Foreign Exchange, Forex or just FX are all terms used to describe the trading of the world's many currencies. The Forex market is the largest market in the world, with trades amounting to more than USD 3 trillion every day. Most Forex trading is speculative, with only a low percentage of market activity representing governments' and companies' fundamental currency conversion needs.
Unlike trading on the stock market, the Forex market is not conducted by a central exchange, but on the "interbank market", which is thought of as an OTC(over the counter) market. Trading takes place directly between the two counterparts necessary to make a trade, whether over the telephone or on electronic networks all over the world. The main centres for trading are Sydney, Tokyo, London, Frankfurt and New York. This worldwide distribution of trading centres means that the Forex market is a 24-hour market.
Trading Forex
A currency trade is the simultaneous buying of one currency and selling of another one. The currency combination used in the trade is called a cross (for example, the euro/US dollar, or the GB pound/Japanese yen.). The most commonly traded currencies are the so-called “majors” – EURUSD, USDJPY, USDCHF and GBPUSD.
The most important Forex market is the spot market as it has the largest volume. The market is called the spot market because trades are settled immediately, or “on the spot”. In practice this means two banking days.
Forward Outrights
For forward outrights, settlement on the value date selected in the trade means that even though the trade itself is carried out immediately, there is a small interest rate calculation left. The interest rate differential doesn't usually affect trade considerations unless you plan on holding a position with a large differential for a long period of time. The interest rate differential varies according to the cross you are trading. On the USDCHF, for example, the interest rate differential is quite small, whereas the differential on NOKJPY is large. This is because if you trade e.g. NOKJPY, you get almost 7% (annual) interest in Norway and close to 0% in Japan. So, if you borrow money in Japan, to finance the trade and buying NOK, you have a positive interest rate differential. This differential has to be calculated and added to your account. You can have both a positive and a negative interest rate differential, so it may work for or against you when you make a trade.
Trading on Margin
Trading on margin means that you can buy and sell assets that represent more value than the capital in your account. Forex trading is usually conducted with relatively small margin deposits. This is useful since it permits investors to exploit currency exchange rate fluctuations which tend to be very small. A margin of 1.0% means you can trade up to USD 1,000,000 even though you only have USD 10,000 in your account. A margin of 1% corresponds to a 100:1 leverage(or “gearing”). (Because USD 10,000 is 1% of USD 1,000,000.) Using this much leverage enables you to make profits very quickly, but there is also a greater risk of incurring large losses and even being completely wiped out. Therefore, it is inadvisable to maximise your leveraging as the risks can be very high. For more information on the trading conditions of Saxo Bank, go to the Account Summary on your SaxoTrader and open the section entitled “Trading Conditions” found in the top right-hand corner of the Account Summary.
Labels: EURUSD, foreign exchange, FX, GBPUSD, margin, market, spot, Trading Forex, USDCHF, USDJPY
Saturday, August 29, 2009
Forex Trading Chosing a Forex Broker - What to Look For
Tight Spreads: Look for competitive spreads. This is the difference between the bid and offer and is measured in pips. This is what it will costs to enter a trade, since it is not possible to buy on the bid or sell on the offer in the Forex market.
Forex brokers are usually tied to large banks due to the large amounts of capital required for the leverage that they provide. While the forex market is unregulated, reputable brokers will be registered with the NFA.
Leverage is necessary because the price fluctuations are so small. It reflects the ratio between usable trading capital and the actual capital in your account. Some brokerages offer leverage as high as 250:1 – so in this case the broker is lending you 250 for every 1 dollar in your account.
When signing up for a forex trading account you will be required to sign a margin agreement. This states that due to the fact that you are trading with borrowed funds the brokerage has the right to interfere with your trading to protect its interests.
Forex brokers are usually tied to large banks due to the large amounts of capital required for the leverage that they provide. While the forex market is unregulated, reputable brokers will be registered with the NFA.
Leverage is necessary because the price fluctuations are so small. It reflects the ratio between usable trading capital and the actual capital in your account. Some brokerages offer leverage as high as 250:1 – so in this case the broker is lending you 250 for every 1 dollar in your account.
When signing up for a forex trading account you will be required to sign a margin agreement. This states that due to the fact that you are trading with borrowed funds the brokerage has the right to interfere with your trading to protect its interests.
Tax Strategies for Forex Traders
Forex, the foreign currency exchange market, can be a lucrative one indeed for traders skilled in its dynamics. This worldwide network of government central banks, commercial and investment banks, hedge funds, international corporations and brokerage firms enables traders to capitalize on the rise and fall of a currency dollar volume that exceeds $1.4 trillion every day, making it the largest and most liquid of the world markets.
But when income tax time rolls around, currency traders receive special treatment from the Internal Revenue Service, the subtleties of which can sometimes trip up the unsuspecting.
Here's a look at the tax landscape for forex traders, and why it may be a good idea to have a Traders Accounting tax professional help guide you through the twists and turns.
Futures and Cash Forex
Forex is traded in two ways: as currency futures on regulated commodities exchanges, which fall under the tax rules of IRC Section 1256 contracts, or as cash forex on the unregulated interbank market, which fall under the special rules of IRC Section 988. Many forex traders are active in both markets.
Because futures and cash forex are subject to different tax and accounting rules, it is important for forex traders to know which category each of their trades fall into so that each trade can be reported correctly to receive optimum tax advantage.
Section 1256: The Advantageous Split
Forex traders receive a significant tax advantage over securities traders under Section 1256: reporting capital gains on IRS Form 6781 (Gains and Losses from Section 1256 Contracts and Straddles) allows you to split your capital gains on Schedule D, with 60%
taxed at the lower long-term capital gains rate (currently 15%) and 40% at the ordinary or short-term capital gains rate of up to 35%. That combined rate of 23% amounts to a 12% advantage over the ordinary (or short-term) rate.
If you trade exclusively in forex futures, it's smooth sailing come tax time; your trades fall under Section 1256 and automatically receive the 60/40 split.
But things get a little more complicated tax-wise if you dabble in cash forex, which is subject to Section 988 (Treatment of Certain Foreign Currency Transactions).
Section 988: To Opt Out or Not?
Section 988 was enacted as a way for the IRS to tax companies that earn income from fluctuations in foreign currency exchange rates as part of their normal course of business, such as buying foreign goods. Under this section, such gains or losses are reported and treated as interest income or expense for tax purposes, and do not receive the favorable 60/40 split.
Because forex futures do not trade in actual currencies, they do not fall under the special rules of Section 988. But as a currency trader, you are exposed daily to currency rate fluctuations, hence your trading activity would fall under the Section 988 provisions.
But because currency traders consider these fluctuations part of their capital assets in the normal course of business, the IRS enables you to opt out of Section 988, and thereby retain the favorable 60/40 split for these gains under Section 1256.
The IRS requires that you note "internally" your intention to opt out of Section 988 before making the trades; you are not required to notify the IRS. Obviously, some traders bend this rule based on their year-end outcome, and there seems little inclination on
the part of the IRS to crack down, at least so far.
As a rule of thumb, if you have currency gains, you would benefit (reduce your tax on gains by 12 percent) by opting out of Section 988. If you have losses however, you may prefer to remain under Section 988's ordinary loss treatment rather than the less favorable treatment under Section 1256.
Tax Time: Tougher for Currency Traders
Forex futures traders tend to breeze through tax time; their brokerage firm sends them an IRS Form 1099, on which their aggregate profit or loss is listed on Line 9.
But since currency traders don't receive 1099s, you are left to find your own accounting and software solutions. Don't be tempted to simply lump your currency trades in with your Section 1256 activity, a common temptation; these trades need to be separated
into Section 988 reporting, and in cases of loss, you could wind up paying more tax than necessary.
As a fast-growing market segment, forex trading is almost certain to come under greater IRS scrutiny in the future. An experienced Traders Accounting tax professional can help you file in full compliance with IRS rules and make the most of your tax advantages.
But when income tax time rolls around, currency traders receive special treatment from the Internal Revenue Service, the subtleties of which can sometimes trip up the unsuspecting.
Here's a look at the tax landscape for forex traders, and why it may be a good idea to have a Traders Accounting tax professional help guide you through the twists and turns.
Futures and Cash Forex
Forex is traded in two ways: as currency futures on regulated commodities exchanges, which fall under the tax rules of IRC Section 1256 contracts, or as cash forex on the unregulated interbank market, which fall under the special rules of IRC Section 988. Many forex traders are active in both markets.
Because futures and cash forex are subject to different tax and accounting rules, it is important for forex traders to know which category each of their trades fall into so that each trade can be reported correctly to receive optimum tax advantage.
Section 1256: The Advantageous Split
Forex traders receive a significant tax advantage over securities traders under Section 1256: reporting capital gains on IRS Form 6781 (Gains and Losses from Section 1256 Contracts and Straddles) allows you to split your capital gains on Schedule D, with 60%
taxed at the lower long-term capital gains rate (currently 15%) and 40% at the ordinary or short-term capital gains rate of up to 35%. That combined rate of 23% amounts to a 12% advantage over the ordinary (or short-term) rate.
If you trade exclusively in forex futures, it's smooth sailing come tax time; your trades fall under Section 1256 and automatically receive the 60/40 split.
But things get a little more complicated tax-wise if you dabble in cash forex, which is subject to Section 988 (Treatment of Certain Foreign Currency Transactions).
Section 988: To Opt Out or Not?
Section 988 was enacted as a way for the IRS to tax companies that earn income from fluctuations in foreign currency exchange rates as part of their normal course of business, such as buying foreign goods. Under this section, such gains or losses are reported and treated as interest income or expense for tax purposes, and do not receive the favorable 60/40 split.
Because forex futures do not trade in actual currencies, they do not fall under the special rules of Section 988. But as a currency trader, you are exposed daily to currency rate fluctuations, hence your trading activity would fall under the Section 988 provisions.
But because currency traders consider these fluctuations part of their capital assets in the normal course of business, the IRS enables you to opt out of Section 988, and thereby retain the favorable 60/40 split for these gains under Section 1256.
The IRS requires that you note "internally" your intention to opt out of Section 988 before making the trades; you are not required to notify the IRS. Obviously, some traders bend this rule based on their year-end outcome, and there seems little inclination on
the part of the IRS to crack down, at least so far.
As a rule of thumb, if you have currency gains, you would benefit (reduce your tax on gains by 12 percent) by opting out of Section 988. If you have losses however, you may prefer to remain under Section 988's ordinary loss treatment rather than the less favorable treatment under Section 1256.
Tax Time: Tougher for Currency Traders
Forex futures traders tend to breeze through tax time; their brokerage firm sends them an IRS Form 1099, on which their aggregate profit or loss is listed on Line 9.
But since currency traders don't receive 1099s, you are left to find your own accounting and software solutions. Don't be tempted to simply lump your currency trades in with your Section 1256 activity, a common temptation; these trades need to be separated
into Section 988 reporting, and in cases of loss, you could wind up paying more tax than necessary.
As a fast-growing market segment, forex trading is almost certain to come under greater IRS scrutiny in the future. An experienced Traders Accounting tax professional can help you file in full compliance with IRS rules and make the most of your tax advantages.
Forex Trading The Relationship between Commodities and the Foreign Exchange Market
Gold and oil in particular have an important relationship with the forex market, and can be used as leading indicators in forex trading. Four major currencies are considered to be the closest tied to commodity prices - the Australian Dollar, the Canadian Dollar, the New Zealand Dollar and the Swiss Franc.
Gold and it's relationship to the Forex Market
While the US is the world's second largest producer of gold, after South Africa, gold normally does not move in line with the US Dollar, rather they tend to have an inverse relationship. This is because during periods of geopolitical uncertainty traders tend to migrate away from the US Dollar and towards gold as a safe haven.
In the world of Forex, no major currency is considered to be as safe and stable as the Swiss Franc. The political neutrality of the Swiss and the fact that 40% of its currency reserves were previously backed by gold underpin the Swiss Franc's image as being a safe haven during periods of uncertainty. For these reasons the CHF/USD has a strong positive correlation with gold prices.
The AUD/USD, NZD/USD, USD/CHF currency pairs tend to trade in line with gold the closest, due to the other currency having close political and natural ties to gold.
Oil and it's relationship to the Forex Market
Canada's total crude oil reserves stand in second place behind Saudi Arabia. The Canadian Dollar is the currency most influenced by rising oil prices- if oil prices rise the CAD is likely to closely follow. Rising oil prices benefit the Canadian economy as it takes in more money for oil and raises profits for domestic oil companies. The US imports 85% of Canada's oil exports. Rising oil prices have in part caused the Canadian dollar to rise to a 28 year high against the US dollar.
Gold and it's relationship to the Forex Market
While the US is the world's second largest producer of gold, after South Africa, gold normally does not move in line with the US Dollar, rather they tend to have an inverse relationship. This is because during periods of geopolitical uncertainty traders tend to migrate away from the US Dollar and towards gold as a safe haven.
In the world of Forex, no major currency is considered to be as safe and stable as the Swiss Franc. The political neutrality of the Swiss and the fact that 40% of its currency reserves were previously backed by gold underpin the Swiss Franc's image as being a safe haven during periods of uncertainty. For these reasons the CHF/USD has a strong positive correlation with gold prices.
The AUD/USD, NZD/USD, USD/CHF currency pairs tend to trade in line with gold the closest, due to the other currency having close political and natural ties to gold.
Oil and it's relationship to the Forex Market
Canada's total crude oil reserves stand in second place behind Saudi Arabia. The Canadian Dollar is the currency most influenced by rising oil prices- if oil prices rise the CAD is likely to closely follow. Rising oil prices benefit the Canadian economy as it takes in more money for oil and raises profits for domestic oil companies. The US imports 85% of Canada's oil exports. Rising oil prices have in part caused the Canadian dollar to rise to a 28 year high against the US dollar.
Forex Trading Understanding Forex Quotes
Reading a foreign exchange quote may seem a bit confusing at first. However, it's really quite simple if you remember two things: 1) The first currency listed first is the base currency and 2) the value of the base currency is always 1.
The US dollar is the centerpiece of the Forex market and is normally considered the 'base' currency for quotes. In the "Majors", this includes USD/JPY, USD/CHF and USD/CAD. For these currencies and many others, quotes are expressed as a unit of $1 USD per the second currency quoted in the pair. For example, a quote of USD/JPY 110.01 means that one U.S. dollar is equal to 110.01 Japanese yen.
When the U.S. dollar is the base unit and a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/JPY quote we previously mentioned increases to 113.01, the dollar is stronger because it will now buy more yen than before.
The three exceptions to this rule are the British pound (GBP), the Australian dollar (AUD) and the Euro (EUR). In these cases, you might see a quote such as GBP/USD 1.7366, meaning that one British pound equals 1.7366 U.S. dollars.
In these three currency pairs, where the U.S. dollar is not the base rate, a rising quote means a weakening dollar, as it now takes more U.S. dollars to equal one pound, euro or Australian dollar.
In other words, if a currency quote goes higher, that increases the value of the base currency. A lower quote means the base currency is weakening.
Currency pairs that do not involve the U.S. dollar are called cross currencies, but the premise is the same. For example, a quote of EUR/JPY 127.95 signifies that one Euro is equal to 127.95 Japanese yen.
When trading forex you will often see a two-sided quote, consisting of a 'bid' and 'offer'. The 'bid' is the price at which you can sell the base currency (at the same time buying the counter currency). The 'ask' is the price at which you can buy the base currency (at the same time selling the counter currency).
The US dollar is the centerpiece of the Forex market and is normally considered the 'base' currency for quotes. In the "Majors", this includes USD/JPY, USD/CHF and USD/CAD. For these currencies and many others, quotes are expressed as a unit of $1 USD per the second currency quoted in the pair. For example, a quote of USD/JPY 110.01 means that one U.S. dollar is equal to 110.01 Japanese yen.
When the U.S. dollar is the base unit and a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/JPY quote we previously mentioned increases to 113.01, the dollar is stronger because it will now buy more yen than before.
The three exceptions to this rule are the British pound (GBP), the Australian dollar (AUD) and the Euro (EUR). In these cases, you might see a quote such as GBP/USD 1.7366, meaning that one British pound equals 1.7366 U.S. dollars.
In these three currency pairs, where the U.S. dollar is not the base rate, a rising quote means a weakening dollar, as it now takes more U.S. dollars to equal one pound, euro or Australian dollar.
In other words, if a currency quote goes higher, that increases the value of the base currency. A lower quote means the base currency is weakening.
Currency pairs that do not involve the U.S. dollar are called cross currencies, but the premise is the same. For example, a quote of EUR/JPY 127.95 signifies that one Euro is equal to 127.95 Japanese yen.
When trading forex you will often see a two-sided quote, consisting of a 'bid' and 'offer'. The 'bid' is the price at which you can sell the base currency (at the same time buying the counter currency). The 'ask' is the price at which you can buy the base currency (at the same time selling the counter currency).
The Risks of Trading in the Forex Market
Although every investment involves some risk, the risk of loss in trading off-exchange forex contracts can be substantial. Therefore,if you are considering participating in this market, you should understand some of the risks associated with this product so you can make an informed decision before investing. As stated in the introduction to article, off-exchange foreign currency trading carries a high level of risk and may not be suitable for all customers. The only funds that should ever be used to speculate in foreign currency trading, or any type of highly speculative investment, are funds that represent risk capital – i.e., funds you can afford to lose without affecting your financial situation. There are other reasons why forex trading may or may not be an appropriate investment for you, and they are highlighted below.The market could move against you. No one can predict with certainty which way exchange rates will go, and the forex market is volatile. Fluctuations in the foreign exchange rate between the time you place the trade and the time you close it out will affect the price of your forex contract and the potential profit and losses relating to it. You could lose your entire investment You will be required to deposit an amount of money (often referred to as a “security deposit” or “margin”) with your forex dealer inorder to buy or sell an off-exchange forex contract. As discussed earlier, a relatively small amount of money can enable you to hold a forex position worth many times the account value. This is referred to as leverage or gearing. The smaller the deposit in relation to the underlying value of the contract, the greater the leverage. If the price moves in an unfavorable direction, high leverage can produce large losses in relation to your initial deposit. In fact, even a small move against your position may result in a large loss, including the loss of your entire deposit. Depending on your agreement with your dealer, you may also be required to pay additional losses. You are relying on the dealer’s creditworthiness and reputation. Retail off-exchange forex trades are not guaranteed by a clearing organization. Furthermore, funds that you have deposited to trade forex contracts are not insured and do not receive a priority in bankruptcy. Even customer funds deposited by a dealer inan FDIC-insured bank account are not protected if the dealer goes bankrupt.There is no central marketplace Unlike regulated futures exchanges, in the retail off-exchange forex market there is no central marketplace with many buyers and sellers. The forex dealer determines the execution price, so you are relying on the dealer’s integrity for a fair price. The trading system could break down If you are using an Internet-based or other electronic system to place trades, some part of the system could fail. In the event of a system failure, it is possible that, for a certain time period, you may not be able to enter new orders, execute existing orders, or modify or cancel orders that were previously entered. A system failure may also result in loss of orders or order priority. You could be a victim of fraud. As with any investment, you should protect yourself from fraud. Beware of investment schemes that promise significant returns with little risk. You should take a close and cautious look at the investment offer itself and continue to monitor any investment you do make.
Forex Trading Forex Trading Regulation
Other Issues to Consider
In addition to understanding how the off-exchange forex market works and some of the risks associated with this product, there are other unique features about the market that you need to understand before you decide whether to invest in this market and which dealer to use.
Who regulates off-exchange foreign currency trading?
The CFTC has some regulatory authority over retail off-exchange forex markets. The Commodity Exchange Act (CEA) allows the sale of OTC forex futures and options to retail customers if, and only if, the counterparty (the person on the other side of the transaction) is a regulated entity. These regulated entities include the following: financial institutions, such as banks and savings associations, registered broker-dealers and certain of their affiliates, registered futures commission merchants (FCMs) and certain of their affiliates, certain insurance companies and their regulated affiliatess financial holding companies, and investment bank holding companies. Under the CEA, the CFTC has the authority to shut down any unregulated entity that acts as a counterparty to forex futures oroptions transactions with retail customers. The CFTC also has the authority to take action against registered FCMs and their affiliates for violating the anti-fraud and anti-manipulation pro-visions of the CEA in connection with OTC forex transactionsinvolving retail customers, but the CFTC cannot adopt rules toregulate these transactions. NFA has rules to protect customers in the retail off-exchange forex market. As mentioned later in this article, firms that introduce customers to forex dealers do not have to be regulated enti-ties. NFA’s rules provide, among other things, that a forex dealer FCM must take responsibility for the activities of unregulated entities that solicit retail customers. Additionally, NFA’s rules require forex dealer FCMs to: observe high standards of commercial honor and just and equitable principles of trade in connection with the retail forex business; supervise their employees and agents and any affiliates that act as counterparties to retail forex transactions; maintain a minimum net capital requirement based on the value of open customer positions; and collect security deposits from those customers. NFA’s forex rules do not apply to all FCMs and their affiliates, however. Therefore, you should ask the dealer if NFA regulates its forex activities.
In addition to understanding how the off-exchange forex market works and some of the risks associated with this product, there are other unique features about the market that you need to understand before you decide whether to invest in this market and which dealer to use.
Who regulates off-exchange foreign currency trading?
The CFTC has some regulatory authority over retail off-exchange forex markets. The Commodity Exchange Act (CEA) allows the sale of OTC forex futures and options to retail customers if, and only if, the counterparty (the person on the other side of the transaction) is a regulated entity. These regulated entities include the following: financial institutions, such as banks and savings associations, registered broker-dealers and certain of their affiliates, registered futures commission merchants (FCMs) and certain of their affiliates, certain insurance companies and their regulated affiliatess financial holding companies, and investment bank holding companies. Under the CEA, the CFTC has the authority to shut down any unregulated entity that acts as a counterparty to forex futures oroptions transactions with retail customers. The CFTC also has the authority to take action against registered FCMs and their affiliates for violating the anti-fraud and anti-manipulation pro-visions of the CEA in connection with OTC forex transactionsinvolving retail customers, but the CFTC cannot adopt rules toregulate these transactions. NFA has rules to protect customers in the retail off-exchange forex market. As mentioned later in this article, firms that introduce customers to forex dealers do not have to be regulated enti-ties. NFA’s rules provide, among other things, that a forex dealer FCM must take responsibility for the activities of unregulated entities that solicit retail customers. Additionally, NFA’s rules require forex dealer FCMs to: observe high standards of commercial honor and just and equitable principles of trade in connection with the retail forex business; supervise their employees and agents and any affiliates that act as counterparties to retail forex transactions; maintain a minimum net capital requirement based on the value of open customer positions; and collect security deposits from those customers. NFA’s forex rules do not apply to all FCMs and their affiliates, however. Therefore, you should ask the dealer if NFA regulates its forex activities.
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