What is Forex Trading & How does it work?
The world’s money market where currencies are sold and bought simultaneously is what we call foreign exchange or, simply, Forex. It is simple to understand if you have traveled abroad. Because if you have, then you must have exchanged your national currency with the currency of that country.
What is unique about Forex is that the exchange always requires a pair of currency. For instance, for Euro, you sell dollars, and so on.
Forex is the world’s largest financial market in terms of volume, more than the combined commodities and stocks volume in daily transactions. According to the 2019 Triennial Central Bank Survey, the daily volume is more than 6.6 trillion US dollars.
Another distinctive feature of the Forex market is the unavailability of any physical location or a centralized exchange system. Instead, it runs on an electronic network of various banks, companies, individuals, and other entities. Moreover, because the currency market lacks any physical exchange, this market works 24 hours a day and five times a week.
The Basics Of Currency Trading
Since the dawn of Mesopotamian civilization 5000 years ago, people started to use money (coin) for exchange. The world has evolved into different nation-states. Now every country has its currency. So any currency supported by an existing government can find a place in the mammoth forex market. However, not all national currencies are the same. Some are traded more frequently than others. For example, the bulk of forex trading happens in seven currencies: USD, EUR, JPY, GBP, CHF, CAD, and AUD. The rest of the national currencies are referred to as either minor or exotic. Most experts may advise you to stay away from exotic currencies.
Every national currency is indicated with the first three letters; the first two identify the country and the last one, its currency. For instance, in USD, the US is the United States and D for dollars. Forex trade requires two different currencies, buying and selling. When you start learning about the money market, you will come across various trader’s terms such as pairs, crosses, majors, minors, exotics, and so on.
The currency pairs
A forex trade always happens in a pair. You sell a currency for another. A forex broker or a CFD provider is the middle link that connects the buyers and sellers worldwide. They quote a pair in the relative value of one another. For instance, USD/EUR is mentioned as 0.84 at the current market price. That means one USD equals 0.84 Euro.
But you might ask why national currencies are valued differently? Well, factors range from the health of an economy and interest rate to market sentiments and others. We will touch upon these later; let’s focus now on major currency pairs. As you have guessed, it consists of currencies from major economies like the US, Japan, Great Britain, and others.
Major Currency Pairs
Major currency pairs always involve the USD. Therefore, these seven pairs are most traded in the forex.
| Pair | Countries/Region |
| USD/EUR | US and European Union |
| USD/JPY | US and Japan |
| USD/GBP | US and Britain |
| CAD/USD | Canada and the US |
| USD/AUD | US and Australia |
| NZD/USD | New Zealand and the US |
These currency pairs dominate the forex market and also are most liquid. Liquidity in forex is defined as the activity in the market. If a significant number of traders are dealing in these currencies, they are the most traded currencies and have a much bigger volume than other pairs. For instance, USD/EUR is forex traders’ darling and more liquid than AUD/USD.
Cross-currency pairs (Minors)
Those major currency pairs without US dollars are often called “minors” or “crosses.” The most-traded crosses include EUR, GBP, and JPY. Although they are not as liquid as major pairs, they provide many opportunities to profit from trading.
Examples include:
| Crosses (Minor Currency pairs) | Countries and Region |
| EUR/GBP | Europe and Great Britain |
| EUR/CAD | Europe and Canada |
| EUR/JPY | Europe and Japan |
| GBP/AUD | Great Britain and Australia |
| AUD/CAD | Australia and Canada |
| CAD/CHF | Canada and Switzerland |
Exotic Pairs
You might think that a couple unusually dancing at a gala can be an exotic pair. Well, you are pretty much close! In the forex market, exotic currency pairs can fluctuate. Combining one major currency with a currency from a developing country forms an exotic currency pair. For example, the pairing of the USD and Brazilian currency is a good example.
Some other examples include:
| Currency Pair | Country/Region |
| USD/BRL | US and Brazil |
| ZAR/USD | South Africa and the US |
| RUB/USD | Russia and the US |
| EUR/THB | Europe and Thailand |
| EUR/PLN | Europe and Poland |
Unlike major currency pairs where the spread is tighter, the exotic pairs can have twice or thrice the USD/JPY spread. They are also relatively less liquid than crosses. They are also more susceptible to market changes, economic and geopolitical developments. The most recent example is Venezuelan currency, which was nosedived to an extremely low level. So be careful when you decide to deal in exotic.
WHO IS A FOREIGN EXCHANGE TRADER?
The short answer is anyone with the intention of exchanging his money for another national currency. But there are two broad categories of traders, companies and governments, and investors—the former consists of entities buying and selling goods and services globally. For instance, when a European company buys raw materials from China, it must pay in Chinese currency, yuan. But this is just a small percentage of daily forex volume. Their trading is called hedging.
The leading traders are global investors such as banks, hedge funds, HNI, financial institutions, and others. Unlike businesses, this group trade for profit or speculation. Although retail trading has grown exponentially in the last few decades, they still take a tiny percentage of forex volume.
Today, a wide range of players from banks to online retail traders either speculate on a currency pair’s price movements or hedge their exposure in other markets to reduce the risk of currency movements.
DIFFERENT WAYS OF FOREX TRADING
Forex trading requires financial instruments. Each instrument is designed for a specific type of investor and trader. For instance, Swaps and Forwards are ways of how institutional traders buy and sell currencies. Futures, Options, ETFs, and Spot FX are other important trading instruments. If you’re interested in retail trading, Spot FX is the way to go. Let’s look at some practical financial tools before we return to our main agenda, Spot FX.
Currency Future:
A futures contract is an agreement to purchase or sell an item at a defined price on a specified future date. Futures are a type of derivative that helps protect against fluctuations in currency prices. For example, if you think the EURO will rise in value relative to the USD, you can buy a futures contract to lock in the current, lower EURO price. This is an advantage for investors who want to hedge their bets and not be exposed to the unknown risks of changes in currency prices. The futures contracts are standardized and traded on a centralized exchange like Chicago Mercantile Exchange (CME). It is one of the few well-regulated trading instruments in forex.
Currency Forwards
A forward currency contract locks in the price of a currency for future exchange. A currency forward is a customized hedging strategy that does not need a cash advance from the investor. A currency forward offers additional benefits as well, such as the flexibility to set customized conditions for a certain amount and a specific maturity or delivery time.
Forward currency contracts are different from conventional hedging strategies such as currency futures and options since these contracts, among other things, usually involve upfront payment for margin needs and premium payments. Nevertheless, a currency forward is inflexible, meaning that the contract buyer or seller will have a contractual duty if the “locked-in” rate is shown to be unfavorable. Therefore, financial institutions that deal in currency forwards must ask for a deposit from ordinary investors or smaller companies to offset the risk of non-delivery of non-settlement.
Currency ETFs
An ETF that invests in many currencies gives exposure to one or more currencies. Ordinary folks may get forex exposure by investing in currency ETFs, which manage their investments without the additional hassles of placing individual transactions. Exchange-traded funds (ETFs) are suitable for speculating on currency markets and being used to diversify portfolios and for currency risk mitigation.
Financial institutions establish and run the Exchange Traded Funds (ETFs), holding single or combination currencies. Then these funds are put on sale for the public. They are similar to stocks and are tightly regulated by financial commissions. However, like currency options, currency ETFs have the drawback of not being available 24 hours a day. ETFs also incur trading fees and other transaction costs.
Spot FX
The spot FX is the simultaneous sale and purchase of a currency at the current market prices. Unlike Options or Futures, it takes just two days for settlement. The current market price is also called the spot price. Many individuals worldwide prefer spot FX as it has a narrow spread and requires smaller amounts for trading. It is an over-the-counter (OTC) market meaning there is no centralized location for currency exchange. It also means that customers can directly trade with a counterparty. So, essentially, it is a private agreement between the two parties.
Most spot trading happens over the electronic trading network. The primary market for spot trading is “interdealer,” where various forex dealers trade between them. A dealer acts as an intermediary that buys and sells currencies at any time. As banks are the leading players of the spot FX, it is also known as the “interbank” market.
This market deals in bulk orders. That’s why only large financial institutions such as banks, insurances, pension funds, MNCs, and other holdings are part of spot FX trading. Interestingly, this currency trade is that you are buying or selling a contract, not the currencies themselves. You enter into an agreement that specifies the agreed-upon price at which the deal will happen. For example, if you buy EUR/JPY on the spot, you will receive a fixed amount of Japanese yen in exchange for euros at the current market price.
The settlement of the agreement usually takes two working days before the payment. So it’s not such a simultaneous transaction as the name suggests. Also, remember that retail investors are not part of spot FX.
Retail FX
As most trading options are limited to institutional investors, the retail FX allows ordinary people to trade in currencies. The retail FX providers are usually OTC dealers and brokers. It is somewhat similar to the Walmart store, where the franchise sources products from individual producers and puts a price tag on each product. You are the buyer of these products.
What differentiates retail forex from other trading options is the availability of leverage. Leverage allows you to bet a large sum of money on trade with a tiny fraction of total trade value. For example, a broker can offer you a 50:1 leverage ratio. That means if you deposit USD 2000 in your trading account, you can order a USD 100000 trading order. But imagine what happens when you lose the trade; how would you pay USD 100000 to the broker. It seems risky, doesn’t it?
It might surprise you to know that nobody takes delivery of any currency in forex trading. As mentioned, you’re not trading any actual money; you are trading a contract. And this contract is unlike any other agreement, and it is a leveraged contract. Retail traders neither take nor makes any delivery of the leveraged spot forex contracts. Your trading volume is simply “rolled over.” More on this in the later segments.
CFD Trading
CFD stands for contract for difference. It is one of the most popular trading instruments among retail investors. A big brokerage house can offer various trading opportunities in metals, currencies, commodities, indexes, and more. CFDs, on the other hand, are a type of derivative trading. That means the value of a CFD depends upon the underlying asset, which can be anything, a currency, or an equity index.
CFDs allow traders to speculate on price changes without owning the underlying asset. As a result, CFD traders can avoid some of the difficulties and expenses associated with conventional trading because they do not own the underlying asset. The profit and loss are determined by when you purchased CFDs and when you would sell them multiplied by the number of CFD units.
Working of Forex Trading With Example
- Forex trading is easily accessible for retail traders through CFDs. Forex trading in South Africa is regulated by FSCA of South Africa.
- Traders need to open their accounts with an FSCA-regulated broker. After that, they can place trading orders on available forex pairs through electronic trading platforms from electronic devices.
- Each broker has different trading conditions, offers different instruments, charges different fees, and supports different trading platforms.
- Brokers with STP/ECN execution method pass on the trade orders to the liquidity providers where orders are matched with other trade orders of opposite sides. The market maker can match opposite orders and can also take the other side of the trade themselves.
- After opening the position, traders can see the profits and loss amount on their trading platform as the price moves with time. Traders can also modify the take profit or stop loss after opening the position.
- On a long position of 1 standard lot, 1 pip upward price movement will generate a profit of $10. 1 pip downward movement will incur a loss of $10.
- Once the position is closed the profit amount will be added to the account equity and losses will be deducted from the same.
SHOULD YOU TRADE FOREIGN CURRENCIES?
In your international relations 101, you might have heard of an “interdependent or interconnected world.” It might be debatable whether countries are really interconnected or not, but financial interdependency is quite visible. Since the decline of Bretton Woods in 1971 and the advent of the free-floating system, national currencies freely float against each other. Almost every country is financially linked to each other. For instance, the US subprime lending crisis in 2008 affected most emerging economies. However, there is a silver lining in this interconnected world. And the mammoth forex volume is a testimony of that. The free-floating regime provides numerous opportunities to make a profit from price changes in one currency against another. If you understand the basics of forex trading, you can also generate colossal profit if you know the risks.
Main benefits of forex trading are:
No middlemen and No commission
The ECN does away with mediators and hefty commissions. Also, online trading is free from any clearing fees and commissions if you trade with a market maker.
High Liquidity
FOREX is the world’s most liquid market, with an average trading volume of more than $5.5 trillion per day. It means that a trader can join or quit the market at any time and under nearly any market conditions.
24-hour market
The market that never sleeps can offer you significant advantages. For example, the forex market operates 24 hours from Australia to the US, five times a week. It means even part-time individuals can also trade, pick any time, day or night.
Higher Leverage
Forex leverage allows trading with much more money than the trader has. Forex brokers offer their clients different percentages of leverage, which means that, for example, a person who has 1,000 can control 10,000 worth of currency. Both commercial and retail traders use leverage to increase their market exposure in order to profit from small price movements in their favor while limiting losses from unfavorable moves against them. The currency market has enormous volatility, which makes it challenging for traders to predict how much they can make on a trade. The higher the leverage ratio you use, the more you’ll be able to make on any given transaction (or lose). Forex leverage provides an increased probability of success and increases your risk many times since losses can be huge when the trading order results in a loss. Therefore, leverage, although it maximizes the profit potential, can also lead to huge losses.
No entry barrier
You’d think that starting out as an FX trader would be extremely costly. The truth is that it does not, when compared to trading stocks, options, or futures. Online brokers provide “mini” and “micro” trading accounts, with some requiring a $50 account investment.
No investment for the practice
Want to hone your trading skills but don’t want to put in any real money, choose a demo account. Many online brokers offer a demo account with preloaded virtual money. Newcomers can take advantage of demo accounts before investing.
Risk of Forex Trading
The following are the major components of risk factors involved in forex trading:
- Leverage Risk
High leverage allows traders to open bigger positions with smaller deposits but it will also increase the risk. In case if the price moves against the anticipation, traders with high leverage will face a higher % of loss and sometimes can also lose whole account equity. - Country Risk
Each currency is used in different countries. The economic, geopolitical, or any other event in a country can affect the prices of its currency against other currencies. A country may face crises, floods, trade deficits, etc that can dramatically affect the prices of the currency pairs. - Counterparty Risk
When you are making a deposit to a broker, your broker holds your possession. Some fake brokers can also run away with your deposits or put restrictions on withdrawals. This risk is also known as third-party risk and can be mitigated by choosing a regulated and trustworthy broker for forex trading. - Position Close Out
When a large position is opened with a little amount left in the account balance, price movement against the anticipation will force close your trading position. This will lead to sudden closing of position in severe loss even when you don’t want to. The trading position can be closed before it reaches the stop-loss level.