What is forex and how does it work?
Throughout history, we have seen the transition of trading from one form to another. From the exchange of one material to another and this hasn’t stopped for a moment. Another form of trading, which has been popular within the last 50 years in forex trading. You might have heard about it but if you haven’t, don’t worry because you will know what forex is all about, how it works, the benefits of trading, and how you can start trading.
What is forex?
Forex simply means foreign exchange; it comprises of buyers and sellers who deal in currencies at a predetermined price. These buyers and sellers can be the central banks, companies, or individuals. Many people indulge in forex without knowing. For instance, you want to travel to Japan from the United States. You can’t use your US dollar in Japan because they use the Japanese Yen. Therefore, you first have to change your US dollar to the equivalent Yen before you can buy anything in Japan. The process of changing the money from one currency to another is known as forex.
Although various foreign exchanges take place for practical reasons, however, the majority of these currency conversions is done with the intention of generating profit from the buying or selling.
How does forex trading work?
Before diving into how forex trading works, it is important to understand how the market itself works. Unlike commodities or shares, forex trading takes place between two parties instead of exchanges. The individuals involved carry out their transactions using an over-the-counter market. Interestingly, the market is a remote market, which is operated by worldwide networks of banks, located in different trading sessions with different time zones. These sessions include Tokyo, Sydney, London, and New York. What makes the market interesting is the fact that it doesn’t have a central location like our traditional banks, and operates a 24 hours market system.
The market comprises of three types:
- Spot Forex Market – This market involves the physical exchange of different currency pairs taking place on the spot.
- Forward forex market – This involves a contract, which is agreed to sell or buy a particular currency amount under a specified price, which will be settled at a predetermined date in the future.
- Future forex market – In this market, a contract is agreed to sell or buy a determined amount of a particular currency under a specified price and date in the future. The primary difference between a forward and future market is that the latter is legally binding.
You can trade forex in different ways, however, they all follow the same way by buying a particular currency while selling the other. Traditionally, numerous forex transactions have taken place through forex brokers. However, recent increase in online trading has given traders the benefit of forex price movements through derivatives such as CFD (Contract for Difference).
Base and Quote Currencies
In forex trading, you will always see currencies in pairs. For instance, you will see GBP/USD, AUD/JPY, CAD/JPY, AUD/USD, etc. The currency on the left-hand side is usually called the base currency whereas the other is the quote currency. Since forex involves buying a currency to sell the other, they usually come in pairs. For instance, if GBP/USD is the forex pair and the current price is 1.24810, it means that the worth of a Pound is 1.24810 in US dollar.
If the price of the pound rises against the dollar, then one pound will have more value than the dollars, which will give rise to an increase. However, if the pound drops, the price of the pair will also decrease. Here is the secret – if after looking at the market and you think that the base currency, which is the Pound in the example above, will increase when compared to the quote currency (US dollar), then the best option is to buy the pair. Nevertheless, if the reverse is the case, then your option will be to sell. Don’t be confused if you hear traders saying they are going long or going short, it means buying or selling respectively.
What Moves the Market?
Another important question to ask is what controls the market that one can decide to buy or sell? Well, the forex market comprises of currencies throughout the world, which is why it is difficult to predict them because many factors can contribute to the movement of price. However, there are certain things that can help one know the particular direction of the market. These include:
- Central Banks – The supply of forex is regulated by central banks. They are responsible for announcing measures that will affect the price of a particular currency. For instance, when the central bank of a country decides to inject more money to its economy, it has the tendency of causing the price of the currency to drop.
- Recent news events or reports – Investors and commercial banks look for economies with a strong outlook. Nobody wants to invest in a business without any prospect. Therefore, positive news about a particular region can influence investment, which will help increase the demand for such currency.
- Economic Data – This data is important to the movement of price between two currencies. Firstly, economic data provides insight into the next action of the central bank, and secondly, it offers investors an insight into how the economy is performing.
Benefits of Trading Forex
Trading forex comes with numerous benefits. These benefits include:
- No commissions – you don’t have to pay clearance fee, government fees, brokerage fees or exchange fees when trading forex. Nevertheless, when compared with our traditional business where individuals must pay certain fees, this makes forex a great option for many investors.
- Minimal transaction cost – The transaction cost for most trade is usually below 0.1%
- No intermediaries needed – You don’t need central bank or any regulatory authority.
- 24/7 market – One distinctive feature of the forex market is the fact that it is always open for traders to trade. From Monday up until Friday, the market is open even if you are sleeping. With the forex market, you can make money always as long as you know when to go long or short.
- Leverage – Importantly, forex trading comes with the benefit of depositing little amount while using a bigger contract value. For instance, with $100 in your account, you can perform trades worth $5,000 depending on the leverage you choose.
What about the disadvantage of trading forex? Well, the primary disadvantage, if you don’t know how to trade comes the dreadful part where you have to lose your hard-earned money. Yes, because if you understand the market perfectly, you can always come on top.
The forex market is a competitive market where traders trade assets such as commodities, bonds, and stocks. The particular strategy employed will determine if you will make a profit or not. With a basic knowledge of the market and the various technical analyses, you can improve your profitability every day.
However, it is always advisable to begin your trading career by using a demo account. Once you consistently make a profit, you can set higher by using a real account. Remember you can wipe your account with a single trade, therefore, ensure to trade wisely