What is Forex Trading?
A Forex trade occurs when you take one currency and trade it against another. For instance, you can buy the US dollar and at the same time sell the Euro, that’s a simple Forex trade. Investors and speculators use this form of trading to make money. They expect one currency to weaken/strengthen in value relative to another. If you buy euros and sell dollars, you expect the dollars to strengthen relative to the euro so that you can make a profit. It’s actually quite similar to trading stocks because you hope that the price per share will increase in the future when you buy it. So ideally, you sell a currency pair if you expect it to weaken in value in the future and vice versa.
How values of different currencies are determined in Forex Trading
There are so many complexities surrounding the foreign exchange market (Forex) so we will only get into the basic details to give you an idea of how the foreign exchange market works. First, you need to understand that there is no physical place where the relative values of different currencies are determined like it happens in stock exchanges.
The exchange rate between two currencies will be determined by the supply and demands of currency which affect their value. For instance, if there is an increase in demand or a decrease in supply of dollars then the value of the dollar will rise. On the other hand, if there is an increase in supply or a decrease in demand for dollars, the value of the dollar will fall.
How Forex Trading Works
Understanding how forex trading works is simple. First, you can always buy or sell any pair of currency. You can know the best times to buy by looking at the prevailing market conditions, historical data and other factors. For instance, if historical patterns show that the price of gold is going to increase then you can buy the Australian dollar in exchange for US dollars.
You can trade at any time because the market is open 24 hours a day. In most cases, there are 8 major currencies so that you don’t get confused as to what to trade and you can easily get an idea of how certain currencies are performing.
There’s also a base currency and a counter currency. The currency on the left of the pair is the base currency and the one on the right is the counter currency. Percentage in points- PIPs, are used to denote how well a currency is performing relative to another. A percentage in point represents a minimum price increase of a Forex trading rate.
When it comes to Forex trading, you are going to have two prices: the ask price and the bid price. The ask price is simply the value of the currency at market rates and that which you can buy the currency at. The bid price is the price in which someone is willing to sell you the currency for that price. The difference between the two is known as the spread.
The Benefits of Forex Trading
There are a number of benefits of Forex trading. We will look into some generally good reasons why you should consider this form of investment.
When there’s a middleman, expect the cost of investing to be high. With Forex trading there is no middleman so you can always trade directly and exchange currencies in the market however you choose. This not only helps to keep costs low but also reduces the execution time and makes trading fast and easy.
The high liquidity in Forex trading is as a result of the massive size of the market. In a day, over 4 trillion US Dollars can be traded. The market is huge and under normal conditions, you are allowed to buy and sell so long as there is someone on the other end to trade with you.
As we already mentioned, Forex currency markets operate 24 hours a day. It’s a market that never sleeps. This means that you can practice Forex trading regardless of your time zone. It’s perfect for traders who have a day-time job or are generally busy and require a flexible investment option. The trading hubs are spread throughout different regions that have different time zones so when one market is closing the other is opening.
The spread (which is the difference between the bid price and ask price) tends to be much less compared to other forms of trading like stocks. The transaction costs can be less than 0.1% in normal market conditions. This is the main reason why forex trading is cost effective.
It’s also important to note that, due to the large size of the market, investors can place large amounts of money without affecting any exchange rate. This means that there can never be a single entity that controls the exchange rates. Not even the central bank can control the market prices for a long period of time. This is different from other forms of trading like stocks where it’s easy for an individual or corporation to corner the market.
Risks of Forex Trading
As much as Forex trading has its advantages, there are also some risks involved with this form of investment.
The high leverage of the market (large amount of players and a lot of money is involved) can work against you and cause sharp moves that sweep out your entire account. Large gains or losses can happen very quickly.
Price risk –The prices are usually driven by supply and demand. This means that the changes in prices are often rapid and erratic. This exposes traders to a great level of risk. However, traders who utilise stop-loss orders effectively can manage this kind of risk.
Interest rates risk – A country’s interest rates will affect its currency value. If the interest rates increase, the currency usually strengthens and on the other hand, a decrease in interest rates will cause the currency to weaken as investors take their money to put it elsewhere in order to get better returns.