The largest financial market globally, forex trading is a hugely important economic activity. For retail traders, understanding their proper position compared to other market participants is important, as the larger players dominate volumes and win the best rates from their brokers. Different trading styles are popular with different participants, who will be hedgers or speculators, although the distinction is often more blurred than it seems.
Hedgers and speculators
Hedging and speculation are the two core activities in the forex market. Hedgers seek to minimize existing risks incurred as part of their business operations – for example, a company that takes payment in one currency and has its costs in another. In order to prevent adverse exchange rate moves from impacting their profitability, such a business will need to hedge their FX exposure, either by buying the target currency at favorable rates or using derivatives such as futures to minimize their FX risk.
Speculators are those market participants who try to make a profit by predicting future price movements. This is of course associated with day traders, proprietary traders, and other ‘classic’ speculators, but can also involve hedgers such as corporate treasurers who have a view on where exchange rates will go. The line between speculators and hedgers is not always clear, but the basic difference is that hedgers have to buy the foreign currency whereas speculators choose to according to their view on the market
Types of forex pair
Forex trading Australia is a typically well-developed market, with an advanced economy, and a strong mixture of services and industrial companies contributing to the overall activity. Because of the importance of metals and mining to the Australian economy, the Australian dollar is considered a commodity-linked currency, along with the South African Rand, Brazilian Real, and Russian Rouble. Unlike those currencies, the AUD is tied to a relatively advanced and stable economy, so comes with a reduced risk of sudden volatility.
Other common pair types include ‘safe haven currencies, such as the Euro, American dollar, or Swiss franc, reserve currencies such as USD, EUR, the British Pound, and Japanese Yen, and emerging market currencies such as the Mexican peso or Indian rupee. Reserve currencies and safe havens are expected to be less volatile and more liquid, whereas emerging market currencies are more volatile and sometimes have restrictions on their tradability.
Who trades forex?
Forex market participants can be divided into institutional, corporate, and retail traders. Retail traders include private individuals, whether they are rich or poor, and can range from small purchases of travel money to large speculative trades with leverage. Corporate clients include most hedgers, who require FX transactions as part of their day-to-day business. Their trades are typically much larger and less speculative in nature. Finally come financial institutions, which include banks, funds, and brokers who buy and sell FX for both speculative reasons and business operations. They are distinguished by the sheer size of their trades, which for large financial companies can amount to billions.
Rates generally improve as you move up the scale, though the competitive nature of forex execution means that large corporates and institutions will essentially get ‘free’ execution, with their bank or broker offering them direct market rates with only a tiny markup. They do this with the understanding that they will be considered a partner for more lucrative transactions involving options, derivatives, or corporate financing.
Of course, these sort of offers is not available to private individuals. Retail FX trading is possible because rates for retail traders have come down significantly in recent decades, but only large traders using specialized platforms will attain anything like institutional rates. Given most retail traders lose money, competition here is more marketing-led and rates can be less competitive.
Of course, retail day traders receive much better rates than one-off purchasers looking for holiday money or to finance a single transaction. Here spreads and commissions of several percent are common, as anyone who has been forced to exchange money at an airport can tell you.
How do people trade?
Hedgers will measure their required exposure and then look for the most cost-effective way to obtain it, whether that be options, spot transactions or forwards. Speculators will use technical or fundamental analysis to form a market view, and then execute trades either on the spot market or with derivatives to gain the required exposure. Both will follow risk management procedures that ensure they are protected in the case of adverse market conditions.
Market participants execute trades OTC – over the counter. There is no centralized exchange for foreign currencies, so all transactions are executed at the going rate. Market makers are businesses that offer to buy and sell a currency simultaneously, the difference between the two rates forming the spread. Market makers facilitate the overall functioning of the market by providing liquidity to other participants.
How do traders make profits?
Profitable traders become so by having an advantage over other market participants. This could be the size of their balance sheet, the speed of their trade execution, or an information advantage provided from a detailed analysis of price and market-contributing factors. Trade opportunities that allow risk-free profits (arbitrage) are vanishingly rare in the forex market due to their size and liquidity. Some traders make money simply by being lucky – this is not a stable category to be in, and retail traders must be sure that their market views are formed by hard analysis and not guesswork.
The forex market is a big place, with many different currencies traded for many different reasons. By familiarising themselves with the overall landscape and their position within it, retail traders can help to even up, or at least become aware of, the gaps in capability between them and the big institutional players. Opportunities exist for traders willing to work hard and who have strong risk management discipline, but this must always be considered against the backdrop of larger market movers. An understanding of the competing demands of hedging, speculation, and market participants can help lead you to a more sustainable perspective.