Swot Up on FX Basics - dummies

By David Stevenson

Currency trading in the UK and around the world is fairly simple and involves a trade in which you buy one currency and sell another — betting that the first is going to rise in value against its counterpart. Buying ‘euro/US dollar’, for example, means that you buy a unit of euros and sell the equivalent amount in US dollars, profiting if the euro subsequently rises in value against the greenback.

This binary relationship between investment opportunities means that most trades take place in ‘pairs’ such as the following (see the table for the currency codes):

  • Majors: EUR/USD (accounts for about 28 per cent of the global pairs trade), USD/JPY (14 per cent of global trade), GBP/USD (commonly called the ‘cable’; 9 per cent of the trade) and USD/CHF (under 10 per cent).

  • Commodity currencies: USD/CAD, AUD/USD and NZD/USD.

Currency Codes
Code Name Notes
AUD Australian dollar Not available
CAD Canadian dollar (also called the Loonie) Not available
CHF Swiss franc Not available
EUR Euro Accounts for 20% of daily turnover
GBP British pound Accounts for 13% of daily turnover
JPY Japanese yen Accounts for 19% of daily turnover
NZD New Zealand dollar (also called the kiwi) Not available
USD US dollar Accounts for 42% of daily volume on global markets

Source: BIS Triennial Survey 2010

Crucially, because returns from currency trading are likely to be small in absolute terms (gains of much more than 10 or 15 per cent from one trade are very unusual), many FX investors use leverage to increase their profits.

Retail currency traders, for example, often borrow enough to turn a mere US$1,000 in principal into a US$50,000 bet. As a comparison, in the stock market the same trader would typically be able to leverage the same stake into just US$2,000 if she’s lucky and has access to a margin account.

You can also trade currencies directly or use exchange-traded funds (ETFs). You can go long (buy) a particular currency with a standard currency ETF or ‘short’ (sell) a currency, by shorting the particular ETF or buying an ‘inverse’ ETF that changes value in the opposite direction to the underlying index.

You can also leverage positions with ETFs that offer 2 times leverage to the underlying currency’s index. Finally, ETFs that simulate the action of currency pairs are available that can replicate the trading action of the underlying FX pairs.

FX trading is a zero sum game (you get no aggregate return from simply holding currencies), in which one country’s currency benefits from another nation’s economic misfortunes. An appreciation in the value of one currency can be expressed only by reference to another currency, which necessarily experiences a corresponding depreciation.