What You Will Learn:
- What constitutes Forex and what is forex trading
- The key players involved and their role
- Principal reasons for investing
- Bid and ask explanation
- How does it work – profit calculation
- Major currency pairs to watch out
- Different varieties of trading platforms
Forex stands for foreign exchange. The Forex market is the financial market where one currency is traded for another. The existence of a global environment created the need to transact with other countries and with their own currencies. For instance, a tourist from one of the European countries in the United Kingdom will have to pay for accommodation in British Pounds (GBP). Since the money is in Euros (EUR), he/she needs to exchange EURs for GBPs. This implies selling EURs and buying GBPs.
Obviously, the constant fluctuation between the currency values created the opportunity to invest on these changing values by buying or selling a currency against another – volatility. This currency value fluctuation created the option of using the market for speculative purposes. In recent years a number of investment firms began offering contracts to individual investors that use the Forex market to speculate on the currency fluctuations.
Who Are the Major Players in the Forex Market?
Speculators: speculators are sophisticated risk taking investors that enter Forex trading in anticipation of an increase in the value of a currency against another with the ultimate aim of making investment profits.
Commercial and investment banks: These are financial institutions or intermediaries whose responsibility is to accept deposits from legal or private individual, corporations and large businesses, invest it in business, make a profit and then return the initial capital plus the interest to the depositors. Banks are involved in Forex for speculative purposes as well as for commercial turnover.
Central Banks: It is the dominant single unitary body that takes full control of state’s currency, money supply and interest rates. Due to the monopoly power granted to them by the government, they single handedly oversee the operations of the commercial banking system and prints the national currency money which is an acceptable legal tender within and outside the state. They are responsible for stabilizing the Forex market through balancing the country’s foreign exchange reserves.
Investment Firms: Firms that manage large accounts on behalf of their clients and sometimes it is required to facilitate transactions through the Forex market.
Large Corporations: They are engaged in activities with foreign counterparts. So their main business is to purchase or sell foreign currencies in exchange of services or goods and therefore they are exposed to currency exchange risk. For this reason, they use the Forex market to hedge their currency risks against future fluctuations.
Retail Forex Brokers: Usually investment firms that carry operations of the Forex trading for speculators. Despite being only a small portion of the total volume of Forex, some of these brokers estimate to have a volume of 50 billion dollars a day.
Consumers and Travelers: Transactions carried out over the internet via credit card other than the currency of the country’s consumer will be converted to the seller’s home currency. If the value of the currency of the purchasing consumer is higher than the currency of where the online store is located, then there will be more money for consumer to spend. On one hand, when the value of the currency of the consumer is lower compared to the selling shop, then the shop will have more money in their account.
Why Trade Forex Online: Key Reasons for Investing
- The Forex market became the largest financial market in the world. When you compare the market with the New York Stock Exchange (NYSE), it is about 200 times bigger in terms of volume and it keeps getting bigger.
- Given that it is a decentralised market (over the counter) an investor is able to trade in the market 24 hours a day. However, investors in a stock exchange are limited to trade only when the said stock exchange is open. Besides there is no any middleman involved in the transaction which allows investors to trade directly with the market that is responsible for the price of a particular currency pair.
- The Forex market is considered as the ideal place of trading for very short-term orders compared to any other financial market. Because of its size, the Fx market is extremely liquid. So an investor is able to enter and exit the market fairly quickly. This means that he is also free to buy or sell a currency against another whenever he feels that there is an opportunity in the market and he can benefit regardless the direction the market takes.
- Leverage on the other hand is another important factor that the Forex market is more popular than any stock market. The highest leverage allows investors to execute trades higher than their margin and as a result the investors have the option to maximise their profits.
- The large competition of the investment firms that offer Forex contracts created an environment where the commissions or fees involved in the trading are extremely low compared to the rest of the financial markets. As a result, there are no clearing fees, no exchange fees and no brokerage fees because most of the investment firms are compensated from the bid and ask spread.
- To enter the market is relatively easy that makes the Forex probably the market with the lowest entry barriers. Some of the investment firms that offer Forex contracts have very low deposit requirements making it easy for investors to enter the market.
- Considered as the biggest financial market, it cannot be controlled by any entity. It makes extensive use of advanced trading systems which are available to everyone.
Major Currency Pairs To Trade
Now we will concentrate on the currencies and how the foreign currencies are priced. The currencies are designated by three letter symbols. Some of the most traded currencies are:
- Euro designated as EUR
- United States Dollar designated as USD
- Canadian Dollar designated as CAD
- British Pound designated as GBP
- Japanese Yen designated as the JPY
The Forex trading is the concurrent buying of one currency and selling another. So the Forex trading is done in currency pairs. Some of the most frequently traded currency pairs are
Bid and Ask Price Explained
GBP/USD = 1.5097/1.5098
This means that you can buy one GBP (or £1) for $1.5098 and sell one GBP (or £1) for $1.5097.The first currency of a currency pair is considered the BASE currency and the second one is called the QUOTE currency. The pairs are quoted on bid and ask spreads. The first part of the quote is the amount you will receive in exchange for one unit of the base currency (bid price). The second part is the amount of the quote currency you must spend for one unit of the base currency (ask price).
If the GBP/USD moves from 1.5097 to 1.5095, then 0.0002 USD fall in value is 2 pips. The pip is usually the 2nd or 4th decimal of a quotation. However, nowadays, most of the investment firms quote currency pairs beyond the 2nd and 4th decimal. They are quoting in fractional of pips. So if GBP/USD moves from 1.50970 to 1.50971 then this change is considered as a rise of 1 fraction of a pip.
This very small change in the value of one currency against another does not offer any advantage for investors unless the investor trades large amounts of a specific currency to experience any significant profit or loss.
How Does it Work?: Typical Market Scenario
Now let’s assume that someone is trading the standard lot of 100,000 units or example he trades 100,000 of GBP/USD at the exchange rate of 1.50970. The pip value (4th decimal) is calculated as below.
(0.0001/1.50970)*100,000=$6.62*1.50970=$9.99 rounded up to $10 per pip.
Typically an investor will require making a trade deposit also known as ‘account margin’ to be able to trade in such volume. This is how leverage works. For example, if you have 100:1 leverage (or 1% position required) and you want to trade a position that’s worth $100,000 units this can be achieved from your account’s leverage level. The investor’s account has only $10,000 and the investment firm will keep aside only $1,000 as margin in order to place a trade of $100,000.
Now let’s see how an investor can calculate the profits or losses from his trades. We will use the same currency pair we used above. Let’s assume that the GBP will get stronger against the USD and we buy 100,000 units of GBP against the USD. The rate you have is 1.5097/1.5098. Because you buy the GBP which is the base currency you are looking on the Ask rate which is 1.5098. A few minutes later, the price moved to 1.5110 and the new quotes are 1.5110/1.5111. Since you have bought the base currency you now need to sell to close your order and therefore you are looking at the Bid rate of 1.5110. The difference between the opening rate of your positions and the closing rate is 12 pips. So you have won from your order (0.0001/1.5110)*100,000=$6.62*1.5110 per pip *12 pips equals to $120.03.
What Are the Trading Platforms?
As mentioned above, the Forex market is the largest market and the competition between the investment firms that offer Forex contracts is extremely high. This created an ideal environment for improving the information technology and to develop electronic trading software. Currently, there are numerous online Forex platforms that allow users/traders to trade in the market with a wide range of options.
Some of the Forex platforms offered on these days are:
- Broker specific trading platforms
- The MT4 platform
- ECN/STP platforms
- Web based platforms
From the aforementioned list, the most popular as well as the most used platform is the MT4 platform. Despite being a third party software, the platform became the top trading platform around the globe. The MT4 platform is extremely user friendly enabling beginners to enter the Forex market with relative ease. At the same time, it provides all the tools needed for the experienced traders. The vast variety of languages allow traders around the globe to trade on the MT4 platform with an ease.
The concept of Fundamental Analysis
Lessons in this section: