The Forex Market
Understanding The Basics
There are many appealing aspects to speculating on the shift in value of one currency compared to another on the Foreign Exchange Currency Market (Forex). This article, however, is intended to provide new traders with a basic framework of what exactly takes place in the Forex market in order to clear a pathway to understanding how to trade currencies for the purpose of income generation.
A Brief Explanation of the Currency Pair
Through state of the art Forex trading platforms, Forex brokers offer clients the ability to speculate on the change in value of one currency compared to another. These are known as “currency pairs,” and the Forex broker decides which currency pairs to offer. New and intermediate traders and for that matter, experienced traders, will be well served by the advice to concentrate on currency pairs involving the seven major currencies: The U.S. dollar, euro, British pound, Swiss franc, Canadian dollar, Australian dollar and the Japanese yen. The economies of the countries where these currencies originate are diverse, so one sector of the economy will not usually generate wildly unpredictable changes in currency value, yet they fluctuate enough to offer valid trading opportunities.
Approximately five trillion dollars’ worth of currency is exchanged every day. About $1.3 billion of that total is the EUR/USD currency pair, making this pair by far the most traded pair. Fourth place belongs to the AUD/USD currency pair, making it a popular component of the Forex market.
Understanding Currency Pair Quotes
Using the just mentioned currency pairs, in the EUR/USD, the euro is known as the “front” or “lead” currency and the U.S. dollar is the “quote” currency. The front currency is sometimes called the base currency of the transaction currency, but all of these terms simply mean the first currency listed in a currency pair quote. A recent quote on one major broker in the Forex market would have looked like this: Sell 1.07170/Buy 1.08183. This simply means that a trader who wanted to sell this currency pair would pay 1.07170 dollars for every euro, while someone wanting to buy the pair would pay 1.07183 dollars for every euro.
For the AUD/USD currency pair, the Australian dollar is the front or lead currency and the U.S. dollar is the quote currency. A recent quote for the pair looked like this: Sell .74659/Buy .74675. Each Australian dollar is worth approximately 74 cents in U.S. currency.
Understanding the Currency Unit
One unit of the EUR/USD is one euro and one U.S. dollar. One unit of the AUD/USD is one Australian dollar and one U.S. dollar. When a trader initiates a trade, he or she instructs the broker to buy or sell a certain number of units. If the trader wants to buy 1000 units, or “go long” of the AUD/USD pair, the broker will buy 1000 Australian dollars and simultaneously sell 1000 U.S. dollars on the client’s behalf.
Understanding Margin and Leverage
The above trader wanting to buy $1000 Australian dollars does not have to pay $1000. The Forex broker requires only a small percentage of the purchase price to initiate the trade. This is called the “margin deposit.” With the Forex broker used in the above examples, a trader trading at a 50:1 leverage level would have to commit $29.82 AUD to initiate the trade. If 100:1 leverage were used, the margin deposit on the trade would be $14.91 AUD.
Many of the leading brokers in the Forex market permit traders to trade at various leverage levels. The simple rule of thumb is the lower the leverage, the lower the risk, the higher the leverage, the higher the risk.
Making a Profit from Forex Trading
In the above example where the trader purchased $1000 AUD whilst simultaneously selling $1000 USD, the trader hopes that the Australian dollar gains in value against the U.S. dollar. If it does, the trader makes money. If the Australian dollar decreases in value relative to the U.S. dollar, however, the trader loses money.
One of the most appealing aspects of currency speculation in the Forex market is that a trader can also speculate that the Australian dollar will decrease in value compared to the U.S. dollar and instruct the broker to “go short” the AUD/USD pair, selling the Australian dollar and buying the U.S. dollar. In this scenario, the trader earns a profit if the Australian dollar decreases in value relative to the U.S. dollar, but loses money if the Australian dollar increases relative to the U.S. dollar.
Understanding the Cost of Forex Trading
Forex brokers charge fees for providing access to the Forex market to their clients via trading platforms. The two primary fees are the “spread” and commissions. The spread is the difference betwixt the buying price and the selling price of the currency pair. It is quoted in “pips.” A pip is the smallest amount by which a currency pair can fluctuate. In the above quote for the AUD/USD currency pair, where the selling price was .74659 and the buying price .74675, the spread was 1.6 pips. For the trader, this spread means that for every $1 dollar of profit, the broker would take a fee of 1.6 cents. The broker would take this same fee from losing trades as well, meaning that for every dollar lost, the client would have an additional 1.6 cents deducted from his or her trading account.
Simple math reveals the cost of trading in the Forex market. In the above 1000 unit transaction, if the trader closed the trade with $100 in profit, the broker would deduct a fee of $16, leaving the trader with an $84 net profit. If the trader closed the trade with a $100 loss, the $16 fee would mean that the trader’s account value would decrease by $116.
Some Forex brokers charge a commission on top of the spread, but in those instances, the spreads are generally much lower than those of a spread only broker.
The ultimate goal for the trader in choosing a broker is to find the lowest total fees for the anticipated trade size, since fees are deducted from winning trades and added to losing trades. There are some other considerations involved in broker selection, such as the level of service offered, available trading software, training resources and perhaps the number of currency pairs offered, but these considerations are distant ones considered to trading fees, mainly because there is so much broker competition for clients that many of these secondary considerations can almost be taken for granted.
The basic mechanics of the Forex market are actually quite simple. It will take a bit of effort to understand the unique jargon involved, but beyond that, currency prices can only increase, decrease or remain stable. This is not meant to imply that trading currency in the Forex market is easy or a quick path to overnight wealth. It is definitely neither of those two things. The fastest way to learn how to interpret price data is with the a Forex platform and associated simulated trading account that are offered by all reputable Forex brokers. These allow aspiring traders to practice trading with actual price data in real time without risking actual money.