WHAT IS FOREX?
Forex trading is the act of exchanging foreign currencies for financial gain. Forex traders can be speculators who buy or sell a currency with the goal of profiting from the currency’s price movement. It can also be a hedger who is looking to protect their accounts in the event of an adverse move against their own currency positions. Forex traders can be individuals on a retail platform, bank traders utilizing their institutional platform, or hedgers who may be either managing their own risk or outsourcing that function to a bank or money manager to manage the risk for them.
THE FX MARKET
The foreign exchange market, or forex (FX) for short, is a decentralized market place that facilitates the buying and selling of different currencies. This takes place over the counter (OTC) instead of on a centralized exchange.
The FX market is the largest financial market in the world and is open 24 hours a day during the week. Traders may be drawn to forex for several reasons, including the size of the FX market, a wide variety of currencies to trade, differing levels of volatility, and low transaction costs. Whether you are brand new to forex trading or looking to build on your existing knowledge, this article seeks to provide a solid foundation to the foreign exchange market.
TWO SIDES OF EVERY MARKET
One unique aspect of the Forex market is the manner in which prices are quoted. Because currencies are the base of the financial system, the only way to quote a currency is by using other currencies. This creates a relative valuation metric that may sound confusing at first, but can become more normalized the longer that one works with this two-sided convention.
Forex trading in a pair does offer the trader a bit of additional flexibility, by allowing the trader or investor the ability to voice their trade against the currency that they feel most appropriate. For example, let’s say a trader has optimistic projections for the European economy and would thus like to get long the Euro. But – let’s say this investor is also bullish for the US economy, but is bearish for the UK economy. Well, in this example, the investor isn’t forced to buy the Euro against the US Dollar (which would be a long EUR/USD trade); and they can instead buy the Euro against the British Pound (going long EUR/GBP). This affords the investor or trader that extra bit of flexibility, allowing them to avoid ‘going short’ the US Dollar to buy the Euro and instead allowing them to buy the Euro while going short on the British Pound.
BASE V/S COUNTER CURRENCIES
One important distinction of a Forex quote is the convention: The first currency listed in the quote is known as the ‘base’ currency of the pair, and this is the asset that’s being quoted. The second currency in the pair is known as the ‘counter’ currency, and this is the convention of the quote, or the currency that’s being used to define the value of the first currency in the pair.
LET'S TAKE THE EUR/USD AS AN EXAMPLE
The Euro is the first currency in the quote, so the Euro would be the base currency in the EUR/USD currency pair.
The US Dollar is the second currency in the quote, and this is the currency that the EUR/USD quote is using to define the value of the Euro.
So, let’s say that the EUR/USD quote is 1.3000. That would mean that 1 Euro is worth $1.30. If the price moves up to $1.35 – then the Euro would have increased in value and, on a relative basis, the US Dollar would’ve decreased in value.
If an investor was bearish on the Euro but bullish on the US Dollar, they could choose to ‘short’ the pair, expecting prices to fall; after which they could ‘cover’ the trade by buying it back at a lower price and pocketing the difference.
THE FOREX MARKET EXPLAINED
In a nutshell, the foreign exchange market works like many other markets in that it’s driven by supply and demand. For instance, if there is a strong demand for the US Dollar from European citizens holding Euros, they will exchange their Euros into Dollars. This will cause the value of the US Dollar to rise while the value of the Euro will fall. It’s important to note that this transaction only affects the EUR/USD currency pair and will not cause the USD to depreciate against the Japanese Yen.
In addition to the example you provided, there are many other factors that can move the foreign exchange (FX) market. These include broad macro-economic events such as the election of a new president, or country-specific factors such as the prevailing interest rate, GDP, unemployment, inflation and the debt to GDP ratio. Top traders make use of an economic calendar to stay up to date with these and other important economic releases that can move the market.
On a longer-term basis, one major driver of Forex prices is interest rates from the related economy. This is because it can have a direct impact on holding a currency either long or short.
WHAT EXPLAINS THE POPULARITY?
The foreign exchange market allows large institutions, governments, retail traders and private individuals to exchange one currency for another. The ‘core’ of the FX market is what’s known as the interbank market, which is where liquidity providers trade amongst each other.
One of the benefits of having forex trade between global banks and liquidity providers is that forex can be traded around the clock during the week. As the trading session in Asia comes to a close, the European and UK banks come online before handing over to the US. The full trading day ends when the US session leads into the Asian session for the following day.
What makes this market even more attractive to traders is that around-the-clock liquidity is often available. This means that traders can easily enter and exit positions as there are many willing buyers and sellers for foreign exchange.
HOW DOES IT WORK?
If you think the value of a currency is going to go up (appreciate), you can look to buy the currency. This is known as going “long”. On the other hand, if you feel the currency is going to go down (depreciate), you sell that currency. This is known as going “short”.
There are essentially two types of traders in the foreign exchange market: hedgers and speculators. Hedgers are always looking to avoid extreme movements in the exchange rate. They look to reduce their exposure to foreign currency movements. Large conglomerates like Exxon are examples of hedgers.
Speculators, on the other hand, are risk-seeking and always looking for volatility in exchange rates to take advantage of. These include large trading desks at the big banks and retail traders.
WHAT IS A 'PIP'?
Pip stands for ‘percentage in point,’ and this is the base unit of measurement in a currency pair. The value of a pip will differ based on the counter-currency in the pairing. For currency pairs in which USD is the counter-currency, or listed second in the quote, the pip value or cost will often be $1 for a 10k lot of currency, which would also mean a pip value or cost of 10 cents for a 1k lot and $10.00 for a 100k lot.
So, if an investor buys a 1k lot of EUR/USD, each pip gained or lost would be worth 10 cents. If the same investor buys a 10k lot of EUR/USD, each pip gained or lost would be worth $1/each. And if the investor buys a 100k lot, the pip value would be $10/per.
To illustrate this with an example: Let’s say that an investor bought EUR/USD and saw a 50 pip gain. If the investor was using a 1k lot, that 50 pip gain would amount to 5(.10 X 50 = 5.00); and an investor using a 10k lot would have a gain of $50 ($1 x 50 = $50). And if the same investor was working with a 100k lot, that gain would be $500 ($10.00 x 50 = $500).
Pip cost or value is an extremely important data point for forex traders to be aware of as this is how spreads are communicated. It is very important for traders to ‘know their pips.’
FOREX TRADING ON DEMO ACCOUNT: GAINING EXPERIENCE WITHOUT RISKING HARD CAPITAL.
One of the biggest risks or drawbacks of learning a market or learning to trade is the fact that trading can be a costly endeavor, and the risk of financial loss is ever-present when trading actual hard capital on a trading platform. Whenever one buys or sells a Forex pair, they bear the risk of losing money, and for a new trader that’s just learning their ways, this can be an expensive tuition.
However, many Forex brokers offer demo accounts so that new traders or prospective customers can familiarize themselves with the market, the platform, and the dynamics of forex trading before ever depositing a Dollar, Euro or Pound of their own money.
The demo account can offer a simulated environment where a new trader can implement their strategies and manage their trades with fictional capital. This can be an ideal area to learn the dynamics of forex trading – how to trigger positions, how to set stops and how to scale out of trades.
WHY FOREX TRADE?
Trading forex has many advantages over other markets. Some of these advantages include:
- Low transaction costs: Typically, forex brokers make their money on the spread provided the trade is opened and closed before any overnight funding charges are applied. Therefore, forex trading is cost-effective when weighed up against a market like equities, which attracts a commission charge.
- Low spreads: Bid/Ask spreads are extremely low for major FX pairs due to their liquidity. When trading, the spread is the initial hurdle that needs to be overcome when the market moves in your favor. Any additional pips that move in your favor are pure profit.
- More opportunities to profit: Forex trading allows traders to take speculative positions on currencies going up (appreciating) and going down (depreciating). Furthermore, there are many different forex pairs for traders to spot profitable trades.
- Leverage trading: Trading forex involves the use of leverage. This means that a trader need not pay the full cost of the trade but instead only put down a fraction of the cost. This has the potential to magnify your profits but also your losses. At TradNx we suggest a disciplined approach to risk management by restricting your effective leverage to 10 to one or less.
KEY FOREX TRADING TERMS TO TAKEAWAY
Here are some definitions of forex trading terms:
- Base currency: This is the first currency that appears when quoting a currency pair. For example, in EUR/USD, the Euro is the base currency.
- Variable/quote currency: This is the second currency in the quoted currency pair and is the US Dollar in the EUR/USD example.
- Bid: The bid price is the highest price that a buyer (bidder) is prepared to pay. When you are looking to sell a forex pair this is the price you will see, usually to the left of the quote and is often in red.
- Ask: This is the opposite of the bid and represents the lowest price a seller is willing to accept. When you are looking to buy a currency pair, this is the price you will see and is usually to the right and in blue.
- Spread: This is the difference between the bid and the ask price which represents the actual spread in the underlying forex market plus the additional spread added by the broker.
- Pips/points: A pip or point refers to a one-digit move in the 4th decimal place. This is often how traders refer to movements in a currency pair, i.e. GBP/USD rallied 100 points today.
- Leverage: Leverage allows traders to trade positions while only putting up a fraction of the full value of the trade. This allows traders to control larger positions with a small amount of capital. Leverage amplifies gains AND losses.
- Margin: This is the amount of money needed to open a leveraged position and is the difference between the full value of your position and the funds being lent to you by the broker.
- Margin call: When your total capital deposited, plus or minus any profits or losses, dips below a specified level (margin requirement).
- Liquidity: A currency pair is considered liquid if it can easily be bought and sold due to there being many participants trading the currency pair.
Here are some answers to frequently asked questions about forex trading: