Forex trading, also known as foreign exchange trading, involves a global network of buyers and sellers who exchange currency at an agreed price. It is the process by which individuals, companies, and central banks convert one currency into another, and it is something that most people have likely done while traveling abroad.
Although some foreign exchange is done for practical reasons, the majority of currency conversion is done with the intention of making a profit. The sheer volume of currency exchanged each day can lead to extreme volatility in the prices of certain currencies. This volatility is what makes forex trading so appealing to traders: it offers the potential for high profits, but also comes with increased risk.
How do Currency Markets work?
The currency markets work differently from shares or commodities markets, as forex trading occurs directly between two parties in an over-the-counter (OTC) market, rather than through exchanges. The forex market is managed by a network of global banks located in four major forex trading centers in various time zones: London, New York, Sydney, and Tokyo. As there is no central location, forex trading can be carried out 24 hours a day.
There are three main types of forex markets:
- Spot forex market: This is the physical exchange of a currency pair, which takes place at the point of trade settlement, or shortly after.
- Forward forex market: This involves an agreement to buy or sell a set amount of a currency at a specific price, with the settlement taking place at a predetermined date in the future, or within a range of future dates.
- Future forex market: This involves an agreement to buy or sell a set amount of a currency at a set price and date in the future. Unlike forwards, futures contracts are legally binding.
Most forex traders do not intend to take delivery of the currency itself; instead, they make exchange rate predictions to capitalize on price movements in the market.
What is a Base Currency?
In forex trading, the base currency is the first currency listed in a forex pair, while the second currency is referred to as the quote currency. When trading forex, one currency is always sold to buy another, which is why it is quoted in pairs. The price of a forex pair represents how much one unit of the base currency is worth in the quote currency.
Each currency in a forex pair is identified by a three-letter code, which typically consists of two letters representing the region and one letter representing the currency itself. For example, the GBP/USD currency pair involves buying the Great British pound and selling the US dollar.
To maintain order, most providers divide forex pairs into the following categories:
- Major pairs: These consist of seven currencies that account for 80% of global forex trading, such as EUR/USD, USD/JPY, GBP/USD, and USD/CHF.
- Minor pairs: These are less commonly traded pairs that often involve major currencies traded against each other instead of the US dollar. Examples include EUR/GBP, EUR/CHF, and GBP/JPY.
- Exotic pairs: These involve a major currency paired with a currency from a smaller or emerging economy, such as USD/PLN, GBP/MXN, and EUR/CZK.
- Regional pairs: These pairs are classified by region, such as Scandinavia or Australasia, and include pairs like EUR/NOK, AUD/NZD, and AUS/SGD.
What Moves the Forex Market?
The forex market is a complex and dynamic marketplace, featuring currencies from around the world, making it challenging to predict exchange rates due to the many factors that contribute to price movements. Despite this, the forces of supply and demand play a significant role in determining forex prices, and it is essential to understand the factors that drive these fluctuations.
Central banks are responsible for controlling the supply of currency and can make announcements that significantly impact their currency’s price. For example, quantitative easing involves injecting more money into an economy, which can lead to a drop in the currency’s price.
News reports can also affect currency prices, as commercial banks and investors tend to invest in economies with a positive outlook. Positive news about a region can boost investment and increase demand for the currency, leading to an increase in price. Conversely, negative news can cause a decrease in investment and lower a currency’s price. As a result, currency prices often reflect the reported economic health of the region they represent.
Market sentiment, often in response to news reports, can also play a crucial role in driving currency prices. Traders who believe a currency is headed in a particular direction will trade accordingly, potentially influencing others to follow suit and increasing or decreasing demand for the currency.
How does Forex Trading works?
In forex trading, there are various methods that allow you to buy one currency while simultaneously selling another. Traditionally, forex transactions were executed through brokers. However, with the advancement of online trading, you can now make the most of forex price fluctuations by using derivatives like CFD trading.
CFDs are leveraged products that enable you to initiate a position for a fraction of the complete trade value. Unlike non-leveraged products, you don’t take ownership of the asset but speculate on whether the market will rise or fall.
While leveraged products can boost your profits, they also come with the risk of increased losses if the market moves against you.
What is the forex spread? The spread in forex trading is the difference between the bid and ask prices quoted for a currency pair. Like other financial markets, when you initiate a forex position, you will see two prices. If you intend to open a long position, you will trade at the bid price, which is slightly higher than the market price. On the other hand, if you plan to open a short position, you will trade at the ask price, which is slightly lower than the market price.
What is a lot in Forex? Lots in Forex refer to batches of currency that are used to standardize forex trades. As forex tends to move in small increments, lots are generally sizeable. A standard lot is equivalent to 100,000 units of the base currency. Since most individual traders may not have 100,000 units of the currency they are trading, almost all forex trading is leveraged.
What exactly is leverage in forex trading? Leverage enables traders to gain exposure to large amounts of currency without having to pay the full value of the trade upfront. Instead, traders are required to put down a small deposit, known as margin. When traders close a leveraged position, their profit or loss is based on the full size of the trade.
While leverage can increase potential profits, it also increases the risk of amplified losses – losses that can even exceed the trader’s margin. As a result, it is crucial for traders to learn how to manage their risk when trading with leverage.
So, what is margin in forex trading? Margin is the initial deposit required to open and maintain a leveraged position. Margin requirements can vary depending on the broker and the size of the trade. Margin is usually expressed as a percentage of the full position. For example, a trade on EUR/GBP might only require a 2% deposit to open the position, instead of the full value of the trade.
Lastly, what are pips in forex trading? Pips are used to measure movement in a currency pair. A pip usually refers to a one-digit movement in the fourth decimal place of a currency pair. For instance, if GBP/USD moves from $1.35361 to $1.35371, it has moved a single pip. Decimal places shown after the pip are referred to as fractional pips or pipettes.
