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What is Forex Trading and how does it Work?

Foreign exchange or Forex could be summarized as an intricate network of buyers and sellers through which they transfer currency amongst each other at a fixed price. It is through this medium that individuals, central banks, and businesses convert one currency into another, if you have had the experience of traveling abroad it is highly likely that you have come across this network and have had to make a forex transaction.

Mostly conversion of currency is used for practical purposes, to aid individuals in their daily lives, this is also used for the accumulation of profit. The key term to achieve this purpose is exchange rates. The vast amount of currency that is being traded by this forum induces volatility in the exchange rate of that currency. It is owed to this volatility in the prices of these currencies that many traders are attracted to this network. The average daily volume of trade in forex is about $5.1 Trillion.

Timings of the Forex Market?

The Forex market closes Friday night at 10 pm (UK time) and subsequently reopens on Sunday Evening at 9 pm (UK time). However as the market only closes for the retail trader and not for central banks and related individuals, there could be a difference in the price of the currency on Friday and Sunday.

Accessibility of the forex network is fairly simple and is available to users 24 hours a day and 5 days a week. These long hours are due to the nature of the transactions between the parties as they are completed Over the Counter (OTC), in contrast to a central exchange system. Furthermore, as Forex is a global chain of networks, users can take advantage of a range of different active sessions in the trading hours of forex.

How do Currency Markets work?

Looking at the unique nature of forex trading, unlike shares and other commodities the trading does not take place on the basis of exchanges but takes place directly between the two parties, in an over-the-counter (OTC) marketplace. A global network of banks runs a forex network which is spread across the four major forex trading zones, namely New York, London, Sydney, and Tokyo. This spread in time zones allows the trading to take place 24 hours a day.

There are 3 main forex markets which you should be aware of.

  1. Forward Forex Market: In this marketplace, a contract is drawn which details the buying and selling of a set amount of currency at a fixed rate at a fixed date in the future, which is decided from a range of future dates. 
  2. Spot Forex Market: This is labels the physical exchange of currency pairs, upon the exact point at which the trade has been settled.
  3. Future Forex Contracts: In this, a contract is drawn to buy and sell a set amount of a specific currency at a fixed date in the future, unlike forwarding forex markets these contracts are legally binding once in effect.

What is Base and Quote Currency?

In forex trading, these terms could be observed to be thrown around a lot thus it is essential to know what each of them means. A base currency is a currency that has been listed first in a currency pair, thus it is the base. A quote currency is the second currency that is listed in a currency pair. The crux of forex trading is the selling of one currency in order to buy another currency, which is also the reason that it is quoted in pairs. The price of forex currency is calculated by looking at how much a single unit of the base currency is worth in the quote currency.

Currency pairs are easily identifiable as they are listed in the form of three-letters codes to represent the details of the currency. The first two letters of that code define the region where the currency originates from while the last letter is used to represent its name. For example, a pair could be, GBP/USD, the first code represent the Great British Pound while the latter is referring to the US Dollar.

In the event that the Great British Pound starts rising against the US Dollar, a single unit of the Great British Pound would be worth more US Dollar thus the price of the currency pair would start to increase as well. However, if the US Dollar starts to rise against the Great British Pound the price of the pair would decrease as now the worth of a single unit of GBP would decrease.

In order to better organize the currency pairs, most providers would split the pairs into the following categories.

  1. Minor Pairs: These are those currencies that are not regularly traded, this group mostly comprises of major currencies being traded against each other instead of the US Dollar.
  2. Major Pairs: This group comprises currencies that are regularly being traded in the market. There are seven major currencies that makeup 80% of the global forex trade.
  3. Exotics: This group comprises of a major currency which is against a minor or an emerging currency
  4. Regional Pairs: This is the group that is comprised of regional pairs such as Scandinavia or Australasia.

This practice could be adopted by newer users as well in order to keep their pairs organized and therefore effectively focus on future trading options.

What moves the Forex Market?

As the market is made up of currencies from all around the world, there are many factors that may influence the market. This makes it difficult to accurately make a prediction as there is a huge number of variables that are at play here. These variables can drastically affect the market at large and thus they must be in the knowledge of every forex trader. However, primarily like all markets, the forex network is also driven by the principles of supply and demand.

Central Banks

Central banks are the entity that essentially controls the supply of currency, furthermore, they may introduce measures that may affect the price of their currency. For example, if the central bank decides to implement quantitative easing and injects more money into the economy, the price of the currency would inevitably drop.

The Market Sentiment

It refers to the reaction of the market resulting due to news reports. If the belief spreads among the traders that a currency is moving in a certain direction, that sentiment can greatly influence the price of the currency as well.

News Reports

Investors and commercial banks aspire to put their capital into economies that are growing and appear to be strong, so when a news report arrives in the market declaring all these features in a specific currency, investors would approach that currency, this would lead to an increase in demand for the currency, further increasing their price.

Credit Ratings

Credit ratings refer to an assessment of the countries likely to pay off their debts. A country with a higher credit rating is considered a safer investment than a country with a lower credit rating. This is something that most investors tend to look at before investing in that currency. The currency could experience an increase in demand, which would increase the price of that currency. Particularly this is noticed when the credit ratings of a currency are downgraded or upgraded.

Economic Data

Economic data is also a powerful factor in moving the forex market. This informs the traders on as to how the economy is performing as well as what are the possible steps which the central bank is going to partake.

How does Forex Trading work?

Today, there are various ways through which you could use to trade forex, however, their essence is still the same; buying one currency while simultaneously selling another. This task has been traditionally fulfilled via a forex broker, however, in the growing age of technology you can now do this online with the help of derivatives like CFD trading and thus take full advantage of forex price movements.

In essence, CFDs are products that are leveraged which allow you to open a position in exchange for a small amount from the full amount of the trade. Contrasting to non-leveraged products, you do not acquire full ownership of the asset, instead, you take a side on if the market would rise or fall. This can help you increase your profits however this can also magnify losses.

Understanding the Spread in Forex

The difference between the buy and sell price quoted of a pair in forex is known as its spread. Similar to many open markets, when you open a position in forex you would be presented with two prices. In the event that you want to open a long position, you would be trading at buying price, this would be slightly higher than the market price. Similarly, if you want to open a short position, you would then be trading at the selling price, which would be slightly lower than the market price.

Understanding what a Lot is in Forex

In forex, the currencies are traded in lots, as forex moves in amounts that are small, the lots tend to be very large, to better understand the size of a lot it must be known that a standard lot is 100,000 units of base currency. However, as most traders do not possess 100,000 pounds to levy on every trade, most forex trading is completed on leveraging.

Understanding what is Leverage in Forex

To put it simply, it can be identified as the exposure to large amounts of currency without the need of paying the full value of the trade being carried out, upfront. Instead of that, you would be putting down what is known as a margin. Whenever a leveraged position is being closed by you, your profit or loss would be calculated from the full size of the trade.

This does bring about the possibility for you to increase your profits, however, it also brings the risk of amplifying your losses, which may exceed your margin. This makes it extremely important for you to know how to manage your risk.

Understanding what a Margin is in Forex

A margin is a crucial component to leveraged trading in forex. This is the term that is used to define the initial deposit you put in order to open and maintain a leveraged position. It is important to remember that the margin requirements you would have to follow may change which would be depending on your broker and also the size of the trade which is being discussed. Margins are usually a percentage of the full position of the trade.

Understanding what a Pip is in Forex

In order to measure the movement in a forex pair, pips are used. Usually, a forex pip would equate to a one-digit movement in the fourth decimal place of a currency pair. The decimal places which lie after the pip are referred to as fractional pips or pipettes.

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