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What is Forex Trading

understanding what is forex tradingForex is the acronym commonly used in place of foreign exchange. Forex trading simply refers to trading in the foreign exchange market by speculators and investors. The foreign exchange market is the place where different currencies are traded. Foreign exchange market, forex market, currency market, etc., are all terms that are used interchangeably. Currencies form an important part of every individual’s life, because any forex trade requires that the currencies be exchanged. This is the main reason as to why the forex market is the most liquid financial market. It is estimated that the average volume traded in a day in forex markets is more than $5 trillion in a day.

A unique aspect about the forex markets is that there is no central trading place for currencies anywhere in the world. Currencies are traded over the counter electronically, meaning that all currency trading transactions occur via computers networks throughout the world instead of through one centralized exchange. Currency markets function for 24 hours in a day and for five-and-a-half days in a week. Some of the major financial markets of the world include New York, London, Hong Kong, Tokyo, Singapore and Sydney, among others. The end of the trading day in the US forex markets marks off the start of currency trading in places such as Hong Kong and Tokyo. Therefore, markets are active at all times of the day and the prices change constantly.

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As an example, consider a situation when a forex trader expects the US dollar to weaken in value against the Euro. In such a case the trader may sell the dollars and buy euros instead. If the value of euro further strengthens, the trader can buy more dollars and will end up with more than the beginning making a profit.

Quotes, Lots and Pips

In forex trading a trader can buy or sell any currency pair subject to the liquidity that is available. As forex is all about comparing one currency to another, it is always quoted in pairs. Currencies are traded in lots. A standard lot size is typically 1,000 units in size. Traders place their orders in different lot sizes and usually in increments of 1,000, for example 5,000, 3,000, 10,000, etc. A quote of EUR/USD at 1.4022 shows the worth of 1 euro in terms of dollars.

In forex trading, the profit or loss is counted in pips. A majority of the currency pairs are quoted up to four decimal places (except the Japanese yen). The fourth place after the decimal point is what a trader looks out for. Any movement in value at that spot is equivalent to one pip. If the EUR/USD pair rises to 1.4028 from 1.4021, then the pair is said to have risen by 7 pips.

Leverage and Margin

Most traders work on the forex markets because it is a leveraged or a margined market. That is, the trader is required to deposit only a small fraction of the full value of the position that they intend to take during the trade. For example, if a forex broker offers a leverage of 400:1 the trader can place orders worth $1,000 by just offering $2.50 as security deposit. Though the potential for earning profits is high, the potential for huge losses also increases with the amount of leverage that is offered by the broker. In this context, leverage has to be made use of with caution and may not be a suitable strategy for all levels of investors. The amount that is kept aside is to hold a specific position is referred to as the margin.

Forex Trading Methods

There are three methods that corporations, institutions and individuals adopt for trading forex: spot market, futures market and the forwards market. The spot market is the largest of the three and both the forwards and futures markets are based on this one. Though futures used to be the favored mode for forex traders till some time ago, the emergence of electronic means for trading has put the focus on the spot market. Both speculators and individual investors prefer the spot market.

However, institutions and corporations that are looking to hedge their risks to specific dates in the future usually trade in the forwards and futures markets.

Spot Market: This is the place where the currencies are traded at their current prices. The current prices are dependent on the supply and demand of the currencies and are a reflection of many factors including economic state of the country, political climate, interest rates, etc. The future performance of one currency against another according to market views is another factor. A finalized deal involving two currencies is called a spot deal. It is a two-sided transaction in which one party decides to give a specific amount of one currency in exchange for a definite amount of another currency at a mutually agreed upon rate value. Once a deal is closed the settlement takes place in cash. Settlement of spot market transactions are completed in about two days.

Forwards and Futures market: The forwards and futures markets do not trade currencies. In both these, contracts are bought and sold. The contracts are claims that relate to a specific currency, a specific price per unit and a settlement date in the future. In the forwards market, individuals buy and sell contracts over the counter. They, however, set the terms of agreement between themselves. The futures market differs in that individuals buy and sell contracts on public commodities markets based on standard sizes. The delivery and settlement dates as well as the number of units being traded and price increments are all specified. Minimum price increments are also clearly stated. Though these contracts are settled on expiry for cash, they can be either sold or bought before the expiry date. These contracts usually offer protection against exchange rate fluctuations that may take place in the future. Though mainly used by big financial corporations to hedge their risk, speculators also deal in these markets.

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