The primary reason the FX market exists is to facilitate the exchange of one currency into another for multinational corporations who need to trade currencies continually (for example, for payroll, payment for costs of goods and services from foreign vendors, and merger and acquisition activity). However, these day-to-day corporate needs comprise only about 20% of the market volume. Fully 80% of trades in the currency market are speculative in nature, put on by large financial institutions, multi-billion dollar hedge funds and even individuals who want to express their opinions on the economic and geopolitical events of the day.
Because currencies always trade in pairs, when a trader makes a trade he or she is always long one currency and short the other. For example, if a trader sells one standard lot (equivalent to 100,000 units) of EUR/USD, she would, in essence, have exchanged euros for dollars and would now be "short" euro and "long" dollars. To better understand this dynamic, let's use a concrete example. If you went into an electronics store and purchased a computer for $1,000, what would you be doing? You would be exchanging your dollars for a computer. You would basically be "short" $1,000 and "long" 1 computer. The store would be "long" $1,000 but now "short" 1 computer in its inventory. The exact same principle applies to the FX market, except that no physical exchange takes place. While all transactions are simply computer entries, the consequences are no less real.
Which currencies are traded?
Although some retail dealers trade exotic currencies such as the Thai baht or the Czech koruna, the majority trade the seven most liquid currency pairs in the world, which are the four majors:
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What is carry?
Carry is the most popular trade in the currency market, practiced by both the largest hedge funds and the smallest retail speculators. The carry trade rests on the fact that every currency in the world has an interest rate attached to it. These short-term interest rates are set by the ebtral banks of these countries: the Federal Reserve in the U.S., the Bank of Japan in
The idea behind the carry is quite straightforward. The trader goes long the currency with a high interest rate and finances that purchase with a currency with a low interest rate. In 2005, one of the best pairings was the NZD/JPY cross. The New Zealand economy, spurred by huge commodity demand from China and a hot housing market, has seen its rates rise to 7.25% and stay there (at the time of writing), while Japanese rates have remained at 0%. A trader going long the NZD/JPY could have harvested 725 basis points in yield alone. On a 10:1 leverage basis, the carry trade in NZD/JPY could have produced a 72.5% annual return from interest rate differentials alone without any contribution from capital appreciation. Now you can understand why the carry trade is so popular! But before you rush out and buy the next high-yield pair, be aware that when the carry trade is unwound, the declines can be rapid and severe. This process is known as carry trade liquidation and occurs when the majority of speculators decide that the carry trade may not have future potential. With every trader seeking to exit his or her position at once, bids disappear and the profits from interest rate differentials are not nearly enough to offset the capital losses. Anticipation is the key to success: the best time to position in the carry is at the beginning of the rate-tightening cycle, allowing the trader to ride the move as interest rate differentials increase.
FX Jargon
Every discipline has its own jargon, and the currency market is no different. Here are some terms to know that will make you sound like a seasoned currency trader:
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