How Forex Trading Works
Most foreign exchange trading in Australia occurs either in the spot market (interbank market) or via currency contracts for difference (CFDs), but there are other ways to trade. Among them are instruments listed on official exchanges, such as currency futures.Spot foreign exchange and CFDs
By far the biggest volumes of trades in foreign exchange in Australia occur through the spot or primary market – the interbank market. In this market you can deal either through a foreign exchange dealer who has access to the primary market, or through a forex provider, who in turn trades with a primary market participant.So how does a CFD or spot trade happen? For most users there will be no real difference between the two. Margins, or initial payments, costs and outcomes will be very similar. In the spot market, any position held for more than two days must be rolled over (closed out and replaced) to avoid having to deliver actual foreign currency. Your provider will arrange this for you so that it happens automatically and you should clearly understand this from your account statement. Your position will typically be closed and reopened at a slightly different price, which is determined by the interest rate differentials between the two currencies. This will result in a credit or debit to your account based on the interest rate and whether you have sold or bought the relevant currency pair.
Both spot trades and CFDs require an initial margin to start with, and further margin payments on a daily basis if the market moves against you (down when you have bought, for example). This means you need more than the initial margin in order to trade, and it’s possible for you to lose more than the initial margin if the market moves rapidly against you. Stop-loss orders help you keep losses to a minimum on each trade.
For technical reasons relating to the variety of methods providers use to hedge their positions, it’s preferable to trade forex on a specialised forex trading platform. Almost all currency CFD providers also offer spot forex styled trading platforms, even if the actual instrument is a CFD and you are trading micro or mini lots.
Example trade
Here’s an example of a profitable trade in the forex market. Suppose you think the Australian dollar is likely to rise against the US dollar because Australian interest rates are increasing. In the market at the time, the Australian dollar is quoted at AUD/USD 0.8278–0.8281 and you open a trade to buy $A100,000 at $US0.8281.A few days later the Australian dollar has moved up and the new quote is AUD/USD 0.8354–0.8358.You close the trade by selling Australian dollars at $US0.8354. Your profit is the difference between the two $US values, or a profit of $US730.00, as illustrated below.
1st March
| Buy AUD$100,000 at USD$0.9281 | USD$92,810.00 (value) |
| Pay initial margin | AUD$1,000.00 |
| Commission | Nill |
| Sell AUD$100,000 at $US0.9354 | USD$93,540.00 (value) + |
| Initial margin returned | AUD$1,000.00 |
| Commission | Nill |
| Profit | USD$730.00 |
| Interest* received: (5 days at 2.0%) | AUD $5.48 |
| Profit in AUD$ (USD$730/0.9354) | AUD $5.48 |
| Net profit | AUD$785.89 |
Note that if the Australian dollar had moved in the opposite direction by a similar amount, or if you had sold Australian dollars instead of buying, there would have been a loss of similar proportions unless reduced by a stop-loss order. The interest received on the trade occurred because the interest rate on Australian dollars (the bought currency) is higher than the interest rate on US dollars (the sold currency). If you sell Australian dollars (the same as buying US dollars) you would pay the interest-rate differential between the two instead of receiving interest.
Need to know
- Most trading happens in the spot market.
- You can also trade foreign exchange using warrants, options or futures.
- You will need more risk capital than the initial 1% margin needed to enter a trade.
- If you hold a position for more than a day, you pay or receive the difference in the interest rates between the two currencies.
