Foreign exchange, also known as “FX,” “forex,” or currency trading, is the exchange of different global currencies. The changes in currency values reflect supply and demand. Traders aim to profit by buying and selling currencies based on their shifting values. The shifting values of currencies in the market affect the prices of goods and services all over the world.
The largest financial market in the world, forex is an extremely popular alternative investment, but many individual investors find it too challenging and risky to participate. Forex has the propensity to generate sizable returns for experienced traders, but it’s also complicated.
How Does Forex Trading Work?
Forex operates differently than many other types of investments. The forex market is open for trading 24 hours a day, Monday through Friday. There are four main forex trading centers around the world, covering different time zones: London, New York, Sydney, and Tokyo.
Unlike the stock exchange, there is no physical foreign exchange market. Banks and financial institutions, rather than central exchanges, run the market and all trading takes place over the counter.
All forex trades occur in currency pairs. For instance, an investor can trade U.S. Dollars for Euros, or vice versa. With every transaction they buy one currency and sell the other.
All currencies continuously increase or decrease in value relative to other currencies. Values shift due to international or national events such as elections, wars, economic crises, natural disasters, and more. Bank and federal announcements such as gross domestic product (GDP) and inflation reports, employment figures, and quantitative easing measures can affect currency values. Based on what’s happening in the world, traders make predictions about whether a particular currency will rise or fall in relation to another currency, and trade accordingly.
Traders swap currencies in batches, or lots. A standard lot is 1000,000 units of currency. Traders can also trade mini lots of 10,000 units, or micro lots of 1000 units.
Since traders generally don’t have tens or hundreds of thousands of units of currency to trade, they often use leverage and margin trading to increase their position without having as much capital investment in a trade.
Risks of Forex Trading
One of the primary risks of forex trading involves the use of leverage. Using leverage can result in greater profits, but there is also a risk of losing more money initially invested. The associated risks are one reason that forex institutional investors, rather than individual investors, typically dominate forex trading. For this reason, it’s important to understand the market, the opportunity cost and the risks of day trading before starting to use leverage.
Many investors consider forex an alternative investment, since it may not correlate to stocks and bonds. Alternative investments may have their own unique risks, too, which investors or traders should be aware of.
Benefits of Forex Trading
The use of leverage is also one of the big potential benefits of forex trading, as it allows investors who lack significant resources to make relatively large trades, and thus, generate relatively large returns. Additionally, the forex markets are open longer than stock markets, which may be an advantage for some traders, and there are low barriers to entry, and an extremely liquid market for traders, too.
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What Are the Major Currency Pairs?
There are four types of pairs in the FX market:
• Major Pairs: Seven currencies comprise 80% of the global forex market. These major pairs include EUR/USD, USD/JPY, GBP/USD, and USD/CHF
• Minor Pairs: Traded less often, many of these pairs don’t include USD. Minor pairs include EUR/GBP, GBP/JPY, and EUR/CHF
• Exotics: Exotic pairs include one major currency and one currency from an emerging or smaller market. These include EUR/CZK, USD/PLN, and GBP/MXN
• Regional Pairs: Based on geography, these pairs include, such as AUD/NZD and EUR/NOK
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Three Markets to Trade Forex
There are three ways to trade in the forex market, used by both short- and long-term traders.
Spot Forex Market
This involves the physical exchange of currencies. Since it happens physically in real time, traders can complete this type of transaction on the spot. Traders can buy and sell derivatives based on the spot forex market through over-the-counter exchanges.
Forward Forex Market
In this type of forex trading, traders agree to buy or sell a specific amount of a currency at a set price on a set future date.
Futures Forex Market
In the futures market, contracts for these forward transactions are bought and sold.
How to Read Forex Quotes
It can be a bit confusing at first to read and understand forex pairs. This is how to read them.
Here’s an example: EUR/USD 1.13012
The currency on the left (EUR) is the base currency. It is always equal to one unit, which in this case would be 1€.
The currency on the right (USD) is called the quote currency or counter currency.
The number 1.13012 is the value of the quoted currency relative to one unit of the base currency. In this example, 1€ = $1.13012. If the base currency (EUR) rises in value, the quoted currency number increases since one unit of the base currency can buy more of the quoted currency, and vice versa.
When trading forex, investors are buying the base currency, in this case EUR. So, if they want to buy EUR they buy the EUR/USD pair, and if they want to buy USD they sell the EUR/USD pair.
Understanding Bid and Ask
Another important part of reading forex quotes are the bid and ask prices. The bid price is the amount that the dealer pays for the base currency, while the ask price is the price for which they will sell it. Bid prices are always lower than ask prices. The difference between these two prices is known as the spread. A lower spread is better for traders.
Using the example above, the ask price tells a trader how much USD they will need to spend to purchase one unit of EUR. The bid price tells them how much USD they will buy when they sell one unit of EUR.
Generally, the bid and ask are shown as bid/ask. For example, EUR/USD 1.13012/23 would mean that the bid price is 1.13012 and the ask price is 1.13023. A trader could sell 1€ for $1.13012 or buy 1€ for $1.13023.
Forex Trading Terms to Know
“Pips” may be the most important term for forex traders to know.
In forex trading, the units that measure the spread, earnings, and losses are called pips, which are the smallest price movement between pairs of currencies. These are similar to points in the stock market. The actual value of a pip changes depending on the currency pair, but it generally refers to a movement in the fourth decimal place of a currency pair. Micro pips or pipettes are the decimal places after the fourth decimal place.
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The Takeaway
Forex trading involves trading foreign currencies, and typically involves a handful of main currency pairs. The forex markets are relatively easy to learn, have low barriers to entry, and allow for the use of leverage, making them attractive to many investors.
Forex is a popular alternative investment and can be a great way to diversify a portfolio. However, it does involve a significant amount of understanding and practice, and can be very risky. If direct forex investing seems daunting, you can still get exposure to forex markets by purchasing ETFs or other funds that focus on foreign currencies.
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FAQ
Why does forex trading matter for average consumers?
The forex markets can have an impact on prices for consumers, which is why they may be a matter of concern for the typical person. Exchange rates internationally may be affected, which can possibly change prices.
What are the biggest differences between investing in stock and forex?
The forex markets tend to be more liquid and volatile than the stock market, as well as more voluminous, which may make them more attractive to investors. The markets are also open longer, and applicable fees for forex trades may be lower, too.
What is considered a large investment in forex trading?
Forex trades are done in “lots,” and a large lot may involve $100,000 trades while using leverage. This could only include $1,000 in actual capital, and if executed, would likely be considered a large trade for the forex markets.
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