Forex Frequently Asked Questions

Foreign Exchange is the simultaneous buying of one currency and selling of another. The world′s currencies are on a floating exchange rate and are always traded in pairs, for example USD/JPY or EUR/GBP. With a daily average turnover of more than $3 trillion, the Foreign Exchange market, also known as the Forex, FX or spot market, is the largest financial market in the world.

The Forex market is called an "Interbank" market due to the fact that historically, it has been dominated by banks, including central banks and commercial and investment banks. However, the Forex market has experienced tremendous growth and now includes large multinational corporations, global money managers, registered dealers, brokers, futures and options traders and retail investors.

Unlike stock and futures markets, Forex trading is not centralized on an exchange. The Forex market is considered an Over The Counter (OTC) or Interbank market, due to the fact that transactions are conducted between two counterparts over the telephone or on an electronic network.

The Foreign Exchange is a 24-hour market. Forex trading begins each day in Sydney and moves around the globe as the business day begins in each financial center, first to Tokyo, then London and New York. Unlike any other financial market, investors can respond to currency fluctuations caused by economic, social and political events at the time they occur, day or night.

Currency prices (exchange rates) are affected by a variety of economic and political conditions with interest rates, inflation and political stability having the greatest impact. Governments will participate in the Forex market to influence the value of their currencies, either by flooding the market with their domestic currency in an attempt to lower the price, or by buying in order to raise the price. This is known as Central Bank intervention. Any of these factors, as well as large market orders, can cause high volatility in currency prices. The most dramatic price movements however, occur when unexpected events happen. The event can range from a Central Bank raising domestic interest rates to the outcome of a political election. However, the size and volume of the Forex market makes it impossible for any one entity to "drive" the market for any length of time.

The most often traded or "liquid" currencies are those of countries with stable governments, respected central banks and low inflation. Today, over 85% of all daily transactions involve trading of the major currencies, which include the US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and the Australian Dollar.

In the Forex market currencies are always priced in pairs; therefore all trades result in the simultaneous buying of one currency and the selling of another. The objective of currency trading is to exchange one currency for another in the expectation that the market rate or price will change so that the currency you bought has increased its value relative to the one you sold.

The Forex quoting convention is globally accepted. There are two ways to quote a currency pair, either directly or indirectly. Some are quoted directly per currency unit value in US Dollar (Euro and Pound) while others are quoted indirectly for dollar value per foreign currency unit (Swiss Franc and Yen). Some examples are as follows:

When a currency is quoted, it is done in relation to another currency so that the value of one is reflected through the value of another. This is referred to as a currency pair. The currency to the left of the slash is the base currency, while the currency on the right is called the quote or counter currency. The base currency is always equal to one unit and the quoted currency is what that one base unit is equivalent to in the other currency.

Currency pairs are traded in lots, which refers to the standard unit size of a transaction. Typically, one standard lot is equal to 100,000 units of the base currency, 10,000 units for a mini lot and 1000 units for a micro lot.

A pip is a standardized unit and is the smallest amount by which a currency quote can change. It is usually $0.0001 for U.S.-dollar related currency pairs and more commonly referred to as 1/100th of 1%, or one basis point.

As with most trading in the financial markets, when you are trading a currency pair there is a bid price (buy) and an ask price (sell). When buying a currency pair (going long), the ask price refers to the amount of quoted currency that has to be paid in order to buy one unit of the base currency. The bid price is used when selling a currency pair (going short) and reflects how much of the quoted currency will be obtained when selling one unit of the base currency.

Margin is a performance bond, or good faith deposit, to ensure against trading losses. It acts as collateral for your position and the margin requirement allows an investor to hold a position much larger than the actual account value. With margin, clients do not need to have an equal dollar balance in their account for each currency lot held. For example, at 50:1 leverage on a $10,000.00 mini lot, clients must maintain $200.00 in their account for each currency lot traded. If the market moves against a customer′s position, additional funds will be requested through a margin call. If there are insufficient available funds, the customer′s open positions will be closed out.

Leverage is the use of borrowed funds, such as margin, to increase the potential return of an investment. The use of leverage also increases the risk of losing capital as both gains and losses are magnified.

Intraday positions are all positions opened anytime during the 24 hour period after the close of normal trading hours at 4:30pm EST. Overnight positions are positions that are still open at the end of normal trading hours (4:30pm EST), which are automatically rolled at competitive rates (based on the currencies interest rate differentials) to the next day′s price.

A long position is one in which a trader buys a currency at one price and aims to sell it later at a higher price. In this scenario, the investor benefits from a rising market. A short position is one in which the trader sells a currency in anticipation that it will depreciate. In this scenario, the investor benefits from a declining market. However, it is important to remember that every Forex position requires an investor to go long in one currency and short the other.

Currency investors may elect out of IRC section 988 for the more beneficial IRC section 1256. This allows investors to split their capital gains between 60% long term and 40% short term. With the top Federal Income Tax Bracket of 35% on regular income and 15% on capital gains, the current maximum blended rate of 60/40 tax treatment is 23%.

IRC section 988 is the default election for cash Forex and provides that fluctuations in exchange rates should be treated as ordinary income or loss. The decision to elect out of IRC section 988 must be made in advance of the trades and filed "internally". This means the investor will keep the election in his or her records as opposed to filing it with the IRS.

This information is for educational purposes only and should not be construed as tax or investment advice of any kind. Please consult with your tax professional for further clarification.

Forex refers to the spot market in which currencies are bought and sold according to the current price. Unlike the spot market, the futures market does not trade actual currencies. Instead, the futures market deals in contracts that are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange. The exchange acts as a counterparty to the trader, providing clearance and settlement.

According to the 2007 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity conducted by the Bank for International Settlements (BIS), average daily currency turnover was in excess of $3.2 trillion. Compared to 2004 this represents an increase of more than 65%. Historically the majority of the Forex volume has been generated by central banks, commercial banks and large financial institutions. However this 65% increase in volume can be attributed to investor groups such as hedge funds, prime brokerage and retail customers. As investors become more sophisticated and continue to seek non-correlating asset classes offering attractive performance attributes, growth in the Forex marketplace shows no signs of abating.