What Is Forex Trading? Reasons to Trade in Foreign Exchange

Posted on 14th December 2017
What Is Forex Trading? Reasons to Trade in Foreign Exchange

A positive attitude: What you think you become. The external conditions are the same for anybody. Your ability to succeed or fail lies within you. If you start off with a positive mindset nothing will seem unattainable. Most forex beginners have the misconception that making money in forex is fraught with too many risks and very hard. But that's not the case. If you observe caution and adopt a smart approach to trading success will follow.

Forex trading: Foreign exchange is the changing of one currency into another by individuals, corporations, central banks and other financial institutions. Currency trading is the largest financial market in the world with the maximum volatility. There are over USD 5.3 trillion forex transactions that happen every day. While a lot of forex trading is done for exchange, currency is also converted to accrue profits.

Currency exchange rate: It is the rate at which one currency can be exchanged for another. The currency exchange rate is quoted in pairs such as USD/CHF (the US dollar and the Swiss Franc) and is floating(variable) or a fixed/pegged exchange rate. Countries using a fixed exchange rate peg the value of its currency to that of another currency, or the gold rate.

Reasons to trade forex:

There are a multitude of reasons as to why you should participate in the forex market.

Global markets access: You can get instant exposure to the global financial markets by trading online. Thus, you can take advantage of market movements in any part of the world without having to deal with impediments like foreign security laws or financial statements in some foreign tongue.

Round-the-clock trading: Forex trading happens 24/5 and offers maximum liquidity to its participants. Transactions happen right from the begin of the Asian session until the close of the US session. So there is never any dearth of buying/selling opportunities.

OTC market: Forex trading does not constitute a brick-and-mortar marketplace. Currencies change hands between two parties in what is called an over-the-counter market. The forex market is an interbank market with no centralised location and is spread across four main forex trading centres in different time zones: London, New York, Sydney and Tokyo. For trading forex, you require a forex broker.

Low entry cost: Most forex brokers offer fixed spreads and one can start trading forex for as low as USD 500.Also, the use of leverage allows traders to participate in market movements at only a fraction of the cost.

Forex rates: Forex price movement is contingent on the fundamental factors of supply and demand. Banks and investors put their money into economies with a robust outlook. So positive news about an economy will attract investments and raise demand for a region's currency and any negative occurrence can similarly lower the currency's demand. Market sentiment can also impact currency prices. If traders speculate over the price of a specific currency they will trade as per the market sentiment increasing or decreasing the demand. But demand isn't the only factor that can influence a currency's price. Supply is controlled by central banks, who can introduce fiscal policies that will have a significant impact on their currency's price. Other factors like political uncertainty, inflation etc can also affect the currency market.

Forex participants: Banks are the biggest participants in the forex market followed by hedge funds, proprietary investment firms, pension funds, insurance companies, retail brokers and individual investors.

Types of forex markets: There are three different types of forex markets: Spot, Forward, and Futures. The Spot forex market is where the buyer/seller buys an asset against the sale of another at the ongoing market rate. The Forward market is an informal over-the-counter contract to buy or sell a set amount of a security/asset at a specified price at a predetermined future date. Again, Futures are standardised contracts to exchange an amount of a given asset at a pre-set price, at a set date in the future. The Futures market is like the Forward market, except that all futures contracts are legally binding and contain a specific termination date when a security must be exchanged.

Types of currency pairs

Majors: Currency pairs that include the US dollar (the single-most traded currency in the world) are called majors. These include: EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD and the AUD/USD and have the highest liquidity.

Crosses and exotic pairs: Major currency pairs which do not include the USD are known as cross currencies. The most popular crosses contain the EUR, GBP or JPY.

Exotic currencies: These consist of one major currency against another from a small or emerging economy. For instance: the MYR Malaysian Ringgit, BHD Bahraini Dinar, MUR Mauritius Rupee are all examples of exotic currencies. These kind of currencies have less market depth and are traded at a lower volume.

Bid/ask rate: A bid price is the rate at which a buyer agrees to purchase a security. The ask rate is the amount that sellers are willing to take in exchange for a security. The difference between a bid and ask price is called a spread.

Pip and lots: A pip (percentage in point) calculates the slightest change in the exchange rate for a particular currency pair. In all pairs involving the JPY, a pip is 2 places to the right of the decimal whereas for all other currency pairs, a pip is 4 places to the right of the decimal. In FX trading, slightest movements of even a single pip can have a huge influence on the overall value of your trading position.

A Lot refers to your specific trade size in the Forex market. The usual size for a lot is 100,000 units of currency. Nowadays, brokers also offer mini, micro, and nano lots corresponding to 10,000,1,000, and 100 units respectively.

Long/short positions: As any currency quote consists of a buy and sell price all currencies provide an investor with either a long or short exposure vis-a-vis currencies. A long position is the buying of an asset hoping that it will increase in value. To go short on a currency implies selling it, anticipating a decrease in the market rate. A short position is expressed in terms of the base currency.

Margin and leverage: Leverage is a concept that allows investors to control bigger trade sizes with less capital and is essentially a loan from your broker. The margin requirement is a percentage of the value of the trade. Leverage is expressed in terms of a ratio and depends on the margin requirements of your broker. For example, a 1:100 leverage would mean that you would need to deposit only $1,000 in order to hold a position of $100,000; your deposit of $1,000 is ‘leveraged’ to allow you to trade in a much larger size. Leverage is a two-edged sword and must be used prudently as it can magnify your gains as well as losses.

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