially pairs trading: You are buying one currency and selling another. If you buy the EUR/USD pair, for example, you’re long the euro and short the U.S. dollar. And the rate is simply the ratio—the numerator over the denominator. Some of the more actively traded pairs today include USD/JPY, GBP/USD, USD/CAD, AUD/USD and EUR/JPY. Major currency pairs consist of any two of the currencies listed in figure 1. All other currency pairs are considered “exotic.” 

Forex: Currency Trading for the Small Investor

FIGURE 1: MAJOR CURRENCIES. For illustrative purposes only.

The minimum price movement in a currency market is called a pip. For example, let’s say the quote for EUR/USD is 1.4168 bid to 1.4170 ask. Since one pip is 0.0001, this means that the difference in price between the bid and ask is two pips. Just as with stocks, investors buy at the ask and sell on the bid.

For many currencies, the pip is equal to 1/100 of a cent, or 0.0001. This seems like a small amount, but a typical trade might be $100,000, so a 0.0001 pip equals $10. If you capture 10 pips on a trade, you’ve made $100. Conversely, if you lose 10 pips on a trade, you’re down $100, plus transaction costs. But the value of a pip is determined by the size of the trade and the currency pair you’re trading. Retail forex traders can trade in increments as small as 1,000 or 10,000 units.

The key is to know your pip value. If you bought 20,000 units of AUD/USD, each pip would be worth $2 (20,000 x 0.0001 = $2). If you bought 20,000 units at 0.7126  and sold them at 0.7118, an 8-pip loss, you would have lost $16.

Commission-Based vs. Commission-Free Platforms

On retail forex brokerages, trade costs are typically paid through the bid/ask spread, although some platforms, including the thinkorswim platform, offer the choice between a commission-based market or a commission-free market. Bid/ask spreads are not guaranteed, but the commission-based market typically has a tighter bid/ask spread than the commission-free market. In addition, major pairs typically have tight spreads throughout the day and night, but exotics generally have less liquidity and wider spreads. It’s important to understand liquidity risks before trading forex. 

The Double-Edged Sword of Leverage

Forex trading involves leverage, which means you can control a large investment with a relatively small amount of money. This is known as margin. In currency trading, margin requirements vary as a percentage of the notional value. Margin requirements are typically between 3% and 5% of the notional value, although certain pairs can be as low as 2%. Remember that leverage is a double-edged sword: it can magnify both your profits and your losses. A small amount of market movement can have a large effect—positive or negative—on your account’s P&L.

Same Board, Different Game 

If you’re an experienced equity, futures, or options trader, you should still do some careful consideration and an assessment of your risk tolerance before you decide to add forex to your product arsenal. You can use many of the same analysis techniques that you do for equities, and many of the indicators that you use to trade stocks, futures, or options can be applied to forex charts as well. Even simple trendlines can be useful when looking for the next major trend in a currency pair (see figure 2).

Forex: Currency Trading for the Small Investor

FIGURE 2: A CHART IS A CHART IS A CHART. If you use technical analysis in to aid in trading decisions, forex may apply some of the same concepts and dynamics, and offer the same indicators as stocks. Chart source: the thinkorswim platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Trading currencies can also provide some portfolio diversification. It’s another asset class and another opportunity to initiate positions to build a portfolio. If, for example, your stock portfolio isn’t doing well, some of those losses might be offset by positive results from a profitable currency position. There’s a lot to be said for trading asset groups that don’t have a high degree of correlation. Of course, the downside is that forex also brings in a whole new set of risks.

Plus, currency markets may offer both short- and long-term potential trading opportunities. For example, the investor focused on fundamental factors such as interest rates and economic data can trade on information from news releases in search of short-term profits, or even intraday moves. Economic news releases tend to cause very short bursts of activity in financial markets, including volatile moves in currency pairs. 

Understanding the risks of trading forex is key, and if it’s a new concept for you, sure, it will take a little time and education to learn the ins and outs. Yet, for many investors, forex is an exciting and liquid market to trade. The key drivers—economic data and changes in interest rates—are easy to follow. 

As with stocks or futures, to trade currencies, you need to open a separate forex account with TD Ameritrade. Once open, your forex account will be listed under the same login and you’ll be able to trade it through the thinkorswim platform. 

Practice Makes Perfect

Once you’ve opened a forex account, you might want to practice a trade or two before committing real capital. To do this, select paperMoney® at the thinkorswim login screen. With paperMoney, you can get familiar with all the trading platform’s features and how to place an order without losing (or gaining) a dollar. Or pound, yen, or euro, for that matter. 

Carrying Currency Positions? Learn About the Roll

Once you’ve got the hang of the basics, be sure you also understand how interest rates could impact your P&L if you’re planning on holding any currency pairs overnight. When you make a forex trade, you’re essentially long one currency and short the other. When you carry a position from one trading day to the next, you earn interest on the currency you’re long and pay interest on the currency you’re short. The differential between the two interest rates amounts to what’s called your “net financing rate.”

Before carrying a currency pair from one day to the next, it’s essential that you learn the ins and outs of forex financing rates. It’s not necessarily complicated; it’s just different, if you’re used to the world of stocks and bonds. Want a little more information before jumping into currency trading? Take a look at the video below.

Forex trading privileges are subject to review and approval by TD Ameritrade Futures & Forex LLC. Not all account owners will qualify.

Forex: Currency Trading for the Small Investor

Leave a comment