What Is Forex Trading, And How Can Investors Profit?
Shanthi Rexaline
Currencies are a popular investment class that allow for speculation on price movements, just like bets on other asset classes.
Foreign exchange, or forex in short, is a decentralized global market where currency pairs are traded. Currency trading takes place electronically over-the-counter across all major financial centers, namely Sydney, Tokyo, Hong Kong, Singapore, Paris, Frankfurt, London, Zurich and New York.
This gives the forex market its 24-hour operational characteristic. When trading in New York ceases, forex traders can trade in Sydney , then in Tokyo and later in the European centers before trading resumes in New York.
Currency is traded in the spot, forwards and futures markets, with spot trading now assuming prominence.
The futures and forwards market are the preferred choice for companies seeking to hedge their foreign exchange risk.
Characteristics Of The Forex Market
Highly Liquid
The appeal of the forex market lies in its copious liquidity, with a $5.2-trillion average daily trading volume.
Limited Investment Choices
The breadth of investment options in currencies is smaller, given that there are only a few major currency pairs that are frequently traded. The major currency pairs include EUR/JPY (euro/yen), USD/JPY (U.S. dollar/yen), GBP/USD (pound/U.S. dollar), USD/CHF (U.S. dollar/Swiss franc), AUD/USD (Australian dollar/U.S. dollar) and USD/CAD (U.S. dollar/Canadian dollar).
Other, more exotic pairs such as USD/MXN (U.S. dollar/Mexican peso), which are rarely traded and therefore are relatively illiquid due to the low volume of trading — and therefore carry a high risk profile.
Rapid Price Movements
The high liquidity of the forex market vests gives it dynamic and rapid price movement, which creates multiple opportunities for retail traders.
Leverage Trading
Leveraging is allowed in forex trading, which means that investors do not have to spend the whole value of the investment, but can instead use only a margin amount. If a broker allows a 100-to-1 leverage, the investor would need to have an equity of $1,000 to fund an order worth $100,000. In this case, the margin requirement is 1 percent.
The price interest point, or PIP, is a term used to refer to gains or losses in trading, and is the smallest price move in an exchange rate. For currency pairs priced to four decimal places, one pip is equal to 0.0001 — or 1 basis point.
Bid Price
The price at which the market is willing to buy a specific currency pair is the ask price, and it appears on the left side of the quote. Alternatively, it is the price at which a trader can sell the pair.
Ask Price
The ask price, appearing on the right side of the quote, is the price at which the market is ready to sell a currency pair or the price at which one can buy it.
Spreads
This is the difference between the bid price and ask price, which is otherwise the cost of trade or the profit that goes to the broker. It is measured in pips.
How To Trade Forex
Here's a simplified explanation of how to trade forex:
Traders interested in the forex market must zero in on a currency pair on which they wish to bet. Before deciding the currency pair, traders should have a fairly good understanding about the associated risk.
Traders should then decide on the type of trading, namely forex trading, CFD or spread betting. Forex trading allows traders to buy lots in the unit of the base currency, which is the currency on the left side of a pair.
Depending on the direction of a bet, traders then decide to buy or sell. Logically, forex traders should be aware of the price of the currency pair, with the currency on the left designated as the base currency and the one on the right being the quote currency.
When traders buy a currency pair, it implies they are betting the base currency will strengthen against the quote currency. For every point rise in the exchange price relative to a trader's open level, a profit is made, while a drop nets a loss.
The sell bet suggests that a trader is betting on the weakening of the quote currency. In this case, a loss is made with every 1-point increase in the exchange rate — and a profit is made if the reverse occurs.
Once an order is placed — an instruction to buy/sell at a future point when a predetermined price level is reached — the order is open. With each move in the pair that's being traded, the profit/loss will fluctuate. Traders can keep a tab on the market price, profit and loss in real time. Fresh orders can be placed, orders can be attached to open positions and existing trades can be closed out.
Finally, when a trade is closed, the trader does the reverse of what they did at the time of the opening. If a buy order was placed, the trader now sells. When a tradeis closed, the net profit/loss now shows in a trader's account balance.
Another option is trading the CFD, or contract for difference. A CFD is a derivative instrument, and it is a contract executed between a buyer and a seller. The difference in the value of the underlying instrument between the time at which the contract was opened and the time it was closed is paid. There is no physical exchange of the asset class.
How To Make Money From Forex Trading
A Sound Education Is a Must
Knowledge is the key to success. Keeping up with this adage, traders should equip themselves with sufficient knowledge before deciding whether to plunge into the forex market. Apart from learning using demonstration accounts, traders should also learn the different factors that impact currency movements — geopolitical news, economics, monetary policy and the like.
Prudence In Outlays
Experts suggest that an uncluttered mind is needed for stress-free trading — and judicious decision-making. Traders should only commit funds they can afford to lose, without dipping into the money they need to sustain themselves. Start small.
Mastering Emotions
Prudent decision-making is a sine qua none while trading a highly volatile instrument like currency. Acting based on sound logic and reason is key to avoiding excessive risk.
Choosing A Forex Broker
The choice of broker is an important factor in forex traders making btetter returns on investment. Benzinga has a review of the best forex brokers.
