Forex Basics

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What is Forex Trading?

Open 24 hours a day and with average daily turnover of $4 trillion the forex market is the largest traded and most liquid market in the world. At the heart of it forex is about speculating on the exchange rate of one currency against another for example the Euro vs. the US dollar. Most of the trading activity takes place on the major currency trading pairs which pit the US dollar against currencies of countries such as the UK, Switzerland, Japan and of course countries within the Eurozone that have adopted the Euro as their currency.

There are several layers of participants in the forex market and at the top is the inter-bank market which is made up of the largest commercial banks, this type of participant accounts for an estimated 53% of trading. Next are smaller banks, hedge funds, pension funds, retail FX market makers together with large corporations. It is estimated that 70-90% of the trading transacted in foreign exchange is speculative in nature which means that the person or institution trading has no intention of taking delivery of the currency but rather seeks to profit from price movements

What Affects Currency Rates?

The question of what affects currency rates is a common one. Forex is no different to any other market in that information is the key driver. There are many cross-currents affecting currency rates at any one time, after all the forex market is setting the value of one currency pair against the other so at a minimum you are looking at the themes affecting two major international currencies. Currency rates are affected by a mix of both fundamental data and technical analysis but like in any market trader psychology and market sentiment play a role too.

Fundamental Data

Fundamental economic data reports are important to market participants since they provide an insight into the health of an economy relevant to a particular currency. Data reports can stir up a market and get prices moving. Fundamentals include:

  • Interest rates
  • Monetary policy
  • Economic data reports
  • International trade and investment flows

Technical Analysis

Technical analysis is the study of charts analysis, pattern recognition and momentum and trend analysis. This type of analysis is especially important to traders in the foreign exchange market due to the large volume of fundamental information released. Traders use technical analysis to refine their trading strategies with some even use technical indicators alone.

Pips - How Forex Profits & Losses are Calculated

In the forex market prices are quoted to the fourth decimal point. For example a EUR/USD bid might be 1.4288 and an ask might be 1.4291. In this example the spread is 3 pips. The only exception to this is the Japanese Yen which is quoted only to the second decimal point. Profits and losses in forex trading are calculated by the movement of pips.

Let’s assume that we are trading 100,000 EUR/USD position, also known as a standard lot. The example below using an exchange rate of 1.4291 shows us that for a position size of this size every pip movement will result in a profit or loss of $10.

.0001/1.4291 x 100,000 = 6.9974 x 1.4291 = $10 per pip

What is Leverage?

Leverage is a loan that is provided to an investor by a brokerage allowing the investor to potentially increase the value of returns achieved on a position. The leverage available to investors within forex market is the highest available when compared to any other investment market. Within the forex market it is common for brokerages to offer 100:1 leverage meaning that a deposit of only a $1000 would be required to maintain a position of $100,000. Although this level of leverage may seem high it is important to remember that it is uncommon for currencies to move more than 1% during a trading day.

Although the potential for much larger profit using leverage is evident it can also work against the investor since the possibility of incurring rapid losses exists. In order to control these risks traders usually implement stop and limit orders.

Advantages of Forex Trading

  • 24 hour trading, the forex market is open from Sunday evening at about 5 pm EST and stays open until Friday afternoon about 5 pm EST.
  • Largest liquidity pool of any market making it possible to quickly enter and exit trades.
  • Profit in both rising and falling markets by taking both long and short positions.
  • Leveraged trading requiring low initial margin requirements from traders.
  • Low transaction costs due to the large amount of liquidity in the market.

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