What is forex trading? definition
Forex comes from the term foreign exchange trading. Apart from being called forex, it is also referred to as FX by broker comparison sites and traders alike. So what is forex trading and how does it work? It involves the foreign exchange market, which is the market where currencies are traded or exchanged for profit. This market is global in scope, meaning that you can trade major currency pairs such as GBP/EUR or USD/EUR and the like. With an estimated daily volume of 4.15 trillion GBP, global currency trading is quite appealing, especially if you take into consideration the money you will make once you start trading. However, no matter how simple it sounds, there is still a need for you to truly master the fundamentals for you to become a successful trader. Selling your euros to buy American dollars, for example, is exactly what forex trading is and how it works by definition, but as mentioned above, there is more to it than exchanging one currency for another. Forex trading involves getting profit from this deal, and like any other type of trading, it also involves risks. Back in the day, this particular market was the domain of the bigwigs in the finance world along with corporations, central banks, large financial firms and hedge funds. Today, anyone with a bit of capital can start buying and selling currencies through their brokerage accounts.
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Forex trading guide: the basics
Currencies are important. They are not only used to buy goods and services around the world but they also need to be exchanged to make foreign trade possible. If you live in Mexico and would like to buy champagne straight from the Champagne region of France, you can buy it in euros or purchase it from a company that imports the product. This means that either you or the importer will have to exchange pesos to the value of the bottle of champagne in euros. This kind of transaction also happens when you travel. If you are an international tourist visiting the Philippines, you would need to exchange your currency to get the local currency for you to pay for your stay. These examples illustrate why the foreign exchange market is both huge and extremely liquid. In fact, it dwarfs even the stock market in terms of size. One thing that every new trader should learn is that the forex market does not have a central marketplace and exchanging or trading currencies is done over the counter (OTC). This means that all transactions are done online between traders from around the world. You already know that the market is open the entire day for five and a half days every week. Once financial centres open, traders can start buying or selling currencies.
Plenty of opportunities
Things that traders should remember:
- The terms foreign exchange market, FX market, forex and currency market are synonymous and all refer to the “place” where currencies from all over the world are traded.
- You can start trading with only a little capital.
- You will need a brokerage account to start trading currencies.
- Learning about the law of supply and demand will be beneficial, including the definitions of economic equilibrium, quantity supplied, competitive equilibrium and supply shock.
Trading currencies is not a get rich quick scheme. With daily currency fluctuations often rather small, traders need to have enormous leverage for them to make meaningful trades. This means that your leverage can be as high as 250:1, but this all depends on the currency and the situation. High leverage is industry standard when it comes to trading currencies, and unlike other markets, the foreign exchange market is less volatile. Due to the availability of high leverage and the extremely liquid market, it is an ideal place to trade. You can open or close trades within a few hours or even minutes and can also opt to hold your position for a number of months. The most basic lessons that an FX trader needs to learn are the law of supply and demand and the fundamentals of currency movements to get plenty of opportunities to make money. When you are ready, you can start trading with as little $500 with a broker that doesn’t charge a lot of fees.
The law of supply and demand
As far as trading strategies go in forex, one of the fundamentals that you need to focus on is the law of supply and demand. This is a theory that involves the interaction between the supply of a particular resource and the demand for it. In this case, you will be focusing on currency supply and the demand for this resource whatever the currency may be. This law basically tells you that the availability of a currency and the desire for said currency commands its price. In general, a low supply of USD, for example, increases its value or price while a greater supply of this resource against a low demand for it means the price or value will fall. This basic economic law is tied with every other economic principle out there. On the ground, these two forces – supply and demand – pull each other until they reach equilibrium, which will then translate to the equilibrium price. However, it is important to keep in mind that a range of factors can affect both of these forces and, as a consequence, increase or decrease their prices. To understand its intricacies, there is a need to answer the following questions:
- What is equilibrium price?
- What are the factors that affect supply and demand?
- Do supply and demand only affect the price of a currency?
Equilibrium price and factors affecting supply and demand
The equilibrium price is also referred to as the market clearing price. To illustrate how this works, one can take a look at an example from the wine industry. Basi del Diablo Wines, a product from a small company, launched its wines at a high price. With the brand relatively unknown, only very few bought it. The business anticipated selling more, but due to the lack of demand, it was stuck with a warehouse full of its wines. The high supply forced the business to decrease the price per bottle of wine and demand increased. A few years later and as supplies dwindled, the brand raised its prices until it found equilibrium, i.e. the right balance based on its available supply and the demand of consumers. This example only takes into account the experience of the wine brand. However, it gets more complicated as supply is determined by other factors. In the Basi del Diablo Wines example, the owners had to take a look at their production capacity, the costs for this production and its competitors. Other factors such as weather, reliability of supply chains and material availability can also affect the brand’s supply. The demand for the product, on the other hand, is affected by its quality and its cost. Demand for the product is also determined by available substitutes and the type of advertising involved.
The factors affecting demand can be illustrated by another example from the wine industry. Before Veuve Clicquot became a popular champagne, Madame Clicquot, the widow of the owner, worked very hard to give it the popularity it now enjoys. While the winery produced high-quality champagne, it needed advertising to increase the demand for it. There are many champagnes on the market, which means that there are many available substitutes. In the case of Veuve Clicquot the brand, Madame Clicquot went to the royal courts of Europe to have royals and noblemen taste the product. From this example, it can be said that the amount of advertising contributed to a higher demand for the brand. It also translated to higher prices for it. In currency trading, a high demand for a certain currency increases its value, while oversupply of the currency will often be followed by a decrease in its value. When a country has a dollar shortage, for example, the dollar will command a higher price against the local currency. The question is, does demand only affect prices? The country’s economy will also be negatively affected as it cannot maintain its growth due to a dollar shortage. This happens because the USD is one of the most widely traded currencies in the world.
Three ways to trade
There are three ways that you can trade forex:
- Spot market – The most basic type of trading in the forex market is through the spot market. This is where currencies are sold or bought based on their current price. The current price is determined by the amount of supply that a certain currency has and the demand for it. It is also a reflection of what is happening in the market. This includes economic performance, current interest rates, the sentiments of people regarding certain political situations both at home and abroad, and the perception on how said currency will perform against another. The British pound has fallen a number of times in the past few weeks due to Brexit negotiations, but on good days when headlines are more hopeful than the day before, its value goes up. This is because the perception of its future performance is factored in by analysis.
- Futures market – Like the forwards market, the futures market does not involve trading actual currencies but deals in contracts representing claims to a particular currency, its price per unit and its settlement date. This is a binding contract.
- Forwards market – This involves contracts being bought or sold over the counter between two entities. The parties determine the terms of said contract. Contracts in the forwards market are binding.
Trading reminders for beginners
Opening a trading account means looking for a reputable brokerage firm that offers the service. To ensure that you only deal with legitimate companies, you can ask your bank if it has a brokerage for forex trading. While looking for a brokerage firm, you must take note of the considerations below. The single most important detail that every new trader must remember is understanding the risks involved. While the forex market is less volatile than others, there are still risks that you should be aware of. Risk depends on leverage. The higher the leverage you choose for a particular currency pair, the higher the risks are. A leverage of 50:1, for example, translates to every pound controlling up to £50. With this leverage and with an account containing £1,000, your broker will lend you £50,000 so that you can trade in the market. This is one of the advantages of forex trading because you can make a lot of profit with very little cash, but as mentioned, this can have extremely difficult results as a trade can move in the other direction, effectively amplifying the leverage you have chosen. You already know that brokers make money through the spread between the bid and the ask. To ensure that you get the most out of your earnings, you can compare the spread offered by the brokerage firm you are looking at.
Making money out of currency trading involves a deep appreciation of the market and the goings-on in the world. It also requires basic trading skills and an understanding of all the trading concepts used by brokers. To be able to trade successfully and to ensure that you do not lose money as a beginner, you will need to master the fundamentals of forex trading first. You can do this by taking advantage of demo accounts to get a feel of how it works. Reading an introductory book can be beneficial, while learning from a successful trader is another way for you to get in-depth insights about the market. Successful traders usually use tools to help them make trading decisions. This can be through manual or automated trading signals or by trading the news. It also involves studying different trading strategies and choosing which one you are most comfortable with. While this particular market can be exhilarating and may even conjure daydreams of earning a huge windfall, you must have realistic expectations and a thorough understanding of the risks involved in forex trading.