What is Forex Trading?
- 1 What is Forex Trading? - Introduction
- 2 What is a Forex Pair?
- 3 Why Do People Trading Forex?
- 4 Where Do People Trade Forex?
- 5 What Makes Forex Trading Unique?
- 6 How Do People Trade Forex?
- 7 What is a PIP in Forex Trading?
- 8 Pipettes in Forex Trading
- 9 What is a Lot in Forex Trading?
- 10 How Does Forex Trading Leverage Work?
- 11 How Does Hedging in the Forex Market Work?
- 12 What is Forex Trading? - In short
What is Forex Trading? The English Forex (Foreign Exchange) is the world's largest market by trade volume and liquidity. Brokers, companies, governments and other financial bodies trade currencies and Forex derivatives to enable international trade.
Traders and investors also use the market for speculative purposes. There are many arbitrage opportunities with exchange rates and interest rates. Therefore, it is a popular market for high volume or leveraged trading.
The Forex market consists of fiat currency pairs and their relative market prices. Typically, these pairs are bought and sold in lots. A standard lot contains 100.000 units of the base currency in the pair, but there are other smaller sizes up to 100 units.
Investors often use leverage to invest with amounts greater than their own capital. You can also offset the risk by using forwards and swaps to trade a currency pair at a specific price in the future.
Combining these two instruments with other trading strategies and products offers a variety of investment opportunities for Forex traders.
What is Forex Trading? - Introduction
Even if you are not a Forex trader, the international currency market often plays a significant role in your daily life. While the effects of a stock market crash are not always so obvious, a change in the value of a currency can affect the price of goods and services.
If you've ever been abroad, you've probably had to change your currency and pay a fee that depends on current exchange rates and quotes.
Forex is a unique asset class, different from stocks, commodities and bonds. When we look at their differences, it becomes clear why there is such a huge market and the need for a truly global Forex market.
Forex trading or Foreign Exchange is the buying and selling of sovereign currencies and other Forex products. When you trade currencies at a bank or exchange house, the rates are determined directly by what happens in the Forex market.
Exchange rate movements are based on a number of economic conditions, world events, interest rates, politics and other factors. As such, the Forex market is highly liquid and has the largest trading volume compared to other financial markets.
Forex Trading: The foreign exchange market comprises two main activities:
- Trading to facilitate economic transactions and speculative trading. For companies and other organizations operating in international markets, buying and selling foreign currencies is a must.
- Transferring your funds back to your native currency or buying goods abroad are important use cases in the Forex market.
Speculators establish the other side of forex trading. Short-term, high-volume trades that benefit from very small fluctuations in currency prices are common.
Forex is full of arbitrage opportunities for speculators. This partly explains the huge volume of trading present in this market.
Investors also try to cash in on longer-term opportunities such as floating interest rates. Economic and geopolitical events also cause large fluctuations over time in foreign exchange markets.
By buying a coin and holding it, there is opportunity for long-term profit. You can also use futures contracts, where exchange rates are set years in advance. In this case, you place a bet for or against the market.
The Forex market can be challenging for resource-poor users. Arbitrage and short-term trading are much more difficult for users who don't make loans or don't have a large amount of start-up capital.
This aspect has resulted in international banks and financial institutions providing most of the volume we see in the Forex market.
What is a Forex Pair?
At the most basic level, the Forex market contains currency pairs that describe the relative price between the two. If you have already traded virtual currencies, you will be familiar with the workings of the foreign exchange market. The first currency displayed in a pair is the base currency.
The second is the quote currency, also known as the quote currency. Dwe demonstrate the quote currency as a value referent to a single unit of the base currency.
The GBP/USD pair shows the £1 price quoted in USD. This ratio is displayed as a number, such as 1,3809, showing that £1 is worth $1,3809. The GBP/USD is one of the most traded currency pairs being known as “cable”.
The nickname is derived from the transatlantic cable built between Europe and North America in the XNUMXth century, which transmitted this quote between the London and New York stock exchanges.
When it comes to Forex trading, we can find many liquid markets. Some of the highest trading volume pairs include EUR/USD, USD/JPY, GBP/USD, USD/CHF. These pairs are known as the “majors” and consist of the US Dollar, Japanese Yen, British Pound Sterling, Swiss Franc and Euro.
Why Do People Trading Forex?
The Forex market is not just speculation. Banks, companies and other organizations that need access to foreign money participate in Forex trading to facilitate international transactions. The companies also make advance arrangements with fixed exchange rates for future exchange transactions.
This process is known as hedging. Furthermore, governments accumulate reserves to meet their economic objectives, including currency indexation or increased imports/exports.
The Forex Market also has attractive features for individual investors:
- Leverage allows even small traders to invest with greater amounts of capital than they have.
- Entry costs are low as small amounts of money can be purchased. Getting a share in the stock market can be very expensive. However, it is possible to enter the foreign exchange market for $1.
- It is possible to trade (virtually) at any time, making the exchange suitable for all times.
- The forex market has high liquidity and a low spread between the buy and sell price.
- Options and futures contracts are standard products. Shorting is available for traders who don't just want to buy and sell at the current (spot) market price.
Where Do People Trade Forex?
Unlike stocks that are mostly traded on centralized exchanges like the NYSE or NASDAQ, Forex trading takes place at brokers around the world. Participants can trade directly with each other through over-the-counter (OTC) trading or join a huge network of banks and brokers on the interbank market.
Overseeing this international trade can be complicated due to different regulations for each currency. Although many jurisdictions have agencies that oversee trade in the domestic market, their international reach is often limited.
You may need a license or the service of an accredited broker for your FX trades, but this does not prevent brokers from simply using other less regulated markets for their activities.
Four main zones make up the majority of foreign exchange trading volume: New York, London, Tokyo and Sydney. Since the Forex market does not have a central hub, you should find a broker that can help you trade around the world.
There are a wide variety of options available for online brokerage services, which are usually free. You will not pay a commission, but Forex brokers generally maintain a spread between the price they offer and the actual market price.
If you are just starting out, choose a broker that offers the option of trading smaller lots. We'll cover this topic later, but it's certainly the most affordable way to get started trading Forex.
What Makes Forex Trading Unique?
The Forex market has many aspects that make it different from other financial markets:
- It has huge geographic coverage. There are 180 recognized foreign currencies worldwide and there are markets for them in almost every country.
- He is extremely liquid and has a large trading volume.
- Your market prices are affected by many global factors. These include politics, economic conditions, speculation, remittances, and more.
- It is open for trading approximately 24 hours a day, five days a week. As the market is not completely centralized, there is almost always an open stock exchange or broker. Markets close on weekends, but on some platforms it is still possible to find deals available after business hours.
- Your profit margins can be low unless large volumes are traded. Small exchange rate differences can be profitable in large value trades.
How Do People Trade Forex?
When it comes to Forex trading, investors have some options available to them. It is simply buying a currency pair on the cash market and holding it.
For example, you buy EUR in the USD/EUR pair. If the quoted currency appreciates, you can sell it for the base currency and guarantee a profit.
You can also leverage your funds by increasing the amount of capital available to you. In this case, you can trade using borrowed funds as long as you cover your losses.
Another possibility in the Forex market is option contracts that allow you to buy or sell a pair at a fixed price on a specific date. Futures contracts are also popular. In this case, you are required to enter into a future trading position at a predetermined price.
An interesting aspect of Forex trading is the possibility to profit from interest rate differences. Central banks around the world set different interest rates, offering investment opportunities for Forex traders.
By exchanging your money and depositing it in a foreign bank, it is possible to earn more money than by keeping your funds idle.
However, there are some extra costs, including shipping fees, bank charges and different tax regimes. You should consider all possible additional costs before putting your strategies into practice.
The opportunities and gains from arbitrage are generally minimal, so your margins will be reduced. A disregarded rate can eliminate all expected gains.
What is a PIP in Forex Trading?
A pip (percentage in point) is the smallest possible price increment for a foreign currency pair. Looking again at the GBP/USD pair:
A move of 0,0001 (positive or negative) would be the minimum value for this pair (1 pip). However, not all currencies are traded to four decimal places. Any pair with the Japanese Yen as the quote currency has a default pip of 0,01 due to the currency's non-decimalization.
Pipettes in Forex Trading
Some brokers and exchanges deviate from the standard and offer pairs that increase the number of decimal places. GBP/USD, for example, will have five decimal places instead of the usual four. The USD/JPY pair usually has two decimal places, but it can go up to three. This extra decimal place is called a pipette.
What is a Lot in Forex Trading?
In the Forex market, currencies are bought and sold in specific amounts known as lots. Unlike stock markets, these lots of foreign currencies are traded in defined amounts.
A lot usually contains 100.000 units of the base currency of a pair, but smaller amounts can also be purchased, including mini, micro and nano lots.
When working with batches, it's easy to calculate your gains and losses from pipe changes. We will use the EUR/USD pair as an example:
If you buy a standard lot of EUR/USD, you would get EUR100.000 for $119.380. If the pair increases its price by one pip and you sell your lot, this is equivalent to a change of 10 units of the quote currency.
That is, you would sell your $100.000 for $119.390 and make a $10 profit. If the price increases by ten pips, the profit would be $100.
As trading has become more and more digitized, the popularity of standard lots has declined and more flexible options have become more widely used.
At the other end of the spectrum, big banks have even increased their standard lot sizes to 1 million to accommodate the sheer volume they trade.
How Does Forex Trading Leverage Work?
One of the characteristics of the Forex market is its relatively small profit margin. To improve your earnings, you will need to increase your trading volume.
Banks can do this easily, but some investors don't have access to enough capital, so they use leverage. THE leverage allows you to borrow from a broker with relatively little collateral.
Brokers present leverage values as a multiplication of the capital provided, for example, 10x or 20x equals 10 times, or 20 times your money. $10.000 leveraged 10x would give you $100.000 to trade.
To borrow, investors keep a margin that the broker uses to cover possible losses. A 10x leverage requires a 10% margin, 20x requires 5% and 100x requires 1%.
With leverage, you experience any gains or losses on an investment based on the total amount leveraged. That is, leverage increases your profits and losses.
Let's look at an example with the pair EUR / USD. If you wanted to buy a lot of this pair ($100.000), you would need around $120.000 at the current exchange rate.
If you are a small investor without access to these funds, you might consider using 50x leverage (2% margin). In this case, you will only need to provide $2.400 to access $120.000 in the Forex market.
If the pair drops 240 pips ($2.400), your position will be closed and your account will be liquidated (you lose all your holdings).
When trading with leverage, small price movements can drastically alter your profit or loss. Most brokers allow you to increase your account margin and, if necessary, top up your account.
How Does Hedging in the Forex Market Work?
With any floating currency, there is always the chance that the exchange rate will change. While speculators try to leverage their profits from volatility, others value stability.
For example, for a company planning to expand internationally, it's a good idea to set a fixed exchange rate to better plan your expenses. This is possible with a process called hedging.
Even speculators may want a specific fixed exchange rate to protect themselves against an economic shock or a financial crisis. You can hedge your exchange rates with various financial instruments.
The most used methods are the use of options or futures contracts. With a futures contract, an investor or trader is required to trade at a specified rate and amount at a future date.
Forex Trading: Futures Contracts
Suppose you sign a futures contract to buy a lot of USD/EUR at 0,8400 ($100.000 for $84.000) a year from now. Perhaps you are selling in the eurozone and want to repatriate your profits a year from now.
A futures contract eliminates the risk of a possible appreciation of the US dollar against the euro and helps you better plan your finances. In this case, if the US dollar appreciates, each euro will buy fewer dollars when you repatriate the funds.
If the US dollar appreciates and the USD/EUR is at 1,0000 in one year, without a futures contract, the rate (spot) would be $100.000 per $100.000. However, instead of this quote, you would use the contract previously established for a lot of USD/EUR at 0,8400 ($100.000 for 84.000 euros).
In this simple example, you will have saved a cost of $16.000 per lot, without considering any fees.
Options contracts offer a similar way to reduce risk through hedging. Unlike futures contracts, option contracts offer the option to buy or sell an asset at a predetermined price on or before a set date.
After paying a purchase price (premium or premium), an option contract can protect you from unwanted appreciation or depreciation of a currency pair.
For example, if a British company sells goods and services in the US, it can buy a GBP/USD call option. This instrument allows the company to buy GBP/USD in the future at a predetermined price.
If sterling appreciates or its rate does not change until the time of payment in dollars, the company will only lose the price paid for the option contract.
If the pound depreciates against the dollar, they have already covered their rate and can get a better price than what is offered in the market.
Forex Trading: Hedged Interest Rate Arbitrage
As interest rates vary around the world, Forex traders can arbitrate these differences while offsetting the risk of an exchange rate change.
One of the most common ways to do this is with so-called covered interest arbitrage. This trading strategy covers future currency pair price movements to reduce risk.
Step 1: Find an arbitrage opportunity
Let's use the EUR/USD pair as an example with a quote of 1.400. The interest rate for deposits in the Eurozone is 1%, while in the US it is 2%.
Therefore, $100.000 invested in the eurozone will give you a $1.000 profit after one year. However, if you could invest the money in the US, you would make a profit of £2.000 if the exchange rate stayed the same.
However, this simplified example does not consider fees, bank charges, and other expenses that you must also account for.
Step 2: Covering Your Forex Exchange Rate
By using a one-year EUR/USD futures contract with a 1,4100 forward rate, you can take advantage of a better exchange rate in the eurozone and guarantee a fixed return. The forward rate is the combined exchange rate (Forex) used in the contract.
A bank or broker calculates this rate with a mathematical formula that takes into account different interest rates and the current spot price.
The forward rate, compared to the spot rate, adds a premium or discount depending on market conditions. In preparation for arbitrage, we entered into a futures contract to sell a lot of EUR/USD at a rate of 1,41 in one year.
Step 3: Completion of arbitration
In this strategy, you buy a lot of EUR/USD at 1.400 in the cash market to get $100.000 for $140.000. Once you have your trade funds in cash, deposit them in the US for one year at 2% interest. By the end of the year, you will have a total of $142.800.
The next step is to convert the $142.800 back into euros. With the futures contract, you will sell back (short) $142.800 at the rate set in the contract, 1.4100, giving you about $101.276,60.
Step 4: Profit Comparison
Let's compare profits made with and without hedging, assuming everything else holds. After the US interest rate hedging strategy, you will have $101.276,60. If you didn't have hedging, you would have $102.000, as mentioned earlier. So why do people hedge if it makes less profit?
Investors mainly hedge to avoid the risk of exchange rate fluctuations. A currency pair is very rare that will remain stable over the course of a year.
So even though the profit is $723,40 less, we guarantee at least $1.276,60. Another factor is that we assume that the central bank will not change the interest rate throughout the year, which is not always the case.
What is Forex Trading? - In short
For anyone interested in international economics, trading and global affairs, the forex market offers a unique alternative to the stock market. For small investors, Forex trading may seem less accessible than virtual currencies or equities.
But with the rise of online brokers and increased competition to offer financial services to the public, the Forex market is not that far out of reach. Many Forex traders rely on leverage to make good profits.
These strategies carry a high settlement risk, so make sure you understand their mechanisms well before taking risks.
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