As a retail forex trader, what are you actually trading?
New forex traders might be puzzled about how it’s possible to trade currencies they don’t physically own. They’re also often confused about how it’s possible to sell something before buying it.
Let’s revisit a part of the earlier story about Batman and Spider-Man:
Oh really? Let’s make a bet then.
What kind of bet? How will it work?
If GBP/USD goes up, I’ll pay YOU the difference between its price right now and whatever the price is when you decide to close the bet. But if GBP/USD goes down, you’ll pay ME the difference. Payouts will be in cash. Also, you can close the bet whenever you want. What do you say?
Let’s do it! I’ll take that bet.
The conversation above should give you a hint.
If you’re not familiar with the story above, this means you haven’t read our earlier lesson on How Forex Brokers (Kinda) Work starring Batman and Spider-Man. It’s highly recommended that you read this lesson first.
When you “buy EUR/USD“, are euros actually transferred to your trading account?
Or when you “sell GBP/USD“, how is this possible if you don’t have any British pounds in your possession?
You might think you’re buying and selling actual currencies, but you’re not.
You are not buying or selling anything tangible, you are simply speculating on currency exchange rates.
Speculation can be described as “taking a view” of the directional movement of a currency pair’s exchange rate.
As a speculator, you are essentially making bets.
An exchange rate represents the relative price of two currencies.
Retail forex trading isn’t about buying or selling currencies, it’s about betting on a change in the exchange rate between two currencies….whether it will rise or fall.
For example, the EUR/USD exchange rate implies the relative price of the euro in terms of U.S. dollars.
If the EUR/USD exchange rate is 1.1050, it means that you need $1.1050 to buy €1.
The exchange rate determines how many units of currency are needed to buy one unit of another currency.
So if we put this all together, trading forex (or FX) as a retail trader is just betting on the future exchange rate of one currency against another.
Betting that the euro will get stronger relative to the U.S. dollar means you have “gone long” euro versus the U.S. dollar or “bought EUR/USD”.
Betting that the euro will get weaker relative to the U.S. dollar means you have “gone short” euro versus the U.S. dollar or “sold EUR/USD”.
Now that we understand that we’re just betting on whether exchange rates will go UP or DOWN, where exactly do these exchange rates come from?
Where Do Exchange Rates Come From?
The exchange rates come from the spot FX market, also known as just “spot FX”.
In the spot FX market, “spot trades”, also known as “spot transactions” occur between institutional traders known as “FX dealers“.
What is being traded exactly in the spot FX market?
Contracts. Specifically, foreign exchange (FX) spot contracts.
FX spot contracts stipulate an actual physical exchange of the underlying currencies at a specific exchange rate.
It’s important to point out that you are NOT trading the underlying currencies themselves, but a contract involving the physical exchange of the underlying currencies.
In the spot FX market, an FX dealer buys or sells a contract to physically exchange one currency for another currency.
This means that a spot trade is a binding obligation to buy or sell a certain amount of foreign currency at an agreed-upon price (or exchange rate).
So if you were to buy EUR/USD on the spot FX market, you are trading a contract that specifies that you will receive a specific amount of euros in exchange for U.S dollars at an agreed-upon price.
This agreed-upon price is known as the “spot rate”.
This price is determined at the point of trade, and the physical exchange of the currency pair takes place right at the point of trade or “on the spot”. (Although in reality, most transactions usually take 2 days to settle.)
The spot rate also referred to as the “spot price,” is the current “market price” (exchange rate) of a currency pair.
The tricky thing to be aware of is that there is no single “market price” for a currency pair. That’s because the FX market is decentralized.
Think of the spot FX market like going to a bazaar.
Let’s say you want to buy a rug and there are 10 different merchants selling this rug.
You visit each merchant at their booths and ask what their selling price for the rug is. Each will quote you its own “spot price” independent of each other (assuming they don’t overhear your conversation with other merchants).
After you’ve asked around, you’ll pick the rug merchant who gave you the best price. This is your “spot price” for the rug.
FX dealers may quote different spot rates to different market participants. The “spot price” is found by asking a bunch of different FX dealers at the same time. So the spot rate is really a matter of “how many people you ask”.
It is from these spot rates that your forex broker (hopefully) uses as a reference when it displays its prices on its trading platform for you to trade on.
We say “hopefully” because as a retail forex trader, it’s important to know that you are NOT trading in the spot FX market.
A spot trade involves physical settlement, meaning if you bought EUR/USD, you’d have to fulfill the contract and physically deliver U.S. dollars and accept delivery of euros.
This would be great if you were like a European manufacturer who exports goods to the U.S. or maybe a wealthy American tourist who is about to go on holiday in Europe for the summer, but we assume you’re neither.
The concept of spot FX trading is similar to that of futures trading, in which the trader is buying and selling agreements to make or take delivery of an underlying asset at a specified time in the future. But the time frames are much different. Whereas spot FX is delivered within a few days, futures are delivered months later.
As retail forex traders, we’re not interested in actually taking possession of actual foreign currencies, all we care about is what happens to the exchange rate of EUR/USD.
Remember, we are simply making bets on (and trying to profit from) the movement of exchange rates of currency pairs.
So the exchange rate (“price”) you want to make bets on (“trade”) is assumed to be based on the “spot rates” made from “spot trades” in the “spot FX market”, but as a retail forex trader, you are NOT trading in the “spot FX market” yourself.
If you’re not making spot trades, WHAT exactly are you trading then?
Numbers on a Screen
You are literally making bets on whether numbers on a screen will go up or down.
Here’s a helpful analogy.
Let’s pretend there’s a website where you can buy or sell an iPhone.
On this website, the price of the iPhone constantly changes based on how many people are buying the iPhone versus how many people are selling their iPhone.
Technically speaking, if the current iPhone price is $1,000, you could write it as:
iPhone/USD = 1,000
1 iPhone can be exchanged for 1,000 U.S. dollars.
The same thing if the iPhone was priced in euros. If the current iPhone price is €900, you could write it a:
iPhone/EUR = 900
1 iPhone can be exchanged for 900 euros.
In this example, we’ll assume the iPhone is priced in U.S. dollars.
You are glued to your computer monitor as you watch the price move up and down.
You’re a devout Android smartphone user and even have a huge green tattoo of the Android logo on your chest, so while you personally hate iPhones, you think the price of the iPhone will continue to rise due to strong demand from irrational Apple fanboys and want to try and make some money on this prediction.
But you don’t want to deal with having to physically buy an iPhone, and then wait for the price to rise, and then have to physically sell it for a profit.
You don’t want to own an iPhone. That would mean having to touch one. The mere thought makes you nauseous. 🤢
You just want to make a bet that the PRICE will go up from here.
Now imagine there is a totally separate website where all it does is monitor the price changes of the iPhone from the first website.
Think of this website like a “scoreboard” that simply displays what’s going on the other website and updates in real-time.
But it doesn’t just display the current iPhone price, it also allows you to make bets on whether the price shown will go up or down.
Here’s how the bet works:
- You and the website agree to pay each other the change in the iPhone’s price.
- Depending on which way the price moves, one party pays the other the difference between the time the bet was made to when the bet was closed.
- If the difference is positive, you win the bet and the website pays you.
- If the difference is negative, you lose the bet and you pay the website.
For example, you see that the current price is $900. You think the price will go UP from here so you place a bet.
In order for the website to accept your bet, it asks you for a “security deposit” of $100. This deposit is needed just in case you’re wrong and the price starts falling.
People who lose bets tend to “ghost” you and disappear rather than paying up. The website wants to protect itself from this risk of dealing with deadbeats.
If the iPhone’s price falls to $800, your bet will automatically be closed and the website will keep the $100 to cover your loss. But if you win, you’ll get the deposit back.
Fortunately, the price proceeds to rise to $1100 and you decide to close your bet.
The website pays you $200, the difference between the price when you opened the bet ($900) and when you closed the bet ($1100). Your security deposit is also returned.
As you can see, when you make a bet on this second website, you’re not actually participating on the first website where the actual buying and selling of the physical iPhones is happening.
You are simply speculating on the price direction. Like a betting game.
You never actually bought or sold an actual iPhone.
Now substitute the scoreboard showing prices of “iPhone/USD” with “EUR/USD” and you now have a good idea of how retail forex trading works!
You are trading a “scoreboard” of FX rates that your forex broker displays to you on its trading platform.
For example, if you think EUR/USD will go up, you click “Buy”.
When you “buy”, you are placing a bet with your forex broker that the PRICE will go up from the current price.
You don’t actually own or take possession of currencies. It’s not like trading stocks, where when you buy Apple, you actually own Apple shares.
When you “buy” or “sell” EUR/USD, you’re not actually buying physical euros or selling physical dollars.
What you’re actually doing is making a directional bet on the exchange rate (or price) itself.
This is done through the use of a financial instrument known as a financial derivative contract (“derivative”).
A derivative is a financial instrument that enables traders to speculate on the price movement (“change in price”) of assets without purchasing the assets themselves.
The value of a derivative is dependent upon or DERIVED from the value of its underlying asset, which can include bonds, stocks, commodities, crypto, or currencies. In this specific example, the underlying asset is EUR/USD.
Because there is nothing physically being traded when derivative positions are opened, they exist as a contract between two parties.
So when you “buy” EUR/USD, your forex broker “creates” (or “issues”) a derivatives contract between itself and you.
This contract is known as a contract for differences (CFD).