Forex, the acronym for foreign exchange, is a complex word with simple logic. You might have heard people use this acronym a lot and find it fascinating. After reading this blog, you can also be that cool guy in the group talking about Foreign exchange trading.
First, let us understand it with an easy example. Assume that you go on a trip to the USA with your parents and you have 1 Lakh Rupees with you. Since you are going to some other country, the Indian currency would not work there. So, you have to use the other currency or, in this case, "Dollars". So, when you reach the airport, your Indian currency will be changed to Dollars according to the prevailing (spot) currency exchange rate.
Let us say, at that time, the spot rate is Rs. 72 for a dollar. Thus, you will be given $1388 (approx) in exchange of your 1 lakh rupees. Assume that you don't spend your money as you had your relative living there who bare all your expenses. So when you go to the U.S. airport while heading back to India, you'll obviously want back Indian Rupees in exchange for the dollars you have. Suppose now, $1 is Rs. 75 at that time, thus fetching you approximately Rs. 104100. Meaning, you just got paid for visiting some other country! That's awesome, isn't it?
If you understood the above example, Congratulations!! You just understood how foreign exchanges work. But the case could be the opposite, as well. So, be grounded and read on.
Let's start from the basics.
What is Foreign Exchange?
In simple words, foreign exchange is the trading of currencies in the international market. For example, one can swap Indian Rupees with U.S. Dollars. It is the most liquid market in the world. With more than 6 trillion dollars, it's the most significant financial asset market. It is a globally operated market and is open 24 hours a day, five days a week (Monday to Friday).
Although there are many practical purposes of forex trading, most people pursue foreign exchange trading to earn a profit. The volatility of the market makes it so attractive to traders, as higher the volatility higher are the chances of gain. Anyway, you might be thinking how these markets work. Let's see.
How do Currency market Works?
In India, we all know equity trading takes place through the two big exchanges NSE ( National Stock Exchange) and BSE ( Bombay stock exchange), but that is not the case with foreign exchange as forex trading does not take place in exchanges but directly between two parties in an Over the counter exchange (OTC) market. You can trade forex for 24 hours a day as there is no centralized location as such. The forex market is run by a global network of banks spread across four major forex trading centres: London, New York, Sydney and Tokyo.
Different Types of Forex Market
There are three types of Forex market:
1. Forex Stop Market
When the physical exchange of currency pairs takes place at the exact point when the trade is settled or when it is done 'on the spot' or within a short period, it is called the foreign spot market. For instance, refer to the example we began this article with.
2. Forward Forex Market
When a contract is agreed to buy or sell a certain amount of currency at a specific price that is to be settled at a set date in future or within the range of future dates, it is called forward forex exchange.
3. Future Forex Market
When a contract is agreed to buy or sell a certain amount of currency at a specific price and date in future, but in this case, unlike forwards, futures contracts are legally binding.
So now, let us have a look at the most popular currencies:
Most Popular Currencies
• The U.S. dollar
• The Euro
• The Pound Sterling
• The Japanese Yen
• The Swiss Franc
These currency combinations form the group of major Forex currency pairs:
• EUR / USD
• GBP / USD
• USD / JPY
• USD / CHF
You might be thinking about the movement of these markets. Let us understand what creates a trend in the forex market.
What Moves the Forex Market?
In forex trading, you speculate the movement of exchange prices while buying one currency and simultaneously selling the other. There may be various reasons for this price change, including economics, geopolitical, and technical factors. Primarily, the change in rates is due to supply and demand laws, but since it comprises so many currencies, it is difficult to predict this market. It is essential to understand the influences that drive the change in the forex market. Let us look at some factors that affect the market.
The central banks control supply as their decisions have a significant impact on their currency's price. Let us understand this with an example. If central banks inject more money into the economy, it will lead to a drop in the currency price and vice versa.
We have all seen this while investing in the equity market; whenever there is positive news about a stock, the stock is likely to go up, whereas when there is negative news, it is likely to go down.
The same happens with the forex market too. Investors and commercial banks are more likely to put their money into economies with a strong outlook. So if there is positive sentiment about an economy, it is expected to attract investment and hence the demand for its currency increases. Unless there is a parallel increase in supply for the currency, this situation will increase the currency price. Similarly, a piece of negative news is likely to reduce investment and decrease the currency's price.
Market sentiment is the reaction of the people to specific news; it also influences the price of the currency as traders make their trades according to the market sentiment and move the price of the currency accordingly.
Credit rating, in layman terms, is the capability of a country to meet its debt obligations. A country with a high credit rating is seen as a safer investment option by the investors, and they are more compelled to invest in the country. Contrary to that, if the rating is downgraded, the likelihood of investors investing in the currency decreases.
How to Trade Forex?
You can trade forex simply by simultaneously buying one currency and selling the other. Traditionally forex trades were made using forex brokers, but today with the rise in technology and online trading, you can take advantage of price movements in forex through derivatives like CFD (Contract for Differences). You might be thinking about what CFD is. Let us understand it first.
So if you cannot buy the full value of a trade, you can open a position for just a fraction of the value of the trade. In this case, you don't take ownership of the trade, but you just take on a position. It works both ways, i.e. it can subsequently increase your profits or increase your losses.
Trading in forex is an easy process nowadays. Let us look at the procedure.
- First, you have to decide how you would like to trade, as there are two ways to trade forex CFDs or trading forex via a broker.
- Now, you should learn how the markets work as forex is bought and sold via banks' network. It is called Over The Counter (OTC) market. These banks offer a bid price to buy a particular currency pair and a quoted price to sell a forex pair.
- Now, you have to open an account with a leveraged trading provider.
- After opening an account, it is essential to build a trading plan.
- Choose a suitable trading platform according to your financial goals and needs. Now, you can start trading.
Now let us understand some complex terms that you may need to know before getting into Forex trading.
Some Important Terms
The difference between the bid (sell) price and the ask (buy) price of a currency pair is called the spread. The bid price is the price at which you can sell the base currency, whereas you use the ask price to buy the currency.
Currencies are traded in lots – batches of currency used to standardize forex trades. Standard lots are very large and very expensive for an individual trader, so for that reason, almost all trading in forex is leveraged. A standard lot is 1,00,000 units of the base currency.
With leverage, you can have exposure to large amounts of currency without paying the whole amount of trade upfront, in layman terms. Leverage is a way for a trader to trade many significant volumes than he usually would, using his limited capital.
Margin is the amount that traders need to put forward to open a trade. You only need to pay a percentage of the full value of the position to open trade while trading forex on margin. For example, instead of depositing 1,00,000 for your position, you may only need to deposit 1,000 if the margin percentage required is 1%.
The unit used to measure movement in the forex pair is called pip. A forex pip is usually equivalent to a one-digit movement in a currency pair's fourth decimal place. If GBP/USD moves from $1.35271 to $1.35281, it has moved a single pip. The places of decimal shown after the pip are called fractional pips.
The bottom line
Forex, at first instance, might entice you to dive in. It's so fascinating because you'll be exposed to matters beyond your country. And the lucrative an investment seems to be, the risky it is. Remember, there are no free lunches. Thus, don't enter a trade you have no knowledge of. Hope our blog should have given you a brief idea about the forex trade. However, there's a lot more than that. If you're planning to dive into the forex waters, learn to swim first.