What is the Foreign Exchange (Forex) Market?
The Forex trading market is the market where foreign currencies are exchanged. Today, Foreign Exchange trading has become widely popular as it allows traders to take a view and potential profit on global macroeconomic trends.
However, the Forex markets, also allow for simpler transactions. For instance, if you were living in the United States of America (USA) and you purchased a product or service from Italy, then your US Dollars will be exchanged into Euros. Furthermore, if you wish to travel from the United Kingdom (UK) to the United Arab Emirates (UAE) for tourism purposes, you will have to exchange British Pounds to UAE Dirham.
The Forex trading market is the most liquid in the world, given the frequency and the importance of exchanging currencies worldwide. According to the Bank for International Settlements (BIS), the December 2016 statistics report shows that the total liquidity traded in currency markets daily is roughly $5.1TR.
Furthermore, given its high liquidity, the Forex trading market exhibits significant fluctuations during the day; its volatile character is considered a chief factor in attracting day traders, investors, and scalpers, to trade.
The Forex trading market is famous being decentralized; meaning that it is not geographically-based at a particular place. Investors trade online from anywhere in the world, and this type of trading is known as an Over-The-Counter (OTC) market, as it is not on an exchange, such as the stock or futures markets.
What is the Spread in Forex?
The Forex spread is the difference between the buy price and the selling price of a currency. This is the cost of trading Forex, and the profit of a Forex broker each time you trade.
What is a Forex Pip?
The Forex pip is the smallest price movement that the price can make. It is the fourth digit after the decimal in all currency pairs; except for the Japanese yen and its pairs, where it is the second number after the decimal.
Below is an example of the Forex pip in the most famous currency pair: the EUR/USD.
The pip in this example is the fourth digit after the decimal, which is the number 2.
Here’s another example of the USD/JPY pair.
The pip in this example is the second digit after the decimal, which is the number 0.
The next logical question is how to calculate pips in Forex?
In fact, several renowned trading platforms offer their traders the possibility to calculate the value of the Forex pip automatically.
However, here is an example to fully-understand how the pip value is calculated.
The base currency’s pip value = (0.0001 / exchange rate) * Contract size
The best example in that context is USD/CAD = 1.2740, where the Pip value = 100,000 USD * (0.00001 / 1.2740) = $7.84.
What is a Lot?
Forex is traded through what is known as lots. In fact, the trader can determine the number of contracts he would like to trade, according to the size of his portfolio and his risk-tolerance.
There are three lots sizes:
Standard lot - equals 100,000 units of base currency, each pip equals $10 in the EURUSD.
Mini lot - equals 10,000 units of base currency, each pip equals $1 in the EURUSD.
Micro lot - equals 1000 units of base coin, each pip equals $0.1 in the EURUSD.
What does Forex Leverage & Trading Margin Mean?
This section will highlight the concept of Forex leverage, its mechanics, and what it stands for.
Forex leverage is a tool provided by brokers; its main objective is to amplify the size of the trader’s capital, so it makes economic sense to trade small prices changes.
As an example, trading a 0.1% price change with a small trading account makes little sense to most traders, but with the use of leverage, the trader can amplify this 0.1% price change. So instead of making a 0.1% impact on the trading account, it could be 1%, or 10%, etc. We just need to remember that leverage amplifies our gains as well as losses.
Trading accounts tend to default to one of the following leverage multiples: 50:1, 100:1, 200:1, 300:1, 400:1, and 500:1. However, the effective leverage is ultimately controlled by the individual trader.
How to Calculate Forex Leverage?
If the available leverage is 300:1, then this implies that every dollar in the trader’s account can purchase $300. The trader only needs to set as side a portion of, in this case, one dollar, and the broker lends the reminding $299 to its client. Once the deal is closed, the client refunds the $299 to the broker. All of this is automatically managed by the trading platform.
Trading with Forex Margin
Forex margin and leverage are linked. Let's say that the trader’s account balance is $1000 and that he chooses leverage of 1:100 to buy a standard USD/CAD contract (100,000 units)
The trader would need to set aside the $1000 as margin with his broker, to open the $100,000 position. So effectively, the margin requirement as a percentage of the total position results in certain leverage. The higher the margin requirement is in percent, the lower is the leverage, as shown in the table below.
The table below shows the required margin in Dollars need to open a standard and mini contract at different margin levels.
|Leverage||Margin requirement||Standard Contract has 100K units of base currency||Mini contract has 10K units of base currency|
|100:1||1%||1000 Units (e.g. dollars)||100 Units (e.g. dollars)|
|200:1||0.5%||500 Units (e.g. dollars)||50 Units (e.g. dollars)|
|400:1||0.025%||250 Units (e.g. dollars)||25 Units (e.g. dollars)|
What Are the Advantages of Trading Forex?
According to the Bank of International Settlements (BIS), the daily Forex volume exceeded $5.1TR, which protects the trader in currency markets as no person or financial entity can manipulate or control price fluctuations in long periods of time
In fact, Forex trading markets differ from Stock markets by being extremely volatile in the short-term, and range bound in the multi-year perceptive.
A 24/5 Market
Forex traders can work around the clock, five days a week, as the FX markets only close for the weekend.
The 24-hour trading gives traders the freedom to trade anytime, whether they have a full-time job or not. Stock markets are not quite as flexible, they close and open every day, and price fluctuations tend to be limited to certain hours each day.
Profits on Price Rises and Declines
A Forex trader can profit on currencies, whether their price is increasing or decreasing. If the price movement is bullish, traders tend to buy; on the contrary, if prices fall, traders can make a profit on the decline (also known as short selling).
Easy Monitoring & Analysis
The Forex trading is limited to a few selected currencies such as the USD, Euro, British Pound, Australian, and New Zealand dollar, and the Japanese Yen, which can be easily covered by a private investor, unlike the stock markets where there are many shares and companies to track.
Ability to Trade Small Amount of Money
Forex trading is known for its low spreads (low costs to trading), and access to leverage, this gives traders with small deposits the possibility to profit on the global markets.
Traders can exchange Forex online; through modern trading platforms provided by brokerage firms, regardless of their location.
Trading Without Commissions
Brokerage firms make a profit from spreads; they do not charge additional fees for their services or trading platforms.
Forex leverage is a tool provided by the financial intermediary to the client. It aims to maximize the traders’ capital and helps them execute transactions that exceed their capital.
Opening a Demo Trading Account
Forex Trading firms offer risk-free, demo trading accounts where traders can test their strategies and get the feel of the Forex market’s dynamics. There is no difference between the real Forex trading account and the demo Forex trading account. However, the latter requires funding, whereas the demo Forex trading account has fictitious capital.
Risks of Trading Forex
Albeit Forex trading exhibits several advantages, it also bares many risks; the speculation activity could lead a trader to overuse leverage, which can be costly sometimes. Any occurring loss in this case results from mild market movements; therefore, traders should focus on carefully managing their capital – according to their risk-tolerance strategy. Moreover, traders should always open a stop loss position for all their deals to avoid dramatic account losses, or trading through the margin.
On another note, given the volatile character of the financial markets and the major fluctuations it undergoes due to political or economic events, price gapes leading to negative account access could arise. That being said, it is recommended to avoid trading during major political events, or presidential elections, or even during the holidays.