What is Forex – Foreign Exchange?
Foreign Exchange, Fx or The currency Market, are all terms used to refer to Forex. A Market where Foreign currency is exchanged internationally across the world. The Forex Market is by far the largest, most liquid market within the financial sector. An Average Daily Trading Volume of $5.3 Trillion US Dollars is passed through the market each day. These Transactions are made by Central Banks, Large Financial Corporations and Hedge Funds.
How does Forex work?
You do not have to be a daily trader to take advantage of the forex market. Whenever you cross overseas and exchange your money into a foreign currency, you become a trader in the foreign exchange, or forex market. In fact, the forex market is so big in the finance world, other major markets seem too small in comparison.
So how does Forex work? Forex trading is the practice of buying and selling currencies and profiting from the changes in the value of one currency against another.
How can you benefit from exchange rate changes?
Exchange rates change all the time, and forex traders attempt to profit from these changes.
The purpose of forex trading is simple. The main goal is to buy a currency at one price and sell it at a higher one. In some situation, you may sell your available currencies for even less price than what you have paid for it, in order to buy another currency at a lower price to make a better deal.
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How to know which currency to buy?
If the way traders make a profit is by cashing in on the difference between the bids and ask prices of currency pairs, the next logical question is, how much can you expect any given currency to move.
This depends on how liquid the currency is. In other words, how much of it is being bought and sold at any one time. The most liquid currency pairs are the ones with the most supply and demand in the Forex market. Banks, businesses, importers, and exporters, and traders are generating this supply and demand. Major currency pairs tend to be the most liquid. For example, the EUR/USD currency pair moving by 90-120 pips on an average day.
By contrast, the AUD/NZD moves by 50-60 pips a day, and the USDHKD currency pair only moves by an average of 32 pips a day. (When looking at the value of currency pairs, most will be listed with five decimal points. A ‘Pip’ is 0.0001. So, if the EUR/USD moved from 1.16667 to 1.16677 that would represent a 1 pip change) the major Forex pairs tend to be the most liquid, and therefore provide the most opportunities for short-term trading. However, there are many opportunities among minor and exotic currencies as well. Particularly if you have some specialized knowledge about a certain currency.
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How do currency transactions work?
Each transaction within the Forex market includes two different trades, the sale of one currency and the purchase of another. The two currencies involved in the trade are known as “currency pairs”. While it is possible to swap virtually any currency for another, the majority of trading occurs among a handful of popular currency pairs.
Calculating your profit
Imagine the spread for EUR/GBP is 0.8414-0.8415. If you think the price of the euro is going to rise against the pound you would buy euros at the offer price of 0.8415 per euro. Say in this case you buy €10,000 at a cost to you of £8415.
The spread for EUR/GBP rises to 0.8532-0.8533 and you decide to sell your euros back into pounds at the bid price of 0.8532. The €10,000 you previously bought is now therefore sold for £8532. Your profit on this transaction is £8532 minus the original cost of buying the euros (£8415) which is £117. Note that you can always determine your profit in the second currency of the forex pair.
Alternatively, suppose in the first instance you think the price of the euro is going to fall, and you decide to sell €10,000 at the original bid price of 0.8414, for £8414.
In this case, you are right and the spread for EUR/GBP falls to 0.8312-0.8313. You decide to buy back your €10,000 at the offer price of 0.8313, a cost of £8313. The cost of buying back the euros is £111 less than you originally sold the euros for, so this is your profit on the transaction. Again you determine your profit in the second currency of the forex pair.
How The Forex Market Is Different to Other Financial Markets
There are some main differences between foreign exchange and other markets. First of all, there are fewer rules. This means investors do not have to keep up with strict standards or regulations as those in the stock. That means there are no clearing houses and no central bodies that oversee the forex market. Second, because trades are not happing on a traditional exchange, you won’t have to pay the same fees or commissions that you would on another market. Next, there’s no cut-off as to when you can and cannot trade. Because the market is open 24 hours a day, you can trade at any time of day. Finally, because it’s such a liquid market, you are free to get in and out whenever you want and you able to buy as much currency as you would like and afford.
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What does Forex spread mean?
The difference between the bid and ask price of a currency pair, in Forex, is called the spread. For example, if the Bid price of the EUR/USD is 1.16678, and the selling price is 1.16679, the spread will be 0.0001, or 1 pip. For a Forex trade to become profitable, the value of a currency pair will need to cross the spread. As mentioned in the previous example, if a trader entered long on EUR/USD @1.16678, the trade would not be profitable until the value of the pair was higher than 1.16679.
If a currency pair involves a wider spread, like the EURCZK, the currency will need to make a greater move in value to make the trade profitable. For example, if the bid price for this pair is 25.4373, while the asking price is 25.4124, so the spread is 0.0200, or 20 pips. It’s quite usual for this currency pair to have movements of less than 20 pips a day. This means that their trader will have to perform a multi-day trade to make a profit.
So in most cases, low-spread trading is a priority for Forex traders, as it’s more likely to make a profit in less time, meaning that they can make a high volume of smaller trades, rather than relying on larger trades to make money.
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