When it comes to finding opportunities in the financial market, forex trading is one such option. It is becoming increasingly popular in this day and age. Fortunately, there are plenty of tutorials and educational materials online so novice traders can also dip their toes into forex trading.
In this article, we delve into different aspects of forex trading, such as what it is, how the forex market work, what are base and quote currencies, and much more. This way, you can gain an understanding of how the forex market operates, and how to take advantage of this active and dynamic market.
What is forex trading?
Forex trading, otherwise known as foreign exchange trading, is where buyers and sellers transfer currency between each other at an agreed-upon price. The forex market is where individuals, companies and central banks go to convert one currency into another.
While a lot of foreign exchange is done for practical purposes, the vast majority of currency conversions are done with the aim of potentially earning a profit. The amount of currency converted every day can make price movements and some currencies extremely volatile. It is this volatility that makes forex trading so attractive. While it can potentially bring about greater chances of making a profit, it also increases the risk to traders.
How does the forex market work?
Unlike shares or commodities, forex trading does not take place on an exchange, but instead directly between two parties. As such, it is categorised as an over-the-counter (OTC) market. As there is no centralised exchange, the forex market runs 24 hours a day, 5 days a week, and is spread across various time zones.
There are three different ways to trade forex:
Spot forex: This is the physical exchange of a currency pair, which takes place at the exact point in time the trade is settled (on the spot) or within a short period of time.
Forward forex: traders sign a contract agreeing to buy or sell a set amount of a currency at a specified price, which will be settled at a set date in the future.
Future forex: a contract is signed to agree to buy or sell a set amount of a given currency at a predetermined price and time in the future. Unlike forwards, a futures contract is legally binding.
Most traders that are speculating on forex prices tend not to take delivery of the currency itself. Instead, they often make exchange rate predictions to take advantage of price movements happening in the forex market.
What is a base and quote currency?
A base currency is the first currency that is listed in a currency pair, while the second currency listed is the quote currency. Forex trading always involves selling one currency in order to buy another, which is why they are quoted in pairs. Currency pairs show traders how much one unit of the base currency is worth in the quote currency.
Each currency in the pair is listed in a three-letter code. For instance, GBP/USD is a currency pair that involves buying the British pound and selling the US dollar. Simply speaking, the base currency is the currency a trader is buying when they trade the forex pair. On the other hand, the quote currency is the currency they are selling when they trade a forex pair.
To keep things organised, most brokers and providers split currency pairs into the following categories:
Major pairs: usually involve stable and popular currencies, such as the Australian dollar, British pound, Canadian dollar, Japanese yen, Swiss franc, and US dollar, to name a few.
Minor pairs: Any currency pair that contains a currency outside of the major currencies.
Exotics: A major currency that is paired against a currency from a small or emerging economy. Examples include USD/PLN, GBP/MXN, and more.
Regional pairs: Pairs classified by regions – such as Scandinavia or Australasia. Includes EUR/NOK, AUD/NSD and more.
What moves the forex market
As the forex market is made up of currencies from all around the world, it is a very dynamic and volatile market. As such, there are many factors that may potentially contribute to price movements. For the most part, like most financial markets, the forex market is primarily driven by the forces of supply and demand. That said, it is still essential that traders gain an understanding of the other influences that drive price fluctuations in the forex market.
Supply is mainly controlled by central banks that can announce measures that will significantly impact the currency’s price. For example, quantitative easing involves injecting more money into the economy, which can cause the currency’s price to drop.
Market sentiment refers to the reaction to news or current events. This can also play a major role in driving currency prices. If traders believe that a particular currency is headed in a certain direction, they will likely trade accordingly. Traders may also end up convincing others to follow suit, increasing or decreasing demand.
Most investors and commercial banks are looking to put their capital into economies that have a strong outlook. So positive current events will likely encourage investment and increased demand for a region’s currency. Vice versa, a piece of negative news can cause investments to decrease and lower a currency’s price. This is why currencies tend to reflect the reported economic health of a particular region.
What is the spread in forex trading
The spread in forex trading refers to the difference between the buy and sell price quotes for a particular currency pair. If a trader is looking to open a long position, they trade at the buy price, which is slightly above the market price. If they want to open a short position, they trade at the sell price, which is slightly below the market price.
What is a lot in forex?
Currencies are traded in lots. These are batches of currency used to standardise forex trades. As forex tends to move in small amounts, lots are often very large. A standard lot is 100,000 units of the base currency. Because individual traders may not have 100,000 units of currency to place on every trade, almost all forex trading is leveraged.
What is leverage in Forex?
Leverage refers to the means of gaining exposure to large amounts of currency, without the trader needing to pay the full value of their trade upfront. Instead, they put down a small deposit, called the margin. However, when a leveraged position is closed, traders will instead base their potential profit or loss on the full size of their trade.
While leverage has the potential to magnify a trader’s profits, it also brings the risk of amplified losses. These losses can also exceed the margin. Therefore, it is vital that traders learn how to manage their risk when trading on leverage.
Whether you are a beginner looking to enter the world of forex trading or an experienced trader seeking to enhance your knowledge, this comprehensive guide will equip you with the knowledge and tools necessary to navigate the forex market effectively. By understanding what forex trading entails and how the market works, you can potentially capitalise on the opportunities that forex trading offers.