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What is Forex Trading?

By Edited Aug 2, 2016 0 2

Foreign Exchange Market (FOREX)

After persistent advertising and bold promotional work by brokerage houses across the globe the forex, or foreign exchange market,  is growing in popularity and attracting investors money in the millions. In an area that was traditionally solely the domain of large investment banks and institutions there is now a growing public retail market. 

But what actually is the Forex market and how does it differ from more traditional investing vehicles?

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What is Forex?

The foreign exchange market or Forex is simply the trading of one currency against another with the aim of making a profit. It's that simple.

Have you ever been on vacation to another country in which you needed to change dollars into another currency? Well you have participated in the foreign currency markets!

Here's an Example

Lets say you are going on vacation to Europe.  Your uncle Giuseppe lives in Italy and you haven't seen him in years so are planning to pay him a visit.

Now you need some spending money and you know that Italy doesn't have the American dollar as it's currency. If you want to buy some of the local pizza's and fabulous ice cream then you'll need some local currency, in this case it is the EURO (abbreviation EUR).

You have $1,000 american dollars which has the abbreviation in Forex of 'USD' that simply stands for the United States dollar. So in summary you need to exchange USD for EUR.

Let's say the exchange rate is 1.2845. This means that for every 1 dollar you will receive 1.2845 euros.

 USD                                                     EUR

      1                        equals                    1.2845

  1000                     equals                   1284.50

 

So for your $1,000 USD you receive 1284.50 EUR. (In reality you will receive less because you'll be charged a small amount by the company for the transaction, but let's ignore fees to keep it simple.)

You have a great two weeks in Italy. Uncle Giuseppe is so delighted to see you that he pays for everything for the two weeks and doesn't allow you to spend a cent. You're delighted and return home to America with the 1284.50 EUR still in tact.

When you return home the exchange rate has changed and is now 1.2450. That means that for every 1.2450 Euros you hand back you will receive $1 USD. So let's do the maths;

  EUR                                                  USD

1.2450                  equals                       1

1284.50                equals                   1031.72

So after your holiday you have $1031.72 USD for your original $1000 USD or a profit of $31.72 Not bad!

This is what forex traders hope to do on a daily basis but only on a larger scale.

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So What Makes the Exchange Rates Move?

So once you understand to make money the exchange rate needs to move, the next logical question is what actually does makes them move?

Well, the first thing to note is that a currency is always stated in relation to another foreign currency. You never hear about the exchange rate between the USD and the USD because...well it'll always be an exchange rate of 1! One dollar will always equal one dollar.

So the dollar is paired up against other currencies like the Japanese Yen, the Euro, the Great British pound, and so on.

If you think about the exchange rate between any two currencies think of the countries as a big company. Good news for one country such as less unemployment is good for that economy and so strengthens the currency.

Bad news for the country such as increased borrowing from the government will weaken the underlying currency and will reduce the value is relation to other currencies.

Why is it Becoming More Popular?

The Forex market is becoming more popular for a number of different reasons:

Reduced Portfolio

The major currency pairs are the USDJPY, EURUSD, GBPUSD and the USDCHF (CHF stands for the Swiss Franc). This is where the majority of forex trading occurs and forex traders only have to look at these 4 pairs. If you compare forex to stocks and shares it can be quite appealing. There are now 3796 Stocks listed on the NYSE and over 3000 in the NASDAQ so keeping an eye on 4 currencies sounds much easier than following over 6000 stocks.

Opening Hours

Stock exchanges are usually open between 8:00am in the morning and around 5:00pm in the evening but this isn't the case with Forex. The trading day starts in Asia/Australasia and as the day progresses Europe opens and then the American session. Each session overlaps with the next so it is possible to trade from late sunday night until late friday night so that 24/5 trading.

Less Manipulation

Have you ever noticed that with stocks there can sometimes be a sharp decline in value and eventually news comes out of a profit warning or some scandal that rocks the share price? The sharp selling occurred before the news because there were people inside the company that knew and sold before it was public knowledge. With Forex trading this is much rarer as countries economies move much slower and reporting on the financial health of a nation is much more transparent.

Volume

Another great advantage to forex over stocks is the vast volumes available in the foreign exchange market. Imagine that you have a chunky amount like $50,000 to invest and a small cap stock takes your fancy. You see that the price is $0.50 and you know that is good value for such a good company so you decide to invest. You phone your broker and he offers it at an average value of $0.60 per share. Why the difference you ask? Well because there are so few shares available your broker has to go around to other brokers and get $50,000 of shares together and this increases the value. With forex it's different. One investor could invest $10 million dollars and the market wouldn't even move.

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Comments

Jun 6, 2012 1:08pm
askformore
Your article gives very good (and easy to understand) information about Forex Trading. Thumbs up!
Jun 7, 2012 2:59am
toebunkers
Many Thanks. I try to be as clear as possible, especially when they are so many confusing articles about Forex that are meant to be for beginners.
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