Forex Trading 101 – A Basic Understanding
What is Forex Trading?
Forex trading involves dealing in the financial markets by speculating on the value of a currency over time. Traders who participate in forex trading aim to buy or sell one currency against the another. They do this with the intention of taking advantage of the change in currency prices by speculating on whether the value of one foreign currency will rise or fall in comparison to that of another.
Currencies are paired, with one currency pitted against another. For instance, in the EUR/USD (Euro vs. US Dollar) pair, a trader looks to make profit where there is a fluctuation in the exchange rate between the Euro and the Canadian Dollar. In a currency pair, the currency to the left (Euro in this example) is the base currency, while the currency to the right (CAD in this case) is the counter currency/quote currency. A forex quote showcases the amount of the currency required to purchase one base currency unit.
So a quote of EUR/USD = 1.0239/1.0241 means that a trader can purchase 1 Euro for 1.0241 US Dollars, while the dealer is ready to purchase 1 Euro from a trader at 1.0239 US Dollars. The difference in pricing here between the two quotes is the spread, which is the dealer’s profit.
What is the Forex market?
The forex market (foreign exchange market, FX market, foreign currency market, currency market) is a decentralized marketplace where businesses, banks, investors, hedge funds, individual traders, retail forex brokers, and governments converge to exchange and speculate on currencies. The market is decentralized because there is no physical location or central exchange for trading forex. Instead, foreign exchange (forex) is a product that is quoted by all the major banks and traded at the interbank level or the broker level. Traders get connected to the interbank network using their broker platforms.
In the forex market, two levels of trading exist. For institutional traders, trade executions are done at the interbank level. For retail traders, the brokers ‘make the market’ by executing the trade in-house at the level of the dealing desk. They aggregate price quotes from the different banks and serve them to traders with a slight markup. Therefore, when a trader buys a currency pair, it is their broker that sells it to them and not another trader.
The currency market runs 24 hours a day, five days a week (Mondays-Fridays) from world trading centers are located in London, Frankfurt, Singapore, Paris, Hong Kong, New York, Tokyo, and Sydney, among others.
The fx market is the most liquid market in the world, with more than 5 trillion dollars’ worth of currencies traded per day. High market liquidity means that currency prices can change very quickly in reaction to the news as well as short-term events. Such fast response helps to create several trading opportunities for forex traders.
Trading the Currency Market
When you’re trading the fx market, you speculate on its future direction by either purchasing (also known as going long) or selling (alternatively known as going short) currency. This depends on whether you believe its value will rise or fall. Movements of forex prices are caused by the rise and fall in the value of currencies. As such, when you are buying a currency pair, you are ultimately taking a long position.
Traders go long on a currency pair if they think that there will be an increase in the value of the base currency against that of the quote currency, or that the counter currency will decrease in value relative to the base currency. Using the USD/CAD pair, for instance, they will go long or place a buy order if they believe that the USD will become stronger against the CAD. Once the move has been made, they will make a gain for every point that the US Dollar (USD) increases against the Canadian Dollar (CAD),
On the other hand, traders sell a pair of currency if they think that there will be a fall in the value of the base currency in relation to the quote currency. Using the USD/CAD as an example, they will take a short position or place a sell trade if they believe that the USD will fall in value relative to the CAD. Once that happens, they will earn a profit for every point the USD drops against the CAD. However, if on the contrary, the USD rises against the CAD, they will record a loss whenever it increases in points.
Also, bear in mind that in the fx market, what you deal with is a leveraged product (a practice referred to as margin trading). What this means is that investing amounts of money in the market can yield a much more substantial amount. However, note that while booting your earnings is beneficial this mechanism magnifies losses just as much. Therefore, it is essential that you handle your risk appropriately.
Trading Currency Pairs
Before you trade currency pairs, it is vital that you understand the what these pairs are. Individuals who trade in the fx market buy or sell in currency pairs, as explained above. Exchange rates vary based on which currency is stronger at a particular point in time. These currency pairs are categorized into majors, minors, as well as exotics.
- Majors are currency pairs that have the USD (US Dollar) on one side and are the most frequently traded, making up to about 84.9 percent of total volume of currencies traded in the markets. Also, they are the most liquid and widely traded pairs in the world.
- Sometimes referred to as minors, crosses, or cross currency pairs, minors are currency pairs that do not contain the USD. Seeing as these currency pairs are not traded as much as major currency pairs, they have a tendency to fluctuate very often. The most actively traded minors are obtained from three major non-USD currencies such as the GBP, EUR, and JPY.
- Exotic currencies are currency pairs that are traded only once in a while. The low trade volumes associated with these currency pairs makes them highly illiquid. They consist of one major currency paired up with the currency of an emerging economy such as Mexico, Brazil, or Hungary, among others.
The fx market is perfect for traders who are looking for an opportunity to participate in a market where they can benefit 24/5 with minimized trading costs in addition to the potential of profiting from rising and falling currency prices. Whether you are looking to trade and make money short-term basis or just want to diversify your trading portfolio, the fx market is ideal for you. The ease of access, ability to trade whenever you want, as well as the freedom to trade anywhere in the world makes the fx market one of the most convenient markets to trade.