What is Forex Trading?

September 26, 2019 - umarkets

Forex trading is done for numerous reasons, but of course, the major reason is simply for earning profits. The total amount of currencies being traded day-in and day-out are high enough to render the price movements of a number of currencies volatile. In turn, the volatility makes Forex viable to the eyes of traders as it brings higher chances of profits. However, it does increase risks.

Currency Markets, How do They Work?

Forex Trading is not like Shares or Commodities; the conversion does not happen on exchanges but between the two interested parties through an over-the-counter (OTC) market. In essence, Forex Trading is a decentralized system or at least concentrated to certain 4 trading centers. Run by a global network of banks, Forex is spread across London, New York, Sydney, and Tokyo. Given that no central location is available, Foreign Exchange can be performed, 24 hours a day.

There are 3 Classifications of Forex Market:

1. Spot Forex Market
Taking cues from the name itself, this type of Forex Market is conducted through a physical exchange of a currency pair. It happens at the exact point the trade is done, hence, “on the spot”, or at least within the shortest time period.
2. Forward Forex Market
Here, a contract to buy or sell a specific amount of currency, set at a specified price, is agreed upon. A range of dates is also set for settlement.
3. Future Forex Market
What sets this apart from a Forward Forex Market is that a Futures Contract is legally binding.

The wisest of traders, as they speculate on Forex prices, do not plan to take the delivery of the currency itself–they make predictions in their attempt to benefit from the market’s price movements.

Base Currency Vs. Quote Currency

Integral to the understanding of currencies and their exchange is the difference between a Base and a Quote currency.

Simply defined, a Base currency is the first currency listed in a Forex pair. The second, is the Quote currency. Being a sell-buy system, Forex is always quoted in pairs. The price of one unit of the Base currency exchanged for the Quote currency is the value of the Forex pair.

As you may already be familiar, each currency is represented as a three-letter code, formed by 2 letters standing for the region, and 1 for the currency itself. For instance, GBP refers to the Great British Pound.

If the GBP is to be traded for the USD (US Dollar), with the GBP/USD at 1.35361, then the value of 1 Pound is equivalent to 1.35361 Dollars.

If in case the GBP rises against the USD, a Pound will be worth more Dollars, leading the pair’s price to increase. Should it drop, the price of the pair will also decrease.

Protip: Should you see that the Base currency in a pair will strengthen against the Quote currency, buy the pair (referred to as “going long”). If you speculate that it will weaken, sell the pair (called “going short”).

Currency Pairs are divided in two:

1. Major Pairs
The 6 Major Pairs are made up by the 7 Major currencies, constituting 80% of Global Forex Trading. These are as follows:

EUR/USD
USD/JPY
GBP/USD
USD/CHF
USD/CAD
AUD/USD

2. Minor Pairs
The Minor Pairs are the currencies that are less frequently traded. These pairs often feature major currencies against each other, instead of the usual US Dollar. This category includes:

EUR/GBP
EUR/CHF
GBP/JPY

Apart from the primary classifications, there are also two secondary pairs that a trader should be aware of:

1. Exotics
This refers to a Major currency pitted against a currency from a small or emerging economy. Exotics include:

USD/PLN (US dollar vs Polish Zloty)
GBP/MXN (Sterling vs Mexican Peso)
EUR/CZK (Euro vs Czech Koruna)

2. Regional
This type refers to pairs classified by regions such as Scandinavia or Australasia. This includes:

EUR/NOK (Euro vs Norwegian Krona)
AUD/NZD (Australian Dollar vs New Zealand Dollar)
AUD/SGD (Australian Dollar vs Singaporean Dollar)

So what moves the Forex market? As it is composed of currencies from all over the world, exchange rate predictions would be difficult to do–given that each of the currencies’ value contribute to price movements.

But of course, the Forex market also submits itself to the relationship of supply and demand. This means a trader should be well-acquainted with the dynamics of and the events within the market.

The Role of Central Banks

Market supply is controlled by central banks. These announce measures that can ultimately affect the prices of the currencies. For example, Quantitative easing, which involves the introduction of more money into an economy, may lead to the drop of the currency’s price.

News Reports are Integral

It is to the Commercial Banks and investors’ interest to put their capital into economies that they see to have solid outlook. As such, positive news on the market of a specific region encourages investment and increases the demand for that region’s currency.

However, should there be a parallel increase in supply for that currency, the difference between supply and demand will lead to a price increase. On the other hand, a piece of negative news can scare off investments and lead to the decrease in the currency’s value. Consequently, the market forms its sentiment in accordance to the nature of the news. This effectively drives the prices of the currency.

Economic Data

Economic data is integral to the currency’s price movements as it paints the picture of how an economy is performing and offers an idea as to what its central bank might resort to moving forward.

So How Does Forex Trading Work Exactly?

While a lot of Forex transactions have been performed through a Broker, online trading is steadily gaining a foothold, giving traders the chance to make the most of Forex price movements through derivatives like CFD Trading.

CFDs are products that have been leveraged. These enable you to open a position even for only a part of the trade’s entire value. Here, you take a position whether you think the market value will rise or fall.

With non-leveraged products, you take ownership of the asset. While a leveraged product can increase your profits, it can also increase your chances of loss.

What is a Spread?

The difference between the buy and sell prices quoted for a Forex pair is called a Spread. As with numerous financial markets, upon opening a Forex position you are presented with two prices:

1. Long Position – trading at the buy price; this is slightly above the market price.
2. Short Position – trading at the sell price; this is slightly below the market price.

What is a Lot?

A lot is a batch of currency used for the standardization of Forex trades.

Given that Forex moves in small amounts, lots can be huge. For instance, a standard Lot is 100,000 units of the base currency. In this light, all Forex would be leveraged as individual traders don’t exactly have 100,000 of whatever currency they’re trading to allocate to every trade.

Leverage in Forex

A Leverage in Forex means the exposure to large amounts of currency without the upfront payment of the full value of your trade. As such, you only make a small deposit called a Margin. Hence, your profit or loss is based on the full size of the trade once you close a leveraged position.

How Leverages Work

Trading on leverage is a double-whammy, as it can augment your profits, it can also magnify the risk of greater losses – including losses that can exceed your Margin. Leveraged trading therefore makes it extremely important to learn how to manage your risks.

Margin in Forex

Margin refers to the initial deposit you use to open and maintain a leveraged position. Upon trading with a margin, your margin requirement will change in accordance to 2 things:

1. Your broker
2. How large the size of your trade is

A Margin also manifests as a percentage of the full position. For example, a trade on EUR/GBP is highly likely only to require 1% of the total value of the position you would be paying for it to be opened. As this is the case, instead of AUD$100,000, you would only need to deposit AUD$1000.

Pips

The units that measure movement in a Forex pair are called Pips. It is a 1-digit movement in the fourth decimal place of a currency pair. To illustrate this, let us take for example GBP/USD movement. If the pair moves from $1.35361 to $1.35371, then it has moved a single Pip. Fractional Pips are the decimal places after the pip. It may also be called Pipettes.

An exception to this is when a Quote currency is listed in much smaller denominations. Let us look into the Japanese Yen. The movement here is in the second decimal place–this is a single pip. Hence, should the pair, EUR/JPY move from ¥106.452 to ¥106.462, it has moved a single Pip.