This article is covers the basics of forex trading. We will explain the basic terms, the different investment options with forex and also reveal how you can get started. You can take it as a forex trading guide for beginners.
What is forex?
Forex is the merging of the words “Foreign currency exchange”.
The process of trading one currency for another is called foreign exchange.
Foreign exchange is done for a variety of reasons. Amongst the most common are trading, commerce, or when people travel abroad and need their currency exchanged.
In 2016 the average daily forex trading volume was a staggering $5.1 trillion. This number was derived from the Bank for International Settlements’ Triennial Report.
Most trading in forex is done by investment and commercial banks. They trade on behalf of big international clients who benefit greatly from the banks efforts.
The rise of forex
In 1971, President Richard M. Nixon announced his New Economic Policy, generally known as the “Nixon shock.” It marked the end of the Bretton Woods system of fixed exchange rates established at the end of World War II.
Now major currencies could float freely against one another, with each currency having a varying value.
This gave rise to the need for foreign exchange services and trading. It also, at the same time, opened the door for investors to speculate in currencies by trading them against each other.
Forex Trading as a Fluctuation Security
Fluctuation in currency values propose a risk to companies who trade goods and services abroad.
In situations like these, using foreign exchange markets to hedge the currency risk by setting a fixed transactional rate, becomes very beneficial.
Using forward or swap markets to trade currencies ahead of time, allows traders to lock-in exchange rates.
As an example of this, picture a business who wants to sell German-produced tires in the United States.
For this example let’s set the exchange rate of the German currency and the U.S. currency as 1-1. This means that these two currencies have an equal value.
Now let’s say the tires cost €300 a piece to produce and ship abroad. The plan is to sell them for the competitive price of $500 to the end consumer.
Now since the two currencies have an equal value, this will leave the German manufacturer with a profit of €200 per tire.
However, if the euro starts to rise in value compared to the dollar, it will impact the profit to be made.
If for example the exchange rate rises to 0.75 in favour of the euro, it means that it now costs €0.75 to buy $1.
This results in a situation where the cost of manufacturing is still €300, and the company still has to sell a tire for $500 due to the competitive state of the market.
Yet, when exchanging the dollar into euro, they will experience a loss of profit.
Since $1 is now only €0.75, the revenue of the sale is reduced to ($500 X 0.75) €375.
When you subtract the manufacturing costs of €300, the company is left with only €75 in profit.
Thus a rise in the value of the euro, resulted in a loss of profit.
To prevent this scenario the company could have shortened the dollar and bought euros when they were at an equal value. When the euro rose in value, the profits the company would gain from the trade, would cover the reduced profits of the tire sales.
If the euro however decreased in value, each sale of tires would become more profitable due to the more favorable exchange rate, thus covering the loss of the currency trade.
This type of hedging is possible in the currency futures market.
The futures contracts are standardized and cleared by a central authority, which leaves traders with a clear advantage.
Still, in forward markets, which are decentralized and exist within the interbank system, it is easier to execute a trade quickly and at a desirable price, because there are numerous buyers and sellers.
Speculative Forex Trading
The supply and demand of currencies is affected by numerous factors.
These could, amongst others, be factors like geopolitical risk, interest rates, tourism, trade flows, and economic strength. Factors such as these create daily volatility in the forex markets.
Currencies are traded in pairs. Changes that could increase or decrease a currency’s value, opens up for forecasting that one currency will weaken against its paired counterpart.
This allows for opportunities to profit.
Let’s take an example where a trader assumes interest rates to increase in Germany compared to the U.S.
The exchange rate EURO/USD is at 0.70. That means for €0.70 the trader can buy $1.
If the interest rates in Germany rise, it’ll naturally increase the demand for euros. This will lead to a lower exchange rate in EURO/USD. Since the euro gets stronger, it’ll require less euros to buy a dollar.
Let’s say the traders assumptions are correct, and the exchange rate of EURO/USD ends up at 0.60. Thats €0.60 to buy $1.
Now, if the trader had shortened the USD, a profit would have been made from the change in value.
Currency as an Asset Class
As an asset class, currencies have two distinct features:
- A trader can earn the differential rate in interest between a currency pair.
- And as in the example above, it is possible to make a profit from exchange rate changes.
Buying currency with a high interest rate and shortening a currency with a low interest rate, allows for a profit to be made from different economies.
This is often called a “carry trade”.
Why Forex Trading Is That Popular?
Thanks to the internet, forex trading has become easy. There are more and more online trading platforms where everyone can open an account and start trading.
In the days before the internet the majority of traders were huge corporations, wealthy individuals, or hedge funds. The reason is simply that a large capital was required to trade.
Now a new retail market has emerged, where individual traders have easy access to the foreign exchange markets through banks or secondary markets created by brokers. If you are searching for the right forex broker, than we highly recommend you to check out our recent article about the top forex brokers of 2019. If you are new to forex trading or you don’t want to take the high risk as a new trader we would recommend you to check out the managed forex accounts options which are probably a more safe option for your money.
Individual traders can now also do large trades with a low account balance, thanks to online brokers offering high leverage trading.
Forex Trading Risks
As with any trading, forex trading can be risky and complicated.
The degree in regulation of the interbank market varies, and forex instruments are not standardized. Forex trading is also practically unregulated in some areas of the world.
Banks trading amongst each other makes up the interbank market.
Here the banks utilize specific internal processes in order to safeguard themselves against the fact that they determine and carry sovereign risk and credit risk. Industry regulations such as these, are put in place for the protection of each individual bank.
Because each bank makes offers and bids for different currencies, the market pricing is set based on supply and demand.
Due to the enormous trade flows in the market, it is virtually impossible for rogue traders to affect the value of a currency. This is great for interbank dealing investors, as it provides transparency into the market.
Some small and somewhat unrelated forex brokers, will sometimes trade against their customers.
Government and industry regulation may exist in some countries, but such safety measures are still not consistent around the world.
It is a wise move for a retail investor to investigate forex dealers to learn whether or not they are regulated in the U.S. or U.K., or in a country with looser rules and oversight.
In the U.S. and U.K. forex dealers are subjects to more oversight and stricter rules. Which will serve as an added layer of security for retail investors.
Any retail investor should also investigate the kind of account protections that are available to him. These will provide extra security in the case of a market crisis, or an insolvent dealer.
Pros and Challenges of Trading Forex
Pro: Due to the fact that the forex markets are so huge in trading volume, they offer the most liquidity of any trading market in the world. That’s why it’s easy to make a small spread in almost any market condition, since you can trade any major currencies basically within the blink of an eye.
Challenge: Traders can acquire high amounts of leverage and control large positions with virtually no money invested of their own. It is not uncommon to see a leverage ratio of 100:1 in forex.
It is important that any trader understands how to utilize leverage efficiently, plus the risk using leverage poses.
A large number of dealers have become insolvent due to enormous amounts of leverage.
Pro: The forex markets are open 5 days a week, and trades can be made 24 hours a day.
The major forex centers are Tokyo, New York, Frankfurt, Hong Kong, Sydney, Singapore, London and Paris.
Challenge: To trade forex efficiently you must posses a good knowledge of the fundamentals of economics and indicators.
Understanding cross-country economics in a big-picture view is required for any trader to understand what drives currency values.
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