What is foreign exchange trading?
Foreign exchange trading, or forex trading, is the practice of buying and selling different currencies to make a profit. Forex traders try to exchange currencies that they believe will lose value for ones that they believe will gain value- this is called taking a long position on the currency they expect to rise. The opposite can also happen- traders can sell currencies they expect to decline in value. This is called taking a short position or “shorting” that currency. Every transaction consists of taking a long position on one currency and a short one on another, although the trader might be principally interested in one or the other.
The forex market is unregulated and takes place internationally over both phone and computer networks. It exists outside the authority of any particular country’s financial authority. The foreign exchange trade is enormous- trillions of American dollars’ worth of currencies change hands every day. The market is the largest and most liquid in the world. It runs all through the day- traders exchange currencies in every major financial market in the world, and it is always daytime in at least one financial hub. The major participants in this market include both banks and other financial institutions as well as individuals.
Sometimes, governments also enter the forex market in order to affect the exchange rate of their own national currency. All traders in the forex market must operate through an intermediary called a broker, who is the person who actually executes the trade orders. The forex market is highly volatile and sensitive to economic and political information, although its size means that it is difficult for any individual entity to make a difference in the price of a given currency pair.
What is a foreign exchange broker?
A foreign exchange broker is a person or organization who executes trades in the forex market. The trader, who could be the representative of a bank or government or just an ordinary individual, transmits orders to the broker. This might take the form of a phone call to the broker or instructions from the trader’s computer interface. Many brokerage firms that cater to individuals use this second form- they create a Web-based trading interface for their customers. The customers use the interface, sometimes called a trading platform, to create orders and positions. Then the brokerage firm executes the orders. Usually, brokerage firms charge fees to the customers. That is the way they make money, because they don’t profit from the trades themselves. The broker might providee resources for learning about forex trading or video tutorials, but they do not trade in the market themselves- they are purely an intermediary.
Brokers can make things easier for the customer by creating templates for deals and trades, educating customers about the market, and allowing potential traders to make demo accounts to test out the trading interface. It is difficult for regulators to examine forex brokers, because they can operate internationally with little to no oversight. This means that selecting a legitimate broker is an important part of starting to trade on the forex market- there are brokers that scam customers or perform fraud. Generally, the trading community reviews brokers, providing an informal kind of policing. While most large brokers are scrupulous, it never hurts to be cautious. The broker can offer a variety of services to help the trader make decisions, like charting, trading tools, and software. Because the forex market is unregulated, it is technically possible for traders to enter the market without a broker. However, the brokers add value to the trader’s experience through the additional services they provide.
What currencies do people trade?
Participants in the foreign exchange market can buy any currency using any other currency, as long as they can find someone willing to make the deal with them. Similarly, they can sell any currency for a different one, provided they can find someone who wants to buy the currency they are holding. There are a few pairs of currencies, called the majors, that see the most trading action. They generally include the U. S. dollar and one other significant currency. For example, U. S. dollar/euro is one major pair, U. S. dollar/Japanese yen is a different major, and U. S. dollar/Great British pound is a third: all of these have the dollar as one element of the pair.
Because so many people are so interested in these currencies, there are lots of buyers and sellers for these pairs. That is the definition of a liquid market- there are lots of people looking to make a deal, so it usually will not take long for a particular trader to find someone willing to trade with them. On the other hand, the markets for these currencies are so big that aside from tiny, rapid fluctuations, the prices of currency pairs is not volatile. Even huge central banks find it hard to alter the exchange rate of their own currency. Some nations try to actively manipulate the price of their currency. For example, China tries to weaken its yuan so that its exports will appear cheaper to foreign importers. For several years, Argentina fixed its currency to be equal in value to the U. S. dollar. But the effort and cost of such operations is enormous. For individual traders, it is enough to say that it is impossible to change the major pairs’ prices.
If the market is not volatile, how do traders make money?
Price movements in currency pairs, especially the majors, tend to be stable. To make money from trades, traders need to take advantage of the small fluctuations that currency prices experience. But if the changes are so small, how do they allow traders to make money? In other markets, like the stock market, asset holders make money by purchasing assets when the price is low and selling them when the price is high. In the foreign exchange market, prices don’t change very much. Traders make money through a process called leveraging.
Leveraging entails making financial transactions using loans. For example, a trader could put in $100 of their own money and borrow $1,000 on top of that for a total investment of $1,100. This is much larger than the amount of money that the trader could have put into a deal with just their own money. Because the amount of borrowed money is 10 times larger than the amount of the trader’s own money, the trader has a “leverage ratio” of 10:1. That ratio says he has invested ten dollars of borrowed money for every one dollar of his own money. In the foreign exchange market, it is common to see leverage ratios between 100:1 and 250:1. These ratios are much higher than the leverage ratios in other financial markets, but without them, it would be difficult to make any money in foreign exchange trading. The use of leverage opens up the possibility of large losses- in the event that the trade winds up losing money, the trader needs to pay back all of the money they borrowed from their own pocket. That is the downside to leverage- it amplifies risk as well as return.
Is it possible to predict price movements?
It is quite a difficult task to attempt to predict how the price of a currency pair will move. In the short term, such as over a period from a few seconds to a day, the price will move almost randomly. Tiny bits of news or information will affect the market for different currencies. Over longer periods of time, the price moves in reaction to larger events and pieces of news, such as economic information, the outbreak of war and disease, or similar events. These can affect the price of currency in both the affected countries and others, because investors will try to rebalance their portfolios and take advantage of the information.
- The difficulty of predicting prices lies in the complexity of the interactions between currencies, as well as the challenge of deciding how information will affect the general foreign exchange market. In addition, these changes can happen very fast- the market reacts almost instantly to new information.
- These factors all mean that short-term prediction of price movements is quite difficult. In addition, the fact that there are so many people and institutions in the market trying to make money with the same information makes it hard to take advantage of price movements even when they do occur.
- The high leverage ratios of most foreign exchange transactions means that a losing trade can result in a lot of lost money, even if the price movement in the wrong direction but small.
- On the other hand, the potential for gains is similarly high. Traders who successfully use leveraged positions to take advantage of price movements can make much more than they would if they were risking only their own money without adding in borrowed money.
What is fundamental analysis?
Fundamental analysis is one of two ways of trying to understand asset prices. Fundamental analysis uses the fundamental traits of an asset to understand the determinants of its price. For example, a fundamental analyst looking at a stock would think about the company’s profitability, its business model, its competition, and how well it is likely to perform, and then decide if the company is going to increase its profits in the future. If so, the stock is also likely to increase in price, reflecting the value of the company. Fundamental analysis concentrates on the underlying influences that should cause a price to move. Generally, people who use fundamental analysis are interested in holding assets like currencies for a long period of time, because they believe that the basic factors that determine the asset’s price are more important than short-term fluctuations.
Fundamental analysts try to find an asset that they believe will experience growth, and then hold onto that asset for years at a time. This is sometimes called a “buy and hold” strategy. For forex traders, fundamental analysis might not be as useful as other methods of asset pricing. Generally, people in the foreign exchange market try to benefit from the short, small fluctuations in price, which fundamental analysis considers unimportant. However, entities like large businesses, banks, and governments might be interested in the long-term price of currency, so it is important to consider what the goals of those market participants are. Knowledge of the entities in the market makes it easier to anticipate where the market might move next. Keep in mind that both price increases and price declines can lead to profits, depending on whether you are taking a long or short position on a given currency pair. By understanding the motivations of other traders, you will be better able to predict the overall market.
What is technical analysis?
Technical analysis is a way to predict the prices of assets. In contrast to fundamental analysis, which focuses on the fundamental aspects of the asset, technical analysis involves studying the past movements of the price. This includes chart analysis, trend analysis, and pattern recognition. Technical analysis is better suited to examining the short, rapid fluctuations in a currency’s price than fundamental analysis. Instead of using the underlying characteristics of the asset as a guide to pricing, technical analysis uses its price alone as an indicator. For example, technical analysis might involve looking at when a stock’s 15 day moving average price moves above its 50 day moving average price. That could signal that the stock’s price is due to rise. However, this analysis has nothing to do with the company that issued the stock.
In the world of foreign exchange, technical analysis would involve looking at the charts of a currency pair’s price and its historical price data, rather than thinking about the economic and political situations of the countries that own the currency. The advantage of technical analysis is that it is useful to trying to make money from short-term fluctuations in an asset’s price. That is exactly the situation for the foreign exchange market: the high liquidity and low volatility mean that fundamental analysis and long-term strategies won’t bring in much money, due to how stable prices are in the long run. Stocks are generally expected to rise in price over time: currencies are not. The downside, however, is that technical analysis can be difficult to do well. There is no one system that will guarantee correct predictions of price movements, so it is impossible to use a technical analysis strategy and expect sure returns.
What are charting tools?
Charting tools or chart tools are the primary tools in the technical analysis kit. They involve examining the chart of an asset’s price and using that information to predict its price. This can be done alone or with the aid of computer analysis. Furthermore, charting tools might take the form of a specific cutoff rule, like the moving average rule described above, or just a gut feeling based on historical trends. The underlying commonality is that as a form of technical analysis, charting tools do not consider the role of an asset’s underlying features. For example, a currency trader using charting tools to think about price movements is not interested in the currency’s home nation’s economic situation- he just looks at the charts.
This strategy and these tools have particular value in the forex market, because of the fact that big price movements are so rare. Political or economic events large enough to change the price of a currency by a large amount are just so rare that it is more worthwhile to think about chart movements and other short-term perspectives. Some brokerages provide some charting tools to traders for free or as a premium service in order to help them make gains. It is also a good idea for forex traders to do some reading about technical analysis and chart tools before starting out. Some brokerages provide information about these topics in videos or tutorials, but there is also a lot of good information available on the Internet. Even if you do not plan to use chart tools yourself, it can be good to develop a basic familiarity due to the fact that so many other traders in the market will be making use of them to make decisions. It always helps to know what other traders are doing.
What kinds of forex markets exist?
There are three different foreign exchange markets.
- The first is the spot market. Currently, this is the one that has the most activity. The spot market contains currency deals that simply trade on the current price of currency pairs. In other words, the spot market takes place in the moment. Two traders agree to exchange one currency for another based on their price as of when they write the deal. It is the most basic and intuitive market for foreign exchange.
- The second market is the forwards market. In the forwards market, traders write contracts to purchase or sell a currency pair at a predetermined price and a predetermined time. The terms of these contracts can be quite flexible- the date at which the deal in the future will be executed as well as the price is completely up to the traders. Because each is unique, these contracts are not traded on public exchanges.
- The third foreign exchange market is the futures market. Like the forwards market, the futures market involves contracts to buy or sell a currency for a predetermined price at a certain time. The unique element to these contracts is that the time horizon is fixed in advance. For example, traders in the futures market might sell 60 day contracts on the USD/EUR pair at a certain price. Because these are “cookie cutter” contracts with fixed time horizons, they can be traded on public exchanges. Large companies and banks often use the futures market as a way to hedge against interest rate risk. Most individuals do not use the futures market, because the forwards market is more flexible. The futures market does not have any advantages for someone who is looking to profit from forex compared to the spot market or the forwards market.
How do future and forwards contracts help me make money in forex?
In the spot market, making money from trades involves a belief that a currency pair’s price is going to change in a certain direction in the future. For example, if you believe that the U. S. dollar is going to strengthen against the euro, then you should exchange euros for dollars now, and then when the price of dollars increases, sell them for a profit. Thinking about contracts and futures involves the same kind of analysis- you expect that the price of a currency will move in a certain direction. However, instead of buying the currency now and holding it until the price changes in the proper direction, a forward-looking contract involves making an agreement to buy or sell a currency at a certain price in the future. For example, suppose that once again you expect the dollar to rise against the euro in one week.
Rather than buying dollars now, you could write a deal in the forwards market to buy the dollar a week from now, but at its current price. To make it more concrete, say that now a dollar is worth 0.75 euro, and you expect it to change to 0.77 euro. You write a contract to buy dollars at the price of 0.75 euros in one week. If the dollar is indeed worth 0.77 euro, or even more, a week from now, you will make money. First you buy dollars using your contract at the agreed-upon price of 0.75 euro. Then you immediately sell them on the spot market for the new, higher price.
You have made money based on the difference in the price of dollars now and the price of dollars a week from now. It is similar to how you buy dollars, hold onto them, and then sell them when the price increases in the spot market, except that you do not actually own the dollars until the contract executes. Furthermore, most forex brokers offer ways to set up forwards and futures contracts, but they might have a different fee structure compared to spot market deals. Consider the fees carefully when trying to use these contracts. Many large institutions use contracts to protect themselves from changes in currency prices, but it is also possible for individual investors to make money from those very same currency prices using contracts.