What is Forex Trading? Foreign exchange simply explained!
What is Forex Trading?
The forex market (forex or FX for short) is one of the most exciting and fast-paced markets ever. Until a few years ago, foreign exchange trading was the domain of large financial institutions, corporations, central banks, hedge funds, and wealthy individuals. The emergence of the Internet has changed all this, and now it is possible for average investors to buy and sell currencies forex simply at the click of a mouse via online brokerage accounts.
Low volatility of the currency market
Daily currency fluctuations are usually very small. Most currency pairs move by less than a cent per day. This corresponds to a change in the value of the currency of less than 1%. This makes the foreign exchange market one of the least volatile financial markets. As a result, many currency speculators rely on the availability of a huge leverage effect. This can significantly increase the value of potential movements. In the forex market, leverage can be up to 400:1, but theEuropean Securities and Markets Authority (ESMA) has made the push to reduce the leverage to max 30:1. Higher leverage can be risky.
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The foreign exchange market offers investors many opportunities. However, in order to be successful in Forex trading, a forex trader must understand the basics of currency movements. TradersClub24 has been a specialist in forex trading for over 11 years and is an experienced trading coach. With the transparent training concept and the combination with a live trading room,beginners and experienced traders can get to know the reliable strategies and the specially developed tools for trading currency pairs.
Forex is an OTC market
The foreign exchange market is the “place” where currencies are traded. Currencies are important to most people around the world, because currencies need to be exchanged to conduct foreign trade and business. If you live in Germany and want to buy cheese from Switzerland, you have to pay for the cheese in Swiss francs (CHF). This means that you have to exchange euros for CHF to pay for the goods.
The need to change currencies is the main reason why the foreign exchange market is the largest and most liquid financial market in the world. It surpasses other markets in size, even stock markets, with an average trading value of around $5 billion per day.
Forex trade - when and where
A unique aspect of this international market is that there is no central marketplace for foreign exchange. Instead, foreign exchange trading is conducted electronically over the counter . This means that all transactions are made via computer networks between traders around the world and not on a central exchange. The Forex market is open 24 hours a day, five and a half days a week. Currencies are traded worldwide in the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney – in almost every time zone. This means that after the end of the trading day in the US, the foreign exchange market in Tokyo and Hong Kong will start anew.
Spot market and futures markets
There are actually three ways institutions, companies and individuals trade foreign exchange: the spot market (cash) and the futures market (forwards). Spot market trading has always been the largest market because it is the “underlying” real value on which futures markets are based. However, with the advent of electronic trading and numerous Forex brokers, the spot market has experienced a huge boost and is now outperforming the futures market as the preferred trading market for individual investors and speculators. When people relate to the foreign exchange market, they usually refer to the spot market. Futures exchanges are generally more popular with companies that need to hedge their foreign currency risks at some point in the future.
What is the spot market?
More specifically, the spot market (cash market) is the place where currencies are bought and sold at the current price. This price, determined by supply and demand, reflects many things, including current interest rates, economic performance, mood in the face of current political situations (both local and international), and perceptions of the future development of one currency over another.
When a deal is completed, it is called a “spot business”. This is a bilateral transaction in which one party delivers an agreed currency amount to the counterparty and receives a certain amount of another currency at the agreed exchange rate value. After a line has been closed, settlement is made in cash. Although the spot market is generally known as one that deals with transactions in the present (and not in the future), these transactions actually take two days to settle.
What are the forward and futures markets?
Unlike the spot market, the forward and futures markets do not trade in actual currencies. Instead, they are contracts that represent claims to a specific currency type, a specific price per unit, and a future settlement date.
In the futures market, futures contracts are purchased and sold on the basis of a uniform size and a uniform completion date on public commodity markets such as the Chicago Mercantile Exchange (CME). In the United States, the National Futures Association regulates the futures market. Futures contracts contain specific details, including the number of units traded, the delivery and settlement dates, and the minimum price increases that cannot be adjusted. The exchange acts as an intermediary between traders and ensures price determination and settlement.
Currency quotes in currency pair trading
One of the biggest confusions for newcomers to the foreign exchange market is the standard for currency price listing. In this section, we discuss currency quotes and how they work in currency pair trading.
When the price or exchange rate for one currency is set, it is always in relation to another currency. So if you try to determine the exchange rate between the US dollar (USD) and the Japanese yen (JPY), for example, the exchange rate would look like this: USD/JPY = 119.50.
Read a quote:
This is called a currency pair. The currency to the left of the slash is the base currency, while the currency on the right is called the exchange rate or counter currency. The base currency (in this case the US dollar) is always equal to one unit (in this case 1 USD), and the quoted currency (in this case the Japanese yen) is that which corresponds to one base unit in the other currency. The price means that 1 USD is the value of 119.50 Japanese yen. In other words, with 1 USD you can buy 119.50 Japanese yen.
Direct currency quote vs. indirect currency listing
There are two ways to quote a currency pair directly or indirectly. A direct currency quote is simply a currency pair in which the local currency is the quoted currency; while an indirect quote is a currency pair in which the local currency is the base currency. So if you were to consider the Canadian dollar as a local currency and the US dollar as a foreign currency, a direct rate would be USD/CAD, while an indirect rate would be CAD/USD. The direct rate varies the national currency, and the base or foreign currency remains set to one unit. In the indirect exchange rate, on the other hand, the foreign currency is variable and the national currency is fixed at one unit.
US-Dollar as Base currency
On the spot foreign exchange market, most currencies are traded against the US dollar, and the US dollar is often the base currency in the currency pair. In these cases, it is called a direct offer. This would apply to the above currency pair USD/JPY, which means that 1 US dollar = 119.50 Japanese yen.
Other Base currencies
However, not all currencies have the US dollar as the basis. The Queen’s currencies – those currencies that have historically been linked to The United Kingdom, such as the British pound, the Australian dollar, and the New Zealand dollar – are all given as the base currency against the US dollar. The relatively new euro is also quoted in the same way. In these cases, the US dollar is the countercurrency, and the exchange rate is called the indirect ratio. For this reason, for example, the EUR/USD quote is given as 1.20, because this means that a euro is the equivalent of USD 1.20.
Most exchange rates are expressed with four decimal places, with the exception of the Japanese yen (JPY), which is indicated by two decimal places.
If a currency quote is indicated as one of its components without the US dollar, it is called a cross currency. The most common currency pairs are EUR/GBP, EUR/CHF and EUR/JPY. These currency pairs expand trading opportunities in the foreign exchange market, but it is important to note that they do not have as many followers (e.B. not traded as actively) as pairs containing the US dollar, also known as majors.
Bid und Ask
As with most trading transactions on the financial markets, trading with a currency pair has a bid (purchase) and an ask rate (sale). Again, these refer to the base currency. When you buy a currency pair (Long), the Ask price refers to the amount of the quoted currency that must be paid to buy a unit of the base currency, or how much the market will sell for a unit of the base currency relative to the quoted currency.
The bid is used when a currency pair is sold (short) and reflects how much of the quoted currency is generated when a unit of the base currency is sold, or how much the market will pay for the quoted currency relative to the base currency.
The indication before the slash is the bid price, and the two digits after the slash represent the bid price (only the last two digits of the full price are usually offered). Note that the bid price is always smaller than the ask price.
USD/CAD = 1,2000/05
Geldkurs (Bid)= 1,2000
Letter price (Ask)= 1,2005
Buy this currency pair:
If you want to buy this currency pair, it means that you want to buy the base currency and therefore look at the bid price to see how much (in Canadian dollars) the market will charge for US dollars. According to the asking price, you can buy a US dollar at 1.2005 Canadian dollars.
Sell this currency pair:
However, to sell this currency pair or sell the base currency in exchange for the quoted currency, you would look at the offer price. It tells you that the market will buy 1 Us Dollar Base Currency (you will sell the base currency to the market) for a price of 1,2000 Canadian dollars, which is the quoted currency.
The currency that is first quoted (the base currency) is always the one in which the transaction is made. You buy or sell the base currency. Depending on the currency in which you want to buy or sell the base, refer to the corresponding foreign exchange pair spot rate for pricing.
Spread and Pip
The difference between the bid price and the ask price is called a spread. If we looked at the following quote: EUR/USD = 1,2500/03, the spread would be 0.00030 or 3 pips, also known as points. A pip is therefore the fourth decimal place, or the second for JPY pairs. In recent years, brokers and banks have added the fifth and third in JPY pairs respectively. This should allow a more accurate calculation.
Leverage in Forex Trading
Although these movements may seem insignificant, even the slightest point change can result in thousands of dollars being made or lost through leverage. This, too, is one of the reasons why speculators are so attracted by Forex trading – even the smallest price movement can lead to huge profits.
The pip is the smallest amount a price can move in any currency. In the case of the US dollar, euro, British pound or Swiss franc, a pip would be 0.0001. For the Japanese yen, a pip would be 0.01, as this currency is quoted at two decimal places. So in theory, if the foreign exchange quotation of USD/CHF were to be quoted, the pip would be 0.0001 Swiss francs. Most currencies trade in a range of 100 to 150 pips per day.
Differences between foreign exchange and equities
A major difference between the foreign exchange and the stock market is the number of instruments traded: the foreign exchange market has relatively few currency pairs compared to the thousands of companies on the stock market. The majority of foreign exchange traders focus their efforts on seven different currency pairs: the four main currencies (EUR/USD, USD/JPY, GBP/USD, USD/CHF) and the three commodity pairs (USD/CAD, AUD/USD, NZD/USD). All other pairs are only different combinations of the same currencies, also known as cross-currencies. This makes foreign exchange trading easier, because instead of having to choose between 10,000 shares to find the best value, forex traders only need to “stay up to date” with the economic and political news of eight countries.
Benefits of Forex Trading
Stock markets can suffer a slump, leading to a decline in volume and activity. So equity investors can only make a profit in a declining market with extreme ingenuity. In addition, it is difficult to make short selling specifically on the US stock market, as this process is subject to strict rules. On the other hand, the Forex market offers the opportunity to benefit from both rising and falling markets. They buy and sell at the same time as any trade. Short selling therefore resonates with each transaction. Because the foreign exchange market is so liquid, traders do not need to wait for an uptrend before they can enter a short position.
Margin rates in Forex trading
Due to the extreme liquidity of the foreign exchange market, the margin is low and the leverage is high. It is simply not possible to find such low margin rates on stock markets – most stock market margin traders need at least 50% of the value of the investments available as margin. More so, commissions on the stock market are much higher than on the foreign exchange market. Traditional brokers charge commissions on the spread and the fees to be paid to the stock exchange. Spot Forex brokers only take the spread as a fee for the transaction.