What Is Forex Trading? Think of It as Macro-Level Pairs Trading

What Is Forex Trading? Think of It as Macro-Level Pairs Trading

Key Takeaways

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

    As with the stock market, traders can look for potential opportunities using fundamental and technical analysis 

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

If you’re a veteran stock trader, you might know about pairs trading—taking a bullish position in one stock or index paired with a bearish position in another. With pairs trading, you’re essentially trading the value of one security relative to that of another. But did you know there’s a market—one in which more than $5 trillion changes hands daily—that’s all about trading relative value?

It’s called forex trading, and it’s made up of currency pairs. Each pair is the ratio of the value of a currency relative to the value of another currency.

Forex trading is a dynamic, global market, with forex trading platforms 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 forex trading pool.

If you’ve never looked at a forex trading platform, perhaps you were afraid of it or just didn’t quite understand how to trade currencies. Plus, forex trading involves leverage, carries a high level of risk and is not suitable for all investors. But if you decide forex is right for you, you can rely on many of the same tools you may already be using on the thinkorswim® platform. 

What Makes the Dollar Move? Interest Rate Differentials

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 United States, investors might move money into Australia, for example, 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 market. But again, forex carries a higher level of risk.

Take a Pair; Mix and Match

Again, forex trading is essentially pairs trading: You’re 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 NZD/USD. Major currency pairs consist of any two of the currencies listed in figure 1. All other currency pairs are considered “exotic.”

What Is Forex Trading? Think of It as Macro-Level Pairs Trading

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. One pip is 0.0001, so the difference in price between the bid and ask is two pips. Just like 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. 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 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.

The Double-Edged Sword of Margin

Forex trading involves margin, which means you can control a larger investment with a smaller amount of money. 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 your profits as well as your losses. A small amount of market movement can have a large effect—positive or negative—on your account’s profit and loss (P&L).

Similar Board, Different Game 

If you’re an experienced equity, futures, or option 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 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. With technical analysis and charting, forex trading works just like stock trading—prices fluctuate, and the charts follow the action (see figure 2).

What Is Forex Trading? Think of It as Macro-Level Pairs Trading

FIGURE 2: A CHART IS A CHART IS A CHART. If you use technical analysis to aid in stock trading decisions, you can adapt them to the forex market—the same concepts, price movement dynamics, and indicators are available on the thinkorswim platform. 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. Also, it’s important to keep in mind that diversification does not guarantee against investment loss.

In Pursuit of Opportunity

Plus, the currency market 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 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 apply for a separate forex account with TD Ameritrade. If you qualify, your forex account will be listed under the same log-in, and you’ll be able to trade using the thinkorswim platform. 

Practice Makes Perfect

Once you’ve opened a forex account, you might want to practice placing trades before committing real capital. To do this, select paperMoney at the thinkorswim log-in 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 in to pairs trading, currency style? Watch the video below.

Forex trading privileges are subject to review and approval by Charles Schwab Futures and Forex LLC, a CFTC-registered Futures Commission Merchant and NFA Forex Dealer Member. Not all account owners will qualify.

What Is Forex Trading? Think of It as Macro-Level Pairs Trading

Doug Ashburn is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.

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