3 of the Most Important Things You Should Know about Trading on the Forex Market
The largest market in the world is the foreign exchange market, also called forex. This market is for exchanging foreign currencies, and forex trends affect the price of just about everything across the world.
Forex trading resembles the currency exchange that you do while you travel abroad. Rates vary according to supply and demand, except that most trading happens between institutional investors on a large scale.
The exchange is not a central one like the New York Stock Exchange. Instead, it is overseen by a network of banks and financial institutions across the globe. Trading happens 24 hours per day between Monday and Friday.
Here are 3 of the most important things you should know about trading on the forex market.
1. The Basics of Forex Trading
People use the forex market for a variety of reasons. For the most part, investors do not intend to take physical possession of the currencies they trade. Many investors speculate or hedge regarding exchange rate fluctuations.
For example, someone might buy pounds and sell euros if that person thinks the pound will strengthen in value against the euro in the near future. Companies may use the forex market to hedge if they have operations in multiple countries to protect the value of their earned income.
All currencies on the forex market get assigned a three-letter code similar to a ticker symbol for an equity. Trading gets expressed as a combination of the two currencies being traded. As an example, consider the currency pair EUR/USD, which represents the euro-to-dollar exchange rate. The currency on the left is the base currency while the one on the right is the quote currency.
An exchange rate expresses how much quote currency is needed to purchase one unit of the base currency. In the above example, if the exchange rate is 1.5, that means $1.50 is needed to purchase one euro. A rise in the exchange rate signifies that the base currency as gained valued relative to the quote currency.
2. Using the Forex Market to Speculate
As mentioned, the majority of forex trades are speculative. Traders want to purchase currencies they think will gain value or get rid of currencies likely to lose value. With that in mind, there are three primary ways to trade forex.
The first is the spot market, which is the primary forex market where currency pair exchange rates get determined in real time through supply and demand. In addition, there is a forward market through which investors can enter a contract with another trade and lock in an exchange rate for a certain amount of currency at a future date. The forward market consists of private contracts. Finally, investors can use the future market, which is similar to the forward market but done on the exchange rather than privately.
Speculating about exchange rates can be a tricky business. While supply and demand are the central drivers of currency price, there are many other factors to consider. For example, bank policy, interest rates, politics, and economic growth within a country all have an influence on the value of its currency.
The forex market tends to respond very quickly to news and novel developments since it is open 24 hours a day during the week. The stock market often gets affected by news much later than the forex markets, so traders generally need to pay close attention to the media as sharp spikes can occur very quickly.
Since forex trading is based largely on speculation, it is a very risky approach to investment. Furthermore, forex trading requires leverage since traders use margin. This fact increases the risk even more. Currency prices often fluctuate only a small amount, which means large trades need to be executed to see real profit and this amount of leverage can magnify both gains and losses.
Traders may lose more than the initial amount borrowed in the long run. When currencies fall too far in value, leverage users may also be subject to margin call, which will force them to sell securities purchased with borrowed funds at a loss. The other fact to consider is that transaction costs can add up quickly and eat into gains.
3. Individual Investors and the Forex Market
Because of the money and risk involved in forex trading, the market is dominated by professional traders. Nonprofessional traders account for only about 5.5 percent of the market. A recent study found that about 70 percent of nonprofessional forex traders lose money in the market. For this reason, many major online brokers do not even offer forex trading. While it is possible for individuals to get involved with the market, they should do so with caution to avoid losing money in the long run.
Even if individual traders do not invest directly in the forex market, it is still important to pay attention to it to some extent. Shifts in the forex market affect trade and can have an impact on the performance of stocks. Business owners likewise should pay attention to the market, especially if they trade internationally or have operations in multiple countries.
When the home currency gains value, importing goods becomes cheaper. However, on the flip side, importing goods becomes more expensive when the home currency weakens. In this position, companies that export goods will benefit from fluctuations in the exchange rate.