The forex market is the largest and most liquid market in the world. In hardly any other area can we achieve such fast and high profits as when trading in the foreign exchange.
But what is forex trading anyway? What are the chances and risks of trading in foreign exchange currencies and how do you get started? Below you will find answers to all these questions and some more information too.
Forex – what is it actually?
Forex stands for Foreign Exchange and it is basically about the exchange of currencies. If you go on vacation and exchange Euro in another currency, then such an exchange is part of the network of foreign exchange markets.
The term “foreign exchange” comes from banking. Foreign currencies are referred to as “varieties.”
In currency trading between banks, this term is for the balance in an account that is transferred electronically or by cheque. So, forex is something that you cannot hold in your hand, because the transfer is completed electronically.
The financial market
Foreign exchange trading is regarded as the supreme discipline in the global financial market. With no other financial instrument do traders sell/buy the large volume present in forex.The daily trading volume amounts to three to five trillion US dollars.
Forex trading takes place using online markets via online platforms offered by brokers. Due to the high volume of money that is used worldwide, foreign exchange trading takes place around the clock every day. Forex traders speculate on rising or falling prices of a currency pair through which they realize their profit.
The exchange rate reflects the value ratio of the traded currencies to each other. You have the option of opening a long or short position. With the long position, you bet on the rising price of a currency pair, with the short position on a falling.
If you made the right decision, you win and make a profit. Speculative trading on exchange market is possible even with a five-dollar account! Some providers require a deposit of a minimum of 100 US Dollars. There are many risks in foreign exchange trading!
The origins of currency trading
Origins of foreign exchange trading go back to the time of ancient Greece, when, at the heyday of the light, merchants of various nations met in port cities of the country to do business with each other.
In order to facilitate the trade of different currencies, so-called “money changer” made it their task to exchange coins of different currencies with each other. At that time, the exchange rate was still settled according to gold ratio and weight. Over time, foreign exchange trading has evolved and refined, and today the foreign exchange market is the largest and most liquid market in the world.
Forex trading, as we know it today, was not always accessible to the private investor. For a long time, only banks and institutional investors were able to participate in trading currencies. Fortunately, this is no longer the case, because today, the world of currency trading is also accessible to the private investor and it is also offered to those with a smaller budget. Though it is a risky business, it does offer a wealth of opportunities to investors who can make a lot of profit.
How does forex trading work?
Forex trading takes place in an international market, which is called the foreign exchange market, forex, or simply FX. As in other markets, all participants are connected through a network and continually work together.
Currencies can be traded either directly or indirectly in the form of derivatives such as CFDs, warrants, certificates, futures, or options. There is, however, no central exchange for foreign exchange trading, but it takes place between many players. In addition to private individuals and companies, these are also financial institutions, central banks, and even governments.
Basically, forex trading is about changing one currency to another, to a certain exchange ratio that is expressed in the exchange rate. Investors are speculating on the change in exchange rates and in foreign exchange trading there are always two currencies that are placed opposite each other.
Although foreign exchange trading is not centrally organized, but runs directly between market participants, there are central trading centers and networks, which are mainly located in London, New York, and Zurich.
The Bank for International Settlements (BIS), based in Basel, is considered to be the “Central Bank of all banks” and regularly collects data from the foreign exchange market. In June 2016, the total daily volume of trading was up to approximately 5.2 trillion USD.
The most important currencies (“Forex majors”) are USD, EUR, JPY, GBP, AUD, CAD, and CHF. The individual currencies of a pair always have a certain value relationship. This ratio is subject to constant fluctuations.
If you look at a pair of currencies, the first one represents the base currency and the [second] reference currency is the opposite currency. Both are being compared. The value of a currency depends on supply and demand. The more demand for a currency, the higher its value is in the respective currency pair and vice versa.
In forex trading, each pair has a quote that represents the current value ratio. If you see the quote 1.25000 in the currency pair EUR/USD, it means that you have to pay 1.25000 dollars to buy one euro.
The largest share of sales, which can be 5+ trillion dollars a day, is achieved by direct trading with large currency pairs. These so-called majors include:
For the decision to buy or sell a currency, different factors play a role in forex trading. This is largely due to political and economic developments, and for this reason it is important to be aware of the current events in the world and to always stay up to date.
Order types on the foreign exchange markets
What types of orders are available, is ultimately decided by the broker and, if necessary, by the liquidity network connected with it.
In addition to simple market orders, stop orders are also possible with almost all brokers. A stop buy order defines a price above the current price level, upon reaching which, a long position is automatically opened. With a stop sell order, it behaves like an image in mirror to aforementioned order type. Stop Loss and Trailing Stop can also be used.
Differences to Security Trading
There are some features that distinguish forex trading from trading in securities. For example, there are the basic economic characteristics of the two trading instruments. While a stock represents a stake in a particular company, a currency pair, in principle, reflects the strength of two economies.
There is also the fact that currency trading is accessible around the clock. Trading with currency pairs does not take place on an institutional, organized futures exchange and while stock exchanges are inferior in opening hours, foreign exchange trading is always possible at any time of day or night anywhere in the world.
Other differences include the fact that market participants can benefit from both rising and falling foreign exchange trading rates, whereas in securities trading, usually, only rising prices bring gains.
Expiry of a transaction in foreign exchange market
How exactly does a trade in foreign exchange market actually executed? To illustrate this, the opening and closing of a long position in EUR/USD will be broken down into their “individual parts” in an example trade.
Opening Long position in EUR/USD
Current exchange rate: 1.24600
Position size: 1 lot
A long position in EUR/USD is realized through three transactions:
1. Borrowing in USD
2. Exchange of USD loan in EUR
3. Investment of EUR | credit
The speculation on an appreciation of EUR corresponds to a speculation on the devaluation of USD. It is intuitively understandable that debts in a weak currency are not a disadvantage when facing these assets in a strong currency. Currency trading is based on this principle.
Therefore, in the first step, a loan is taken out in USD. Since the position size is EUR 100,000 and the exchange rate is 1.24600, the credit amounts to USD 124,600.
In the second step, this loan amount is converted into EUR at the current exchange rate. In practice, both steps are performed within a fraction of a second.
The long position in EUR/USD thus consists of two accounts:
1. A credit account with $124,600 in liabilities
2. A credit account with 100,000 EUR credit
What happens if the trader’s bill goes up and EUR/USD exchange rate rises from to 1.32500?
Then the trader can close the position and make a good profit in the process. For this purpose, the credit account is first dissolved. The entire balance (100,000 EUR) will be exchanged for the new exchange rate (1.32500) in USD, so that 132,500 USD are available.
$124,600 of this will be needed to balance the credit account. The remaining sum is equal to the realized gain/profit. In this example, neither spreads nor financing costs nor taxes were taken into account.
Access to the foreign exchange market for private investors
In principle, private investors could exchange foreign currency at a bank, store these (varieties) at home, and exchange them again at a later date. In practice, however, this approach is not suitable for speculative purposes. What is needed is a broker that can be used to trade quickly, at low cost, and with little equity.
The crucial point concerns the costs. Costs may apply to explicit transaction fees, but may also be included in the trades. Traders trade (with all brokers) with spreads: in EUR/USD the spread or buying/selling price can be 1.31050 to 1.31055. The difference of 5 pips is the spread. A long position is opened at the asking price (1.31050) and then immediately valued at the bid price, resulting in an immediate, very small loss.
In the forex broker comparison, low transaction costs (as the sum of commissions and spreads) are therefore some important factors. Experience has shown that STP and ECN brokers tend to be cheaper than market makers. While the latter provides a market themselves, STP and ECN broker place orders only in larger liquidity networks.