Even some of the investors usually only got to know about Forex trading from their holiday trip 🙂 So, don’t blame yourself is you are new to this. The foreign exchange market is many times larger than the stock market. In forex trading, investors are relying on changes in exchange rates. How Forex trading works and how can you too become a successful forex trader?
Surely, you know from holiday trips the counters where you can exchange money into another currency. If we go to Europe, they will exchange dollars with euros. If you fly to Japan, Japanese yen is the payment method of choice. But as an investor, you can also trade foreign currencies from home. Even with a small investment, you can achieve a big profit thanks to the large leverage being offered. But how do you use the Forex market? What does forex traders have to pay attention to and what advantages does the FX market offer to currency traders?
Advantage No. 1: Trading hours in forex trading
There is no rest for the foreign exchange market. Have you ever waited for the opening of stock markets? Forex traders do not have to deal with any waiting times. Foreign exchange trading, with a few exceptions, takes place around the clock. And you too can participate in forex trading virtually at any time via your forex broker.
Advantage No. 2: Liquidity in foreign exchange trading
You don’t have to wait long for your order to fill. Because: The foreign exchange market is by far the largest financial market in the world and offers quasi liquidity in abundance; daily currencies deals in volume of around 5 trillion US dollar.
And if you ask yourself where the heart of forex trading beats, where the business is brought together, the answer is sobering: foreign exchange trading spans the entire globe. Foreign exchange transactions are mostly held in the OTC interbank via electronic systems. Therefore, unlike stock markets, there is no “Central” Forex Exchange.
What currency pairs does forex trading has to offer?
Around eighty percent of foreign exchange trading takes place in the leading currencies US dollar, euro, yen, pound, and Swiss franc. These currencies are called the “majors.”. The rest are Minor and Exotic currencies. You buy or sell a lead currency, such as the US dollar, against another currency. For example: US dollar against South African rand (USD/ZAR) or US dollar against Thai baht (USD/THB.)
The influence of central banks on foreign exchange trading
In addition to currency pairs, forex traders must know the most important players in the foreign exchange market, the central banks like the European Central Bank (ECB), the Fed (Federal Reserve), the Bank of England (BoE,) and the Bank of Japan (BoJ.) They can decide with the control of the interest level significantly the attractiveness of their currency. For example, if the U.S. Federal Reserve raises interest rates, the US dollar should tend to revalue against other currencies. Those who have US dollars in interest rate increases can earn above-average profits in forex trading.
Investment in stock market is different since corporate investments (share prices) tend to suffer from rising interest rates, because the money is more expensive and investments are made more difficult, the shareholder, at least temporarily, is on the losing side. He’s going to have to adjust to the falling prices. This comparison between the stock and foreign exchange markets also shows you that you can expand your investment portfolio with a meaningful building block with foreign exchange futures.
Inflation or deflation: the impact of economic activity on the currency
With central banks, however, the most important price influences in forex trading are far from exhausted. It is also important to take a look at the economic situation. Regardless of whether producer or consumer prices, the number of house sales or the growth in money supply, it is always a question of the future purchasing power of the foreign currency.
Many currencies also bring some special features. Thus, the South African rand, the Canadian dollar and the Austral dollar are freely translated as “commodity currencies.” Their rates are particularly sensitive to price changes in commodity markets. Forex traders know that the South African rand is always benefiting from rising gold prices.
In the past, forex trading was only for investment banks or pension funds, and forex trading was virtually only taking place among institutional investors. The entry barriers were very high. For some time now, internet and global networking have made currency transactions not only accessible and affordable for private investors, but also in the context of an overall portfolio strategy, as an attractive extension of the investment. With sophisticated forex strategies, forex traders can generate returns regardless of the ups and downs of stock markets. An interesting and, at the same time, exciting depository building block that serves to diversify.
Forex Broker Selection: Compare Costs and Benefits
In the meantime, more and more forex brokers are entering the market and offering you forex trading on favorable terms; so many ways lead to currency trading. When selecting your forex broker, it is important that your FX broker meets the crucial basic requirements. In addition to favorable fees, good accessibility, and order execution; in particular, small margins between buying and selling price, the so-called spreads, and fast-reacting customer service.
Forex trading: an example of trading in EUR/USD
This is how Forex trading with your forex broker works: for example, if you expect US dollar to rise against euro in the near future [short term,] then you can sell EUR/USD. You think that the rising interest rates in USA will further weaken euro. You therefore sell euros against US dollars.
Fundamentals of Forex Trading: Understanding Lot and Pip
Lot and Pip are the alpha and omega of forex trading. A lot denotes the size of the foreign exchange transaction: 100,000 units in the base currency. But there are now also smaller lots: A mini lot comprises 10,000 units and a micro lot only 1,000 units.
Pip, on the other hand, is the smallest possible price movement: unlike paying for goods in the supermarket, where the smallest price change is exactly one cent, the minimum foreign exchange market is even lower: Currency trading takes place to the fourth [or fifth] decimal place. Thus, even the hundredth of a cent plays a role in forex trading.
The euro-dollar strategy works
Back to our forex strategy of dollar buying: As a forex investor, you have now become familiar with the basics, now on to the action and act as a strategically minded person wisely. For the time being, assume that you only want to buy two lots in Euro against US Dollars at a price of $1.16580. This trade has a volume of 200,000 US dollars (2 x 100,000 units.) This means you bought $200,000 and spend ~171,556 euros (200,000/1.16580.) Of course, you do not have to pay the entire volume (contract size.) As it is a forward foreign exchange transaction, you only deposit a margin in Forex trading with your broker. Let’s assume it is one percent of the contract size. This means that you deposit only one-hundredth of the contract size, but you are still fully participating in the trade. Consequently, you are dealing with a powerful lever of one hundred.
Our tip: make sure you have a low margin when choosing the forex broker. In this way, you never tie up more capital than is absolutely necessary.
First FX trade completed with profit
Back to our FX trade assumption: As a forex trader you are now not only good in doing analysis, your position [trade] is also in your favor i.e. the US dollar is rising. By implication, this means that the euro is falling and let’s assume that it falls from 1.16580 to 1.16380 US dollars per euro. As a result, you earned 200 pips (1.16580 – 1.16380.) You can now exchange your acquired two lots in euros and receive 177,430 euros. Forex traders call this closing the position. As a result, you can realize a profit of 400 US Dollars. Does not sound like much? But it is! You can make this profit with an investment of only $1000!
This small fluctuation in currency price translates into a profit of around 8 percent.
Important tip: Forex trading beginners should first of all gain experience with opening small positions/trades or by trading in a demo account. Gradually increase the risk to a level that suits your personal risk appetite. Very important: Before every trade, calculate the risk that you are willing to accept or afford. Because without calculations, patience, and proper planning you will add yourself in the list of millions of failed Forex traders!
Forex trading via leverage instruments
You do not have to open a special forex account to get leverage in the foreign exchange market. All brokers now offer this service. Some even offer huge leverage that can sometimes be dangerous to use.
An example of a knock-out leverage on euro-dollar currency pair illustrates the explosive return. Imagine that the euro is currently priced at $1.18520, and on the back of modest economic data in the US, you expect falling US dollar soon. Especially as you know, falling interest rates weaken the attractiveness of a currency and therefore tend to lower the price.
The most important parameter that you should use to research a suitable leverage is, of course, the amount of the loss threshold that you are willing to have. Also look what the margin-call is. The closer the margin-call is to the current price, the greater the opportunity and risk – and with them the leverage of the currency being traded.
In this example, you use only one-fifth of the capital, but still fully participate in the trade. You get a powerful leverage of 1:50. If you want it less risky, you can also choose a less margin like 1:10 or 1:5.
If euro-dollar price then moves in the right direction, you will achieve a profit of ten or twenty percent with a 1:50 leverage even with a movement of only one percent.
Since the leverage can act in both directions, in your favor or against you, you should first keep it low. The top priority must be the safety of your capital. It is therefore important to avoid margin-calls. If necessary, sell the position before the trade depletes all funds.
Forex profits without withholding tax?
Contrary to some circulating rumors, profits from foreign exchange transactions are not tax-free. In most cases, the withholding tax of twenty-five percent plus a solidarity surcharge is applied to the profit as flat tax. If your personal income tax rate is lower, you can get back part of the tax paid in the form of your annual tax return from the tax office.
By the way: Losses from futures transactions are taken into account. You may tax them with all other types of investment income.
But there are also special situations: If your broker grants you – at least on paper – a delivery claim for foreign exchange, your personal income tax rate will be used instead of the final withholding tax.
Our tip: For tax issues on forex trading, consult a tax adviser.