What exactly are you trading as a retail FX trader?
New forex traders may be perplexed as to how they can trade currencies that they do not physically hold. They’re also frequently perplexed as to how it’s feasible to sell something before purchasing it.
Are euros deposited to your trading account when you “purchase EUR/USD”?
Or, when you “sell GBP/USD,” how can you do so if you don’t have any British pounds on hand?
You may believe you are purchasing and selling actual currency, but you are not.
You are not purchasing or selling anything physical; instead, you are gambling on currency exchange rates.
Speculation is defined as “taking a position” on the direction of a currency pair’s exchange rate.
You are effectively betting as a speculative. The relative price of two currencies is represented by an exchange rate. Retail forex trading is not about buying or selling currencies; rather, it is about betting on whether the exchange rate between two currencies will rise or decline. The EUR/USD exchange rate, for example, denotes the relative value of the euro in terms of US dollars.
If the EUR/USD conversion rate is 1.1050, it indicates that $1.1050 is required to purchase €1. The exchange rate defines how many units of one currency are required to purchase one unit of another.
To summarize, trading forex (or FX) as a retail trader is simply wagering on the future exchange rate of one currency against another.
If you bet on the euro strengthening relative to the US dollar, you have “gone long” on the euro versus the US dollar, or “purchased EUR/USD.”
If you bet that the euro will fall in value relative to the US dollar, you have “sold EUR/USD” or “gone short” on the euro. Now that we’ve shown that we’re simply wagering on whether exchange rates will rise or fall, where do these exchange rates come from?
Where do Exchange Rates Come From?
The exchange rates are derived from the spot FX market, usually known simply as “spot FX.” Spot trades, also known as “spot transactions,” take place in the spot FX market between institutional traders known as “FX dealers.”
What exactly is traded in the spot FX market?
Contracts. Spot foreign exchange (FX) contracts, to be specific.
FX spot contracts call for the physical exchange of the underlying currencies at a predetermined exchange rate. It is critical to note that you are trading a contract involving the physical exchange of the underlying currencies, not the underlying currencies themselves.
An FX dealer buys or sells a contract to physically swap one currency for another on the spot FX market.
This means that a spot deal is a legally binding agreement to buy or sell a certain amount of foreign currency at a predetermined price (or exchange rate).
So, if you buy EUR/USD on the spot FX market, you are trading a contract that states that you will receive a certain amount of euros in return for US dollars at a predetermined price.
The agreed-upon price is referred to as the “spot rate.”
This price is set at the moment of trade, and the physical exchange of the currency pair occurs there, or “on the spot.” (However, most transactions normally take two days to settle.)
The spot rate, often known as the “spot price,” is the currency pair’s current “market price” (exchange rate).
The important thing to remember is that no currency pair has a single “market price.” This is due to the fact that the foreign exchange market is decentralized.
Consider the spot FX market to be a bazaar.
Assume you want to buy a rug and there are ten different merchants selling it. You go to each merchant’s booth and inquire about the rug’s selling price. Each will quote you its own “spot pricing” that is unrelated to the others (provided they do not overhear your talk with other merchants).
You’ll choose the rug dealer who provided you the best price after asking around. This is the rug’s “spot price.”
Different market participants may receive different spot rates from FX dealers. The “spot price” is determined by simultaneously contacting a number of different FX dealers. As a result, the spot rate is really determined by “how many people you ask.”
Your forex broker (ideally) utilizes these spot rates as a reference when displaying its prices on its trading interface for you to trade on.
We say “ideally” because it’s critical for retail forex traders to understand that they are NOT trading in the spot FX market.
A spot trade requires physical settlement, which means that if you purchased EUR/USD, you would have to satisfy the contract by physically delivering US dollars and accepting delivery of euros.
This would be fantastic if you were a European producer who sells items to the US, or a wealthy American tourist planning a summer vacation in Europe, but we assume you are neither.
As retail forex traders, we aren’t interested in acquiring actual foreign currency; all we care about is what happens to the EUR/USD exchange rate.
Remember, we’re merely betting on (and hoping to profit from) the movement of currency pairings’ exchange rates.
So the exchange rate (“price”) you want to wager on (“trade”) is assumed to be based on “spot rates” made from “spot trades” in the “spot FX market,” but you are NOT trading in the “spot FX market” as a retail forex trader.
What precisely are you trading if you’re not making spot trades?
Numbers on a Screen
You are essentially betting on whether the figures on a screen will rise or fall.
Here’s an illustration.
Assume you have a website where you can buy or sell an iPhone. The price of the iPhone on this website is continuously changing dependent on how many people buy the iPhone vs how many people sell their iPhone.
If the current price of an iPhone is $1,000, you could write it as:
iPhone/USD = 1,000 One iPhone can be traded for $1,000 USD. The same thing would happen if the iPhone was priced in euros. If the current price of an iPhone is €900, you could write it as:
iPhone/EUR = 900
For 900 euros, you can exchange one iPhone. We’ll suppose the iPhone is priced in US dollars in this scenario.
You are glued to your computer monitor, watching the price go up and down.
While you personally despise iPhones, you believe the price of the iPhone will continue to grow owing to strong demand and want to try and profit from this prediction. But you don’t want to deal with literally purchasing an iPhone, waiting for the price to grow, and then physically selling it for a profit.
You simply want to wager that the PRICE will rise from here.
Consider a completely separate website that does nothing but tracks the price changes of the iPhone from the first page.
Consider this website to be a “scoreboard” that simply displays what is happening on the other page and updates in real-time. However, it does more than just display the current iPhone pricing; it also allows you to place bets on whether the price displayed will rise or fall. The bet operates as follows:
- You and the website agree to split the difference in the price of the iPhone.
- Depending on how the price changes, one side pays the other the difference between when the bet was made and when it was closed.
- You win the bet if the difference is positive, and the website rewards you.
- If the difference is negative, you forfeit the wager and must compensate the website.
For instance, you may notice that the current price is $900. You bet because you believe the price will rise from here.
The website requires a $100 “security deposit” before accepting your wager. This deposit is required in case you are incorrect and the price begins to fall.
People that lose bets tend to “ghost” you and vanish instead of paying up. The website wishes to avoid the risk of dealing with deadbeats.
If the price of the iPhone falls below $800, your wager will be automatically cancelled, and the website will keep the $100 to compensate for your loss. However, if you win, you will receive your deposit back.
Fortunately, the price rises to $1100, and you decide to call your bet.
The website pays you $200, which is the difference in price between when you opened the bet ($900) and when you closed it ($1100). Your security deposit will also be refunded. As you can see, when you place a wager on this second website, you are not participating in the first website, which is where the actual buying and selling of physical iPhones takes place.
You are basically gambling on price movement. Like a gambling game. You never purchased or sold a real iPhone. Now, replace the scoreboard with “iPhone/USD” pricing with “EUR/USD” and you’ll have a fair sense of how retail forex trading works!
You are trading a “scoreboard” of FX rates displayed by your forex broker on its trading platform.
For example, if you believe the EUR/USD will rise, you click “Buy.” When you “buy,” you are betting with your forex broker that the PRICE will rise from its current level.
You do not genuinely own or possess currencies. It’s not like trading equities, where if you buy Apple, you own Apple stock. When you “purchase” or “sell” EUR/USD, you are not actually purchasing or selling tangible euros or dollars. In reality, you’re putting a directional wager on the exchange rate (or price).
This is accomplished by utilizing a financial instrument known as a financial derivative contract (“derivative“).
A derivative is a financial product that allows traders to speculate on the price movement (“change in price”) of assets without actually purchasing the assets. A derivative’s value is based on or DERIVED from the value of its underlying asset, which can include bonds, equities, commodities, cryptocurrency, or currencies. The underlying asset in this example is EUR/USD.
Derivative positions exist as a contract between two parties because nothing is physically traded when they are opened. When you “purchase” EUR/USD, your forex broker “creates” (or “issues”) a derivatives contract with you. This is referred to as a contract for differences (CFD).
Next Lesson: Trading Forex with CFDs