Forex Trading in Australia: Profiting From Currency Exchange Fluctuations

 

Most television news broadcasts tend to feature a small capsule related to economy and investing; for example, a two-minute segment may report on activity at Australian Stock Exchange (ASX) in Sydney plus major index products such as the ASX200; there may also be a report about Wall Street and other major financial marketplaces such as the Shanghai and London Stock Exchanges, which offer the trading of equity securities. Finally, you will see a mention about the currency exchange value of the Australian dollar (AUD) against the United States dollar (USD), which on February 22, 2018 was around 0.79.

The reason behind newscasts focusing on AUD/USD is because this particular exchange rate constitutes important information for Australian consumers and the national economy; after all, the U.S. is a major trading partner. Consumers who purchase American goods will often see prices in USD, and they need a point of reference to calculate how much they will pay in AUD. Furthermore, some individuals may have deposit accounts that hold USD, or they may have borrowed USD. What many Australians are not aware of is that the AUD/USD exchange rate is part of a global trading platform called the foreign exchange market, more commonly shortened to forex.

The forex market is the most active and liquid exchange platform in the world. Similar to the ASX, the forex market allows investors to trade security instruments; specifically, forex traders deal in fiat currency. AUD bank notes are legal tender instruments issued by the Reserve Bank and printed by Note Printing Australia. Fiat currency can be exchanged for similar instruments from other countries; for example, AUD can be used to purchase USD and vice versa. Currency exchange operations are conducted for various purposes: to enable tourism, to trade goods across borders, to boost financial reserves at the national level, and to profit at a personal level through forex trading.

It is estimated that the daily forex volume is six trillion USD; this massive level of monetary activity can be explained by the sheer diversity and quantity of market participants, which include:

* Sovereign central banks
* Interbank participants
* Commercial banks
* Investment funds
* Investment banking firms
* Currency exchange houses
* Retail forex brokers
* Individual traders

The forex market operates on a 24-hour cycle and is active six days a week. On any given day, central banks may enact monetary policy or shift their foreign currency holdings while participants in the interbank system loan funds to each other. While this is taking place, investment funds may load up on certain currencies, thus creating opportunities for retail forex brokers to adjust their operations so that individual traders can take positions on the market.

How Forex Works for Individual Traders

Investors can participate in the forex market through retail brokers who provide trading accounts in addition to an electronic exchange platform. In essence, individual forex traders can realize profits by taking advantage of currency exchange fluctuations. If you have American friends visiting you in Melbourne, you can help them obtain AUD that they can use during their visit; let’s say they have USD $200 and you give them AUD $255 in exchange, you can hold on to these greenbacks until AUD/USD shifts in your favor, then you can head to an American Express office or kiosk to collect your profits.

When you open a trading account with a retail forex broker, you will be given access to an online exchange platform where you can take market positions on currency pairs. You will be trading money for money and your positions will always be liquid; unlike the equity securities traded on the ASX, you will not hold shares in a company, your investment will be represented by legal tender. If you take a position on the AUD/USD currency pair, you may be able to profit from exchange fluctuations.

Understanding Currency Pairs

Thus far, we have used AUD/USD as an example, but this is not the most popular forex currency pair. The most actively traded forex pair is the euro against the USD, known as the EUR/USD, which denotes the relative value of these two currencies; this is known as a price quotation. The first monetary symbol in a pair is called the base currency, which is arranged by forex priority. When reading forex pairs, the following syntax should be interpreted:

Prices on February 22, 2018

* AUD/USD = 0.78 - this means that one Australian dollar can be exchanged for 0.78 American dollars

* EUR/USD = 1.23 - this means that one euro can be exchanged for 1.23 American dollars

There are two main components of retail forex trading accounts: the client account and the market position. The client account works like a bank in the sense that you can deposit and withdraw funds. Your market positions are funds that you have invested in currency pairs that can be liquidated at any time, meaning that they can be converted back into cash and transferred to your client account. It should be noted that most client accounts and market positions are handled in USD because of the prominence of this currency in the global financial markets. Once you start trading forex, you will get used to thinking and calculating in USD, and in the back of your mind you will envision collecting your profits and putting them to use in AUD.

BUY/SELL Forex Trades
 

Forex traders can either buy or sell currency pairs. Most beginners will focus on taking “buy” market positions because they are intuitive; if you think that the booming Australian economy will continue to flourish thanks to mining, gaming and tourism while the American economy will suffer under the scandalous weight of the Trump administration, buying $100 worth of AUD/USD will reflect your sentiment, and you may be able to profit in the future if this trade works for you. In forex terms, a “buy” transaction is also known as “going long.”

A “sell” transaction means that you believe a currency pair will lose value. Let’s say you do not have confidence in the European Union’s ability to grow its economy after the United Kingdom formerly executes the terms of the Brexit referendum; it is not unreasonable to think that the euro may take a dip once this happens. If you “sell” $100 worth of EUR/USD now, you may be able to take profits in the future if your analysis is confirmed and the euro loses value against the greenback.

The BUY/SELL intention will be clearly displayed on your trading platform before you execute and take a market position. Based on the examples above, you may see confirmation messages similar to:

BUY $100 AUD/USD?
SELL $100 EUR/USD?

Forex Pips, Spreads, Bids, and Offers

When you see a financial index such as the ASX200 reported on the news, you are seeing its value represented in points. In the forex trading world, the value of currency pairs is represented by pips, which are percentages of points. It is much easier to understand currency pair pips than the value of the ASX200 because pips represent fractional monetary increments to the fourth decimal point, for example:

AUD/USD = 0.7801 - the last digit is a pip

If the price of the currency pair above climbs by 0.7810 overnight, it is said to have appreciated by nine pips.

When pricing currency pairs, their value is indicated in pips; moreover, the prices are presented on a bid/offer basis by forex retail brokers:

EUR/USD = 1.2300/04

The bid price is always lower and it reflects what individual traders who wish to sell a currency pair will pay when they wish to take a short market position; in other words:

SELL $100 EUR/USD at 1.2300?

could be a confirmation message for a short seller.

The offer price is for traders who intend to take long market positions with a “buy” market position, thus:

BUY $100 EUR/USD at 1.2304?

could be a confirmation message for a long trader.

In the two confirmation examples above, the bid rate is for traders who wish to sell EUR and buy USD while the offer rate is for traders who wish to buy EUR and sell USD. Notice how these transactions are very similar to exchanging currency at American Express offices or kiosks, but they are more complex in the sense that there is a spread of pips. The spread is set by the forex retail broker for the purpose of covering expenses and generating profits; these spreads are calculated internally by means of algorithms. Forex traders do not beat spreads; taking a long position means that there is an expectation that pips will be incrementally added to the offer rate while taking a short position means that there is an expectation that the bid rate will be lower in the future.

Speculation, Settlements and Trade Execution

What prospective forex traders must always keep in mind is that their participation in this massive financial exchange market is highly speculative. Forex participants at the highest levels of the market do not engage in speculation; they enact monetary policy for the purpose of managing national economies. Individual traders do not directly compete against each other; they seek profits from currency exchange fluctuations that may or may not materialize in the future, which means that they must engage in speculation.

Just like most stock traders do not acquire shares of a company for equity ownership purposes, forex traders should not assume that their market positions will determine currency exchange values. The only difference is that forex traders will always hold cash regardless of their market positions. To collect profits, market positions must be settled; for example, a forex trader who went long on $100 worth of AUD/USD could settle her position once enough pips have accumulated to turn her investment into $108.

Due to the high liquidity of the forex market, traders do not generally have to worry about late executions. As long as the retail forex broker is solvent and operational, traders can close their positions and see their funds transferred into their client accounts; however, this can only be assumed by traders who deal with regulated brokers.

Forex Trading Regulation in Australia

The Australian Securities and Investment Commission is the regulatory entity in charge of forex trading oversight. The ASIC issues licenses to retail brokers based on various factors related to liquidity, experience, track record, supervision, and compliance. A retail broker cannot solicit or operate without an Australian Financial Services License, which means that the companies providing services must answer to the ASIC in case of any complaints or disputes brought forward by clients. Prospective traders can check if retail brokers are listed on the ASIC Connect Professional Registers; they should only do business with entities whose licensed status appears as “current.”

It certain cases, Australian traders may also open accounts with forex retail brokers that are licensed in offshore jurisdictions; however, the legal recourse and assistance provided by ASIC is only available to individuals who deal with entities that hold Australian Financial Services Licenses.

Getting Started With Forex Trading

Before opening an account, new forex traders should spend as much time as possible learning about this financial activity. There is a lot to learn about forex; introductory courses will only scratch the surface of this complex market, which should prompt you to constantly do your own research.

The first thing you should know about forex is that there is considerable risk involved. You will be getting into an investing activity, which means that you could potentially lose all the funds that you deposit into your account, and this could also happen if you invest in the ASX or if you purchase a Saturday Lotto ticket. With this in mind, you should only invest what you can reasonably stand to lose, and this does not mean dipping into your savings. Smart investors will always make sure that they have saved up at least three months worth of household expenses before they commit any funds towards investing. You can certainly allocate disposable income towards forex trading, but it should not come from your reserves.

Once you have determined how much you can realistically start with, the next step involves understanding forex leverage and margin sizes:

Forex Lots

Prior to the advent of online trading, the forex market was limited to the participation of major players who could afford to take positions in what is known as a standard lot, which means 100,000 units of a currency pair. Retail brokers these days offer what is known as mini lots of 10,000 units and micro lots of 1,000 units. There are smaller trades available, but those are more similar to wagers than actual investments.

If you were to take a long position on EUR/USD, a micro lot confirmation would look like this:

BUY $1,230 EUR/USD?

while a mini lot confirmation would be:

BUY $12,300 EUR/USD?>

and a standard lot confirmation would be:

BUY $123,000 EUR/USD?

As you can see, standard lot trades can be sizable. The standard EUR/USD lot example above means that a trader is taking a $123K position on the forex market; while there is always a chance that she could lose everything, it should be noted that the euro is a currency that supports a highly developed and very powerful economic bloc, which means that it is unlikely that its value against the USD will suddenly reach zero.

Investment banking firms trade forex lots all the time, but very few individual traders are afforded this luxury. To facilitate the participation of individuals in the forex market, retail brokers offer leverage in the form of margin. Micro lots of 1,000 are the minimum positions that can be taken on the market, but in many cases you can actually invest as little as $50 because the broker will let you make up the difference with margin. In essence, the margin provided by brokers is a loan that will be deducted from the funds you commit for trading.

Your retail broker may offer a margin of 0.5 percent, which translates into 200:1 leverage. If the margin is 0.25 percent, the leverage will be 400:1. Each time you require margin, the broker will charge you upfront with pips, and the going rate charged by many brokers is three pips per trade. Margin and leverage should always be in the back of your mind when you evaluate potential trades:

EUR/USD = 1.2300/04 is actually 1.2303/07 when you trade on margin, which means that you are taking a loss of three pips when you take a forex position. If you went long and EUR/USD reaches 1.2310 after positive news from the European Central Bank, you would be breaking even if you close your position at that point.

Now that you know how your broker makes pips off your trades, you should also keep in mind that your broker will not allow you to lose the money provided to you at margin. The funds in your client account represent your equity, and there is a good chance that your margin could be higher than this amount. Whenever the funds you commit to trading are equal or less than the margin you requested, the broker will execute a margin call, which involves closing the position and taking as many funds left over from the trade as possible. Without proper safeguards, margin calls would take place all the time; for this reason, forex traders need to learn about money management as well as trading strategies.

Money Management and Risk Mitigation in Forex Trading

You already took the first step in money management by setting aside three-month reserves and resolving to invest only what you can stand to lose in the forex market. The next step is to realize how much you would tolerate losing.

Many traders mention one or two percent as their risk tolerance level; this should be on each trade and not on the funds that are in your client account. If you have $100,000 in your account, the thought of losing two percent would translate into a loss of $2,000. On a $100 EUR/USD trade, your risk tolerance of two percent is equivalent to $2, which is more reasonable, but you would be scraping the bottom after the broker takes three pips in exchange for margin; nonetheless, your maximum tolerance should not be higher than five percent on each trade.

Risk mitigation means applying strategies that will enforce your risk tolerance level; thankfully, all retail brokers offer trade features such as guaranteed stop loss and automatic taking of profits. These features are set prior to entering the trade, and in some cases they may limit your profit taking to just five percent, but they will not let your lose more than that.

Trading Style

The final step before opening a forex account and starting with paper trades is to develop a trading style based on your personal philosophy. You should learn about fundamental analysis for the purpose of understanding the geopolitical factors and macroeconomics events that move the market, but you should also practice technical analysis to spot certain opportunities created by the behavior of market participants.

Ideally, you should be comfortable with both fundamental and technical analysis so that every position you take has a logical foundation. Some traders will only pay attention to the news when they take positions while others will only evaluate technical charts because traders are creatures of habit; the best approach is to approach the market from both fundamental and technical angles.

Australian Finance Directory FOREX Section

REFERENCES

MoneySmart Australia

https://www.moneysmart.gov.au/investing/complex-investments/foreign-exchange-trading

ASIC License Check

https://www.moneysmart.gov.au/tools-and-resources/check-asic-lists