What is forex trading?

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The forex industry is the global market used for exchanging currencies. It is also referred to as the foreign exchange, FX or currency market. As such, the forex market is used for a variety of reasons such as tourism, commerce and currency trading.

An estimated $5.1 trillion is traded each day on the forex market, making it the most liquid market globally.

The trading of currencies dates back hundreds of years when silver and gold were valued by their size and weight and then traded accordingly. Copper later became a player when it was used to create coins at a lower value.

During the middle ages the world’s oldest bank, Monte dei Paschi, was built in Italy with the primary function of trading currencies. A few hundred years later the first forex market was created in Amsterdam, the Netherlands, and went on to expand exponentially.

With modern forex trading, central banks conduct monetary policies for economic growth and price stability. These policies influence the forex market greatly as they determine interest rates, resulting in exchange rate movements.

Traders, commercial banks, brokers and hedge funds profit from these movements by speculating about the exchange rates, buying a currency for a low price and then selling it for a higher price when the market rate changes.

The forex market is open 25 hours a day, 5 days a week, as this is when international banks operate, essentially acting as an anchor point for trading currencies. These trading centres are spread across different time zones, including Sydney, London, New York and Tokyo.

The forex market is divided into three groups, namely spot forex, forward forex and future forex.

Spot forex is the exchange of a currency pair on the spot or at the exact time the trade is made. Forward forex occurs when there is a price, time and date set to buy a currency. Future forex is similar to forward forex, with the exception of a legally binding contract.

Forex trading is the selling of a currency from one country while buying a currency from another on the forex market. As such, forex trading is done in currency pairs (for example USD/ZAR), which are referred to as the base and quote currencies.

The first currency in the forex pair is the base currency, which is bought while selling the second currency, called the quote currency. The price of the pair is estimated by how much a unit of the first or base currency unit is worth in the second or quote currency.

A currency symbol consists of three letters, for example ZAR. The first two stand for the country, in this example South Africa, and the last symbol stands for the currency of that specific country, in this case the Rand.

In other words, ZAR is an abbreviation for the South African Rand and USD is an abbreviation for the United States Dollar.

Forex pairs are classified into major, minor and exotic groups. Major currency pairs are those most frequently traded in the world and usually include the USD. The cost for trading these pairs is usually lower as they makes up an estimated 80% of all currency pairs traded.

Minor currency pairs are traded less frequently than majors and usually hold major currencies that do not include the USD. Exotic currency pairs hold a major against one of the smaller, lesser used currencies from small economies.

Forex is usually traded using a forex or CFD broker.

When choosing a forex broker, it is very important to select one that is authorised and regulated by the financial institution which prevails in a specific region. Regulated brokers are by law accountable to provide safe and secure trading practices.

Other factors to keep in mind when choosing a good broker are the supported platforms, maximum leverage, costs and fees, funding options and the variety of financial instruments offered, as well as the research and educational tools a trader has access to.

CFDs (Contract for Difference) enable a trader to speculate on forex and other financial markets without actually buying the underlying assets. Instead, the trade derives its value from that specific asset’s value, thereby making it a derivative. CFDs are leveraged products.

Leverage is a loan from the broker granted to a trader to buy a currency pair or invest in assets. Leverage ratios are controlled by the broker’s regulating financial institution and differ in several regions.

Leverage allows a trader to gain exposure and potentially increase profits significantly with a small initial investment, called a margin. For example, with a leverage ratio of 1:500, a broker will provide $500 for every $1 invested by the trader.

Leverage can also potentially amplify losses as the risks are higher, especially when the loss exceeds a trader’s margin. Traders should always keep this in mind and make sure they fully understand the risks involved in leveraged trading.

Spreads also play an important role when trading forex. Spreads are the difference between the buy and sell prices on a pair. Spreads are measured in pips, and are typically the means by which a broker makes a profit.

Currency units bought or sold by a trader are measured in lots.

To trade forex successfully, one needs to understand market movements. As currencies from around the globe are in constant use and can be extremely volatile, speculations on exchange rates can be very difficult to determine correctly.

Supply and demand are major factors to consider when speculating and trading the forex markets. With increased currency values, one can say that the demand is greater than the supply and with decreased currency values, the supply is greater than the demand.

By understanding the influences which drive demand, traders can make informed decisions and potentially make massive profits.

As previously mentioned, central banks play a significant role in the interest rates of a currency, affecting the economy and the exchange rate movements.

The value of a currency is a reflection of its region’s economic stability. Staying updated with world events is important, as positive news will result in higher investor percentages in that specific region, increasing demand for the currency and vice versa.

Most brokers offer a free demo account that simulates a real trading environment. Potential traders should always consider this option before opening a live account. When opening a live account, it is suggested that beginners start off with small, manageable amounts.

 

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