What is forex trading?
Forex, or foreign exchange, can be explained as a network of buyers and sellers, who transfer currency between each other at an agreed price. It is the means by which individuals, companies and central banks convert one currency into another – if you have ever travelled abroad, then it is likely you have made a forex transaction.
While a lot of foreign exchange is done for practical purposes,
the vast majority of currency conversion is undertaken with the aim of earning
a profit. The amount of currency converted every day can make price movements
of some currencies extremely volatile. It is this volatility that can make
forex so attractive to traders: bringing about a greater chance of high
profits, while also increasing the risk.
How do currency markets work?
Unlike shares or commodities, forex trading
does not take place on exchanges but directly between two parties, in an
over-the-counter (OTC) market. The forex market is run by a global network of
banks, spread across four major forex trading centres in different time zones:
London, New York, Sydney and Tokyo. Because there is no central location, you
can trade forex 24 hours a day.
There are
three different types of forex market:
·
Spot forex market: the physical exchange of a currency pair, which takes place at
the exact point the trade is settled – ie ‘on the spot’ – or within a short
period of time
·
Forward forex market: a contract is agreed to buy or sell a set amount of a currency
at a specified price, to be settled at a set date in the future or within a range
of future dates
·
Future forex market: a contract is agreed to buy or sell a set amount of a given
currency at a set price and date in the future. Unlike forwards, a futures
contract is legally binding
Most traders speculating on forex prices
will not plan to take delivery of the currency itself; instead they make
exchange rate predictions to take advantage of price movements in the market.
What is a base and quote currency?
A base currency is the first currency
listed in a forex pair, while the second currency is called the quote currency.
Forex trading always involves selling one currency in order to buy another,
which is why it is quoted in pairs – the price of a forex pair is how much one
unit of the base currency is worth in the quote currency.
Each currency in the pair is listed as a
three-letter code, which tends to be formed of two letters that stand for the
region, and one standing for the currency itself. For example, GBPUSD is a
currency pair that involves buying the Great British pound and selling the US
dollar.
So in the example below, GBP is the base currency and USD is the
quote currency. If GBP/USD is trading at 1.35361, then one pound is worth
1.35361 dollars.
If the pound rises against the dollar, then
a single pound will be worth more dollars and the pair’s price will increase.
If it drops, the pair’s price will decrease. So if you think that the base
currency in a pair is likely to strengthen against the quote currency, you can
buy the pair (going long). If you think it will weaken, you can sell the pair
(going short).
To keep things
ordered, most providers split pairs into the following categories:
·
Major pairs. Seven currencies that make up 80% of
global forex trading. Includes EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD and
AUD/USD
·
Minor pairs. Less frequently traded,
these often feature major currencies against each other instead of the US
dollar. Includes: EUR/GBP, EUR/CHF, GBP/JPY
·
Exotics. A major currency against one from a small or
emerging economy. Includes: USD/PLN (US dollar vs Polish zloty) ,
GBP/MXN (Sterling vs Mexican peso), EUR/CZK
·
Regional pairs. Pairs classified by region – such as
Scandinavia or Australasia. Includes: EUR/NOK (Euro vs Norwegian krona),
AUD/NZD (Australian dollar vs New Zealand dollar), AUD/SGD
What
moves the forex market?
The
forex market is made up of currencies from all over the world, which can make
exchange rate predictions difficult as there are many factors that could
contribute to price movements. However, like most financial markets, forex is
primarily driven by the forces of supply and demand, and it is important to
gain an understanding of the influences that drives price fluctuations here.
Central banks
Supply
is controlled by central banks, who can announce measures that will have a
significant effect on their currency’s price. Quantitative easing, for
instance, involves injecting more money into an economy, and can cause its
currency’s price to drop.
News reports
Commercial
banks and other investors tend to want to put their capital into economies that
have a strong outlook. So, if a positive piece of news hits the markets about a
certain region, it will encourage investment and increase demand for that
region’s currency.
Unless
there is a parallel increase in supply for the currency, the disparity between
supply and demand will cause its price to increase. Similarly, a piece of
negative news can cause investment to decrease and lower a currency’s price.
This is why currencies tend to reflect the reported economic health of the
region they represent.
Market sentiment
Market
sentiment, which is often in reaction to the news, can also play a major role
in driving currency prices. If traders believe that a currency is headed in a
certain direction, they will trade accordingly and may convince others to
follow suit, increasing or decreasing demand.
Economic data
Economic
data is integral to the price movements of currencies for two reasons – it
gives an indication of how an economy is performing, and it offers insight into
what its central bank might do next.
Say,
for example, that inflation in the Eurozone has risen above the 2% level that
the European Central Bank (ECB) aims to maintain. The ECB’s main policy tool to
combat rising inflation is increasing European interest rates – so traders
might start buying the euro in anticipation of rates going up. With more
traders wanting euros, EURUSD could see a
rise in price.
Credit ratings
Investors
will try to maximize the return they can get from a market, while minimizing
their risk. So alongside interest rates and economic data, they might also look
at credit ratings when deciding where to invest.
A
country’s credit rating is an independent assessment of its likelihood of
repaying its debts. A country with a high credit rating is seen as a safer area
for investment than one with a low credit rating. This often comes into
particular focus when credit ratings are upgraded and downgraded. A country
with an upgraded credit rating can see its currency increase in price, and vice
versa.
How does forex trading work?
There are a variety of different ways that
you can trade forex, but they all work the same way: by simultaneously buying
one currency while selling another. Traditionally, a lot of forex transactions
have been made via a forex broker, but with the rise of online trading you can
take advantage of forex price movements using derivatives like CFD trading.
CFDs are leveraged products, which enable
you to open a position for just a fraction of the full value of the trade.
Unlike non-leveraged products, you don’t take ownership of the asset, but take
a position on whether you think the market will rise or fall in value.
Although leveraged products can magnify
your profits, they can also magnify losses if the market moves against you.
What is
the spread in forex trading?
The
spread is the difference between the buy and sell prices quoted for a forex
pair. Like many financial markets, when you open a forex position you’ll be
presented with two prices. If you want to open a long position, you trade at
the buy price, which is slightly above the market price. If you want to open a
short position, you trade at the sell price – slightly below the market price.
Currencies are traded in lots – batches of currency used to
standardise forex trades. As forex tends to move in small amounts, lots tend to
be very large: a standard lot is 100,000 units of the base currency. So,
because individual traders won’t necessarily have 100,000 pounds (or whichever
currency they’re trading) to place on every trade, almost all forex trading is
leveraged.
Leverage is the means of gaining exposure to large amounts of
currency without having to pay the full value of your trade upfront. Instead,
you put down a small deposit, known as margin.
When you close a leveraged position, your profit or loss is based on the full
size of the trade.
What is
margin in forex?
Margin is a key part of leveraged trading. It is the term used
to describe the initial deposit you put up to open and maintain a leveraged
position. When you are trading forex with margin, remember that your margin
requirement will change depending on your broker, and how large your trade size
is.
Margin is usually expressed as a percentage of the full
position. So, a trade on EUR/USD, for instance,
might only require 1% of the total value of the position to be paid in order
for it to be opened. So instead of depositing USD$100,000, you’d only need to
deposit USD$1000.
Pips are the units used to measure movement in a forex pair. A
forex pip is usually equivalent to a one-digit movement in the fourth decimal
place of a currency pair. So, if GBP/USD moves from $1.35361 to $1.35371, then it has moved
a single pip. The decimal places shown after the pip are called fractional
pips, or sometimes pipettes.
The exception to this
rule is when the quote currency is listed in much smaller denominations, with
the most notable example being the Japanese yen. Here, a movement in the second
decimal place constitutes a single pip. So, if EUR/JPY moves from ¥106.452
to ¥106.462, again it has moved a single pip.
Thank you for reading our article.
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