Did you know that the foreign exchange market (forex or FX) is the largest market in the world, with some US$5 trillion in average daily transactions? All the world's combined stock markets don't even come close to this. But what does that mean to you? Take a closer look at forex trading and you may find some exciting trading opportunities unavailable with other investments.
Forex transactions are all over the place. Visit Germany from the UK, and a forex transaction comes about since you have to convert pounds to euros. The exchange rate between these two currencies is dependent on the market forces of supply and demand. This causes the rate to fluctuate continually according to the market conditions. The prevailing exchange rate determines how many euros you get for your pounds. You may find the exchange rate for a pound standing at 1.20 euros on Thursday and 1.21 euros on Friday. This may be a very slight change. However, given that there are merchants that spend thousands of pounds in buying items or paying overseas workers, you will find that the slight change has a very big impact. It matters when you exchange currencies. Both the company and you may hold onto your pounds until the exchange rate becomes favourable.
A single pound on Monday could get you 1.19 euros. On Tuesday, 1.20 euros. This tiny change may not seem like a big deal. But think of it on a bigger scale. A large international company may need to pay overseas employees. Imagine what that could do to the bottom line if, like in the example above, simply exchanging one currency for another costs you more depending on when you do it? These few pennies add up quickly. In both cases, you-as a traveler or a business owner-may want to hold your money until the exchage rate is more favorable.
Similar to the stock market, trading in currency is dependent on your opinion of the value of a given currency or your prediction on the possible rise or drop in value. However, unlike the stock market, you can buy or offload your currency fast. If you feel that the value of a given currency is likely to go up, you can buy the currency. On the other hand, if you feel that the value is likely to go down, you sell the currency. Since the market is very large, you will not have problems getting a buyer and a seller for your currency.
There is a time in the past when China devalued its currency to bring in more investors into the country. If you were in the Forex trade at the time, you would have sold your Chinese currency for a higher value currency such as the US dollar. The more the devaluation of the Chinese currency, the more profit you make by exchanging it with another currency. However, if the currency, which you are selling, increases in value, your profits go down.
In all cases, forex trading involves with the trader profiting from betting one currency against another. Let us take an example of the most traded currencies around the world EUR/USD. If you take the EUR as the first currency in the exchange, it becomes the base currency. USD, which is the second currency, becomes the counter currency. The price that you see quoted on the account is how much dollars one Euro is worth.
There are two prices in every case, one buying and the other the selling price. The difference between the buying price and the selling price is called the spread. Every time you buy and sell, you are buying or selling the base currency.
If you feel that the euro will increase in value against the US dollar, you buy EUR/USD. In the same way, if you feel that the euro is likely to drop against the dollar, you will sell EUR/USD. If the buying price of the EUR/USD is 0.8005 and the selling price is 0.8008. The spread, in this case, is 0.03 pips.
The price is usually quoted in hundredths of cents. Leverage helps you see the return on your investment.
When trading in forex, you usually borrow the first currency in your trading pair to buy or sell the second one in the pair. As said earlier, the forex market is a US$5 trillion a day market where liquid runs deep. The liquid providers allow you to trade with the leverage. This is done by setting aside the required margin depending on the trade size.
Let us take the 200:1 leverage. You can trade $2.000 in the market but only be required to set aside only $10 margin for your trading account. You get a lot of exposure while keeping the capital investment low.
On the other hand, the leverage can also increase your losses in the market. Sometimes, these losses can exceed your deposited funds. You should start trading with lower leverage ratios and increase them as you get to understand the market.