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An Introduction To Forex Trading
What is Forex?
The Foreign Exchange market, also known as “Forex”, “FX”, “Spot FX” or just “Spot” is the oldest, largest and most liquid financial market in the world, tracing its history back centuries to Babylonian times. While the global financial markets were collapsing in 2008, the FX market experienced tremendous growth, reaching more than 1.78 million transactions per day - an average daily trade volume of $3 trillion. That’s three times the stock and futures markets combined. With so many investors and so much money changing hands each day, it is the perfect market for traders who use technical analysis tools. Forex trading offers investors an excellent way to diversify their portfolios, lower volatility and reduce market risk, and being a Global market it is possible to trade Forex 24 hours a day.
How Does Forex Work?
Forex trading is the simultaneous buying of one currency and selling of another, as traders speculate the value of one currency will strengthen or weaken against the other. As such, trading is always conducted in currency pairs. The first currency in the pair is known as the ‘base’ or ‘transaction’ currency and the second is known as the ‘quote’ or ‘counter’ currency. For example, the pound and the US dollar (GBP/USD) or the US dollar and the Japanese Yen (USD/JPY). The price that is quoted corresponds to the number or quote currency that is required to buy a unit of the base currency.
You buy a currency pair if you expect the exchange rates to increase in value; you sell a currency pair if you expect the exchange rates to fall in value.
If a trader buys GBP/USD, they effectively buy British Pounds and sell US Dollars; if the trader sells GBP/USD, they sell British Pounds and buy US dollars.
Movement of currency is expressed as percentage in point, or ‘pip’ also known as ‘point’. The pip size depends on what is being traded. A pip on currency pairs is typically 0.0001, however on Japanese Yen currency pairs a pip is 0.01. For precious metals a pip on Silver is 0.0001 and a pip on Gold is 0.01.
Ways to trade currency
Unlike equity trading, Forex doesn’t take place via a centralised exchange and is instead conducted over-the-counter (OTC). Buyers and sellers trade directly with one another or through brokers, dealers and market makers, rates can therefore vary.
You can trade currencies via:
- Forex broker - “Spot Forex”
- Spread betting
- Currency Futures
Forex Trading Account
You trade Forex in lots. Mini lots typically start at $10,000 and increment by $10,000 typically up to $100,000. Maxi lots are based on $100,000 increments.
To buy and sell lots, you need a percentage of the lot size as a cash deposit to cover the margin requirements.
When you buy and sell a currency pair, you need a minimum margin requirement typically between 1% and 2.5% of the lot size e.g. $10,000 requires $100 cash deposit at a margin rate of 1%.
Even though you only require a small percentage to trade a Forex lot, you realistically need a cash deposit of between 5% and 10% of the lot size to cover volatility and avoid a margin call on open positions held over days or weeks.
A margin call is where the broker will ask you to deposit more money to cover the margin on a losing position.
With a minimum trade on a $10,000 GBPUSD lot you make or lose $1 for every 0.0001 change in the exchange rates; it is essential to understand the inherent leverage that comes with varying lot sizes and therefore consider carefully your lot size and the associated risk and margin requirement before opening a position.
Forex Spread Betting Account
With Spread betting, you typically bet on exchange rates increasing or decreasing with a minimum bet of £1 per 0.0001 movement; for some currencies the unit size is 0.01.
The minimum bet is typically £1 for every 0.0001 point movement in the exchange rate, therefore if you take recent volatility that saw the pound swing between 1.4300 and 1.4600 against the dollar within 24 hours, it would have resulted in a gain or loss of £300 if a minimum bet of £1 per point was placed.
Futures & CFDs
Futures and CFDs typically require about 5% to 10% of the contract size and are normally cash settled.
Forex Options are typically settled by exchanging Forex Futures.
Forex Trading & Interest
If you buy a currency you get paid interest; if you sell a currency you have to pay interest. To trade a currency pair you have to buy one currency and then sell another, therefore for long term positions, you will receive interest on the currency bought and pay interest on the currency sold.
The interest rates on each currency varies; for example, if you buy Pound and Sell US Dollars, the interest rate on the Pound is higher than the Dollar, therefore you will receive more interest than you have to pay out; this can be used to generate an income on a difference between the two rates.
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