What is Forex Trading?
Foreign Exchange, often referred to as Forex, is the exchange which takes place between two currencies, also known as the trading of currencies. The Forex market is by far the largest financial market one may come across. Trade generally takes place between National Banks, Central Banks, currency speculators, corporations, financial institutions, individuals and Governments.
The Forex market is one where currency trading takes place and its purpose is to facilitate trade and investment. The foreign exchange (Forex or FX) market is an over-the-counter (OTC) market. This means that it does not have a central exchange or clearing house that matches orders. There is no single exchange where all the trades are recorded. Instead, every market maker records its own transactions. The FX market is a means for companies to hedge currency risk, or to protect themselves against volatility in currency values.
Purchasing a quantity of one currency in exchange for a quantity of another is generally termed as Forex. Buying Euros when USD is stronger in value and then selling the Euro when it strengthens is a typical example of how a trade takes place. Not all benefit from this trade. It depends on how well one understands the markets and how well a strategy is planned. There are various indicators which help one analyse the Forex market. A thorough analysis of the past and present economic & political scenarios of the countries involved, also analyzing the price trends and the volume of transactions helps one develop successful trading strategies.
The main incentive to trading currencies by private investors is the speed and liquidity of the market. It can be traded 24-hour a day, 5 days a week.
Further incentives to Forex trading:
- An enormous liquid market making it easy to trade most currencies.
- Volatile markets offering profit opportunities.
- Standard Forex instruments for controlling risk exposure.
- The ability to profit in rising or falling markets.
- Leveraged trading with low margin requirements.
- Many options for zero commission trading.
Forex trading education
The investor’s goal in Forex trading is to profit from foreign currency movements. Forex trading or currency trading is always done in currency pairs. For example, the exchange rate of EUR/USD on Aug 26th, 2003 was 1.0857. This number is also referred to as a “Forex rate” or just “rate” for short. If the investor had bought 1000 euros on that date, he would have paid 1085.70 U.S. dollars. One year later, the Forex rate was 1.2083, which means that the value of the euro (the numerator of the EUR/USD ratio) increased in relation to the U.S. dollar. The investor could now sell the 1000 euros in order to receive 1208.30 dollars. Therefore, the investor would have USD 122.60 more than what he had started one year earlier. However, to know if the investor made a good investment, one needs to compare this investment option to alternative investments. At the very minimum, the return on investment (ROI) should be compared to the return on a “risk-free” investment. One example of a risk-free investment is long-term U.S. government bonds since there is practically no chance for a default, i.e. the U.S. government going bankrupt or being unable or unwilling to pay its debt obligation.
(Please note that past performance is not indicative of future performance)
When trading currencies, trade only when you expect the currency you are buying to increase in value relative to the currency you are selling. If the currency you are buying does increase in value, you must sell back the other currency in order to lock in a profit. An open trade (also called an open position) is a trade in which a trader has bought or sold a particular currency pair and has not yet sold or bought back the equivalent amount to close the position.
It is estimated that anywhere from 70%-90% of the FX market is speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency.
Exchange rate
Because currencies are traded in pairs and exchanged one against the other when traded, the rate at which they are exchanged is called the exchange rate. The majority of the currencies are traded against the US dollar (USD). The four next-most traded currencies are the euro (EUR), the Japanese yen (JPY), the British pound sterling (GBP) and the Swiss franc (CHF). These five currencies make up the majority of the market and are called the major currencies or “the Majors”. Some sources also include the Australian dollar (AUD) within the group of major currencies.
The first currency in the exchange pair is referred to as the base currency and the second currency as the counter or quote currency. The counter or quote currency is thus the numerator in the ratio, and the base currency is the denominator. The value of the base currency (denominator) is always 1. Therefore, the exchange rate tells a buyer how much of the counter or quote currency must be paid to obtain one unit of the base currency. The exchange rate also tells a seller how much is received in the counter or quote currency when selling one unit of the base currency. For example, an exchange rate for EUR/USD of 1.2083 specifies to the buyer of euros that 1.2083 USD must be paid to obtain 1 euro.
At any given point, time and place, if an investor buys any currency and immediately sells it – and no change in the exchange rate has occurred – the investor will lose money. The reason for this is that the bid price, which represents how much will be received in the counter or quote currency when selling one unit of the base currency, is always lower than the ask price, which represents how much must be paid in the counter or quote currency when buying one unit of the base currency. For example, the EUR/USD bid/ask currency rates at your bank may be 1.2015/1.3015, representing a spread of 1000 pips (also called points, one pip = 0.0001), which is very high in comparison to the bid/ask currency rates that online Forex investors commonly encounter, such as 1.2015/1.2020, with a spread of 5 pips. In general, smaller spreads are better for Forex investors since they require a smaller movement in exchange rates in order to profit from a trade.
Most Forex dealers, including easyMarkets, are compensated by the spreads that are embedded in the currency rates.
Margin – Amount to Risk
Banks and/or online trading providers need collateral to ensure that the investor can pay in case of a loss. The collateral is called the margin and is the minimum security in Forex markets. In practice, it is a deposit to the trader’s account that is intended to cover any currency trading losses in the future.
Margin coupled with leverage provided by your forex provider allows traders to hold a much larger position than their account value. Margin trading also enhances the rate of profit, but has the tendency to inflate rates of loss if the market moves against you.
Leverage
Leveraged financing, i.e., the use of credit, such as a trade purchased on a margin, is very common in Forex. The loan/leveraged in the margined account is collateralized by your initial deposit. This may result in being able to control USD 100,000 for as little as USD 1,000. A relatively small market movement will have a proportionately larger impact on the funds you have deposited or may have to deposit. This may work against you as well as for you. You may sustain a total loss of the margin funds deposited and any additional funds deposited to maintain your positions.
Five ways private investors can trade in Forex directly or indirectly:
- The spot market
- Forwards and futures
- Options
- Contracts for difference
- Spread betting
Risks
Forex trading is risky. There are ways to reduce risk such as setting a Stop Loss on deals. Read more about the risks involved and how to lower exposure to risk.
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