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Forex Trading: What is Forex?
Forex trading is a term used to describe a person who engages in active foreign exchange trading, usually for financial gain or profit. This can take the form of a speculator who wants to buy or sell a currency to profit from the currency’s price movements; or it can be a hedger who wants to protect their account from their own currency positions in the event of an adverse move Impact.
The term “Forex trader” can describe an individual trader on a retail platform, a bank trader using their institutional platform, or a hedger who manages their own risk or outsources this function to a bank or money manager to manage risk.
Forex Trading: The FX Market
The foreign exchange market, or foreign exchange (FX) for short, is a decentralized marketplace that allows the buying and selling of different currencies. This is done over-the-counter (OTC) rather than a central exchange.
Before you know it, you may have participated in the foreign exchange market by ordering imported products such as clothes or shoes, or more obviously buying foreign exchange while on vacation. There are many reasons why traders are attracted to Forex, including:
- The size of the foreign exchange market
- Tradeable Multiple Currencies
- different volatility levels
- low transaction costs
- Trade 24 hours a day for the week
This article is suitable for all levels of traders. Whether you are new to Forex trading or want to build on your existing knowledge, this article attempts to give you a solid foundation in the Forex market.
Forex Trading: Two Sides to Every Market
A unique aspect of the foreign exchange market is the way it is quoted. Since currencies are the foundation of the financial system, the only way to quote currencies is to use other currencies. This creates a relative scoring metric that may sound confusing at first, but becomes more and more normal the longer you use this two-way convention.
Trading Forex in pairs gives traders a little extra flexibility by allowing traders or investors to price their trades in whatever currency they deem most appropriate.
For example, suppose a trader is bullish on the European economy and therefore wants to go long on the currency, using the euro as an example. But – suppose this investor is also bullish on the US economy but bearish on the UK economy. Well, in this example, investors wouldn’t be forced to buy EURUSD (which would be a long EUR/USD trade); they could instead.
This provides an investor or trader with some additional flexibility as they can avoid shorting the dollar and buying the euro, and instead buy the euro while shorting the pound.
Forex Trading: Base v/s Counter Currencies
An important difference in forex quotes is convention: the first currency listed in a quote is referred to as the “base” currency of the pair, which is the quoted asset. The second currency in a currency pair is called the “counter” currency, which is an exchange rate or currency convention used to define the value of the first currency in a currency pair.
Let’s take EUR/USD as an example…
The euro is the first currency listed, so the euro will be the base currency in the EUR/USD pair.
The US dollar is the second currency in the quote, which is the currency used by EUR/USD quotes to define the value of the euro.
Therefore, let’s assume that EUR/USD is quoted at 1.3000. This means that 1 Euro is worth $1.30. If the price rises to $1.35, the euro will appreciate and the dollar will fall relatively.
If an investor is bearish on the euro but bullish on the dollar, they can choose to “short” the pair in anticipation of a fall in price; they can then “cover” the trade by buying back the trade at a lower price and pocketing the difference.
Forex Trading: The Forex Market Explained
In short, the foreign exchange market works like many other markets because it is driven by supply and demand. As a very simple example, if European citizens holding euros have a strong demand for dollars, they will exchange euros for dollars. The dollar will appreciate and the euro will depreciate. Keep in mind that this trade only affects the EUR/USD pair and will not cause USD/JPY to depreciate, etc.
Forex Trading: What Drives the Flows?
In fact, the above example is just one of many factors that can drive the Forex market. Others include broad macroeconomic events, such as the election of a new president, or country-specific factors such as current interest rates, GDP, unemployment, inflation, and debt-to-GDP ratios, among others. Top traders use the economic calendar to stay abreast of this and other important economic news that can move markets.
In the long run, the interest rate of the relevant economy is an important factor in foreign exchange prices, as this directly affects whether a currency is long or short.
What Explains the Popularity?
The foreign exchange market allows large institutions, governments, retailers and individuals to exchange one currency for another, and the “core” of the foreign exchange market is the so-called interbank market, where liquidity providers trade.
The advantage of foreign exchange transactions between global banks and liquidity providers is that foreign exchange transactions can be conducted 24 hours a day (within a week). As the Asian trading session draws to a close, European and UK banks come online ahead of the handover to the US. The full trading day ends when the US session enters the Asian session the next day.
What makes this market more attractive to traders is the often available 24/7 liquidity. This means that traders can easily enter and exit positions as there are many buyers and sellers willing to buy forex.
FOREX TRADING: HOW DOES IT WORK?
This is very similar to other markets: if you think a currency will increase in value (appreciate), you can try to buy that currency. This is called “long”. If you feel that the currency is going to fall (depreciate), sell the currency. This is called “short”.
Forex Trading: Who are the Major Players?
There are two main types of traders in the foreign exchange market: hedgers and speculators. Hedgers always try to avoid extreme exchange rate fluctuations. Think large conglomerates like Exxon Mobil and how they are trying to reduce their exposure to foreign exchange volatility.
Speculators, on the other hand, are risk-takers, always looking for currency fluctuations to profit. These include large trading desks at major banks and retailers.
Reading a Forex Quote
All traders need to know how to read Forex quotes as this will determine the price at which you enter and exit trades. Looking at the currency quotes below, the first currency in the EUR/USD pair is called the base currency, the euro, while the second currency in the pair (the US dollar) is called the floating or quote currency.
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