The forex market is a globally decentralized/OTC (over-the-counter) market that enables traders to buy, sell, exchange, as well as speculate on currencies. The forex market comprises of banks, investment firms, central banks, hedge funds, retail forex brokers, individuals, etc.
You don't need to be a day by day trader to utilize the forex market. Each time you travel abroad and trade your cash into foreign money, you are taking an interest in the foreign trade, or forex market. In fact, the forex market is a monster of finance, overshadowing all other capital markets in its magnitude.
When it comes to forex trading currencies, the concepts, as well as the strategies used in forex, are quite simple despite the considerable size of the forex market. Let us take a look at a few basic concepts about the forex market that every investor should understand.
In contrast to the stock market, where financial specialists and investors have a vast number of stocks to pick, in the forex market you are required to understand and follow eight significant economies to figure out which will give the best chances. The eight economies that make up most of the trade in the forex market are the United States, The Eurozone, Japan, The United Kingdom, Switzerland, Canada, Australia, and New Zealand.
The economies of these countries have the most comprehensive and largest financial markets in the world. By rigidly concentrating on these countries, you can benefit by focusing on the most trustworthy and liquid instruments in the financial markets. Economic data is published from these countries daily that allows investors as well as financial specialists to know more about each country and its economy.
Yield and Return
A primary concept that must be remembered on forex trading is that yield initiates return. One trade in the forex spot market is equivalent to buying and selling two underlying currencies. Currencies that are being traded are quoted in pairs, as each currency is valued according to another currency. For example, if the currency pair EUR/USD is quoted as 1.7700, it means that in order to purchase 1 euro, it requires 1.77 dollars.
In every foreign exchange transaction, you simultaneously purchase one currency and sell another currency, and you use the rewards from the sold currency to buy the other currency. Moreover, every currency is associated with an interest rate that is fixed by the nation's central bank. You will be bound to pay the interest on the currency that you sell. However, you will also have the right to earn interest on the currency that you buy. The interest rates are calculated in basis points (1% = 100 basis points).
Consider the currency pair USD/EUR and assume that the United States holds an interest rate of 8% whereas the Eurozone has an interest rate of 2%. The interest rates of USD is 800 basis points, and the interest rates of EUR is 200 basis points. If you want to trade USD/EUR, you will gain 8% in annual interest, and you will have to pay 2% for a net return of 6%, or 600 basis points.
The foreign exchange market also grants huge leverage, usually as high as 100:1. It implies that you will be able to control $10,000 worth of assets with just $100 of capital. When you follow the right steps, leverage can generate massive profits. However, leverage can also be a risky factor. It can result in huge losses when your steps are wrong. Such losses can be restricted by using stop-losses.
Currency rates never stay stable; therefore, there are several trading strategies used while trading currencies. One of the most renowned trading strategies of all time is the carry trade. A carry trade involves the process of borrowing at a low rate of interest and funding in an asset that yields a higher rate of return. That is, a carry trade is generally based on borrowing in a currency that has a low-interest rate and turning the borrowed amount into another currency. Carry traders desire to gain not only in the interest rate difference between the two currencies, but also examine for the positions of currencies to appreciate in value.
Carry Trade Success
Pairing up a currency with high-interest rate upon a currency with low-interest rate is not the only decisive step to create a successful trade strategy. The direction of the spread also matters more than the spread itself. For carry trades to work well, you should belong in a currency with an interest rate that is currently growing against a currency with a fixed or contracting interest rate. This dynamic can be valid if the central bank of the particular country that you are long in is hoping to raise interest rates or if the central bank of the nation that you are short in is hoping to bring down interest rates.
Basically, you need to pick carry trades that advantage from both positive and developing yield. However, it can also hold the possibilities of value appreciation. This is significant as currency appreciation can increase carry trade earning values. To say the least, currency depreciation can eradicate the entirety of your carry trade profits.
Knowing the Interest Rates
Realizing where interest rates are going is significant in forex trading and requires a good understanding of the fundamental financial elements and economics of the nation. As a rule, countries that are performing well on an overall basis, with substantial growth and development rates and expanding inflation will likely raise interest rates to tame inflation and control growth. On the other hand, countries that face economic and financial issues that range from expansive slowdown to full downturn will think about diminishing interest rates.
Forex trading, in this digital era, is more open and accessible than ever. Being the most comprehensive financial market in the whole world, forex offers broad opportunities for traders and investors to earn profits. The currency exchange rates vary continuously due to the evolving market dominance of supply and demand. Get started with the forex market and invest wisely to establish a strong career in forex trading.