Trading in the Off-Exchange Foreign Currency Market

National Futures Association (NFA)

Companies and individuals may speculate in foreign currency exchange rates (commonly referred to as “forex”), and a number of firms are presently offering off-exchange foreign currency futures and options contracts to the public. If you are a retail investor considering participating in this market, you need to fully understand the market and some of its unique features. NFA has prepared this information to educate you about off-exchange foreign currency trading. Like many other investments, off-exchange foreign currency trading carries a high level of risk and may not be suitable for all investors. In fact, you could lose all of your initial investment and may be liable for additional losses. Therefore, you need to understand the risks associated with this product so you may make an informed investment decision.You should also understand the language of the forex markets before trading in those markets. The glossary at the end of this feature defines some of the most commonly used terms.

The Foreign Currency Markets

What are foreign currency exchange rates? Foreign currency exchange rates are what it costs to exchange one country’s currency for another country’s currency. For example, if you go to England on vacation, you will have to pay for your hotel, meals, admissions fees, souvenirs and other expenses in British pounds. Since your money is all in US dollars, you will have to use (sell) some of your dollars to buy British pounds. Assume you go to your bank before you leave and buy $1,000 worth of British pounds. If you get 565.83 British pounds (£565.83) for your $1,000, each dollar is worth .56583 British pounds. This is the exchange rate for converting dollars to pounds. If £565.83 isn’t enough cash for your trip, you will have to exchange more US dollars for pounds while in England. Assume you buy another $1,000 worth of British pounds from a bank in England and get only £557.02 for your $1,000. The exchange rate for converting dollars to pounds has dropped from .56583 to.55702. This means that US dollars are worth less compared to the British pound than they were before you left on vacation. Assume that you have £100 left when you return home. You go to your bank and use the pounds to buy US dollars. If the bank gives you $179.31, each British pound is worth 1.7931 dollars. This is the exchange rate for converting pounds to dollars. Theoretically, you can convert the exchange rate for buying a currency to the exchange rate for selling a currency, and vice versa, by dividing 1 by the known rate. For example, if the exchange rate fo rbuying British pounds with US dollars is .56011, the exchange rate for buying US dollars with British pounds is 1.78536 (1 ÷ .56011= 1.78536). Similarly, if the exchange rate for buying US dollars with British pounds is 1.78536, the exchange rate for buying British pounds with US dollars is .56011 (1÷ 1.78536 = .56011).This is how newspapers often report currency exchange rates. As a practical matter, however, you will not be able to buy and sell the currency at the same price, and you will not receive the price quoted in the newspaper. This is because banks and other market participants make money by selling the currency to customers formore than they paid to buy it and by buying the currency fromcustomers for less than they will receive when they sell it. The difference is called a spread and is discussed later in article.

How can I trade foreign currency exchange rates?

As you can see from the example, currency exchange rates fluctuate. As the value of one currency rises or falls relative to another, traders decide to buy or sell currencies to make profits. Retail customers also participate in the forex market, generally as speculators who are hoping to profit from changes in currency rates. Foreign currency exchange rates may be traded in one of three ways: 1. On an exchange that is regulated by the Commodity Futures Trading Commission (CFTC). For example, the Chicago Mercantile Exchange offers forex futures and options on futures products. Exchange-traded forex futures and options provide their users with a liquid, secondary market for contracts with a set unit size, a fixed expiration date and centralized clearing. 2. On an exchange that is regulated by the Securities and Exchange Commission (SEC). For example, the Philadelphia Stock Exchange offers options on currencies (i.e., the right but not the obligation to buy or sell a currency at a specific rate within a specified time). Exchange-traded options on currencies have characteristics similar to exchange-traded futures and options (e.g., a liquid, secondary market with a set size, a fixed expiration date and centralized clearing). 3. In the off-exchange, also called the over-the-counter (OTC), market. A retail customer trades directly with a counterparty and there is no exchange or central clearinghouse to support the transaction. Off-exchange trading is subject to limited regulatory oversight. This article focuses on the off-exchange foreign currency market.