Forex trading is becoming more popular in the recent years due in part to the fact that it is more accessible to the general public. It used to be that the currency market was the province of institutions and the wealthy, but technology and other factors have made forex investing, like other types of investing, more accessible to a wider audience. However, it is important to note that forex trading is rather risky, and the currency market is quite volatile. If you have the risk tolerance for trading currencies, and you are good at it, you can make a great deal of money. Conversely, it is also possible to lose a great deal of money in the forex market.
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First of all, it helps to known how the forex market works. “Forex” is short for “foreign exchange.” This is the market in which currencies are exchanged with each other. The forex market consists of foreign banks and institutions both financial and otherwise. $1 trillion a day exchanges hands on the forex market, and it is the most liquid market in the world. The market opens on Sunday evening at 5 p.m. Eastern, and trading happens 24 hours a day until it closes on Friday at 5 p.m.
When you invest in currencies, you really aren’t investing at all. Rather, you are speculating, trying to figure out how one currency will move relative to another currency. You don’t actually buy or sell anything, although when you are reading about the currency market all of the language used is that of investing.
There is no physical exchange of currencies when you “trade” on the forex market. Transactions on the currency market resemble electronic over the counter transactions. You have to go through institutions known as market makers in order to participate. Market makers set bid-offer prices, and you make a profit if you correctly guess how a currency will move against another one, and manage to overcome the spread between the bid price and the offer price. The market makers make money on the spread, so once you overcome that, you make nothing but profit — no transaction fees, no commissions.
If you are going to trade in any market, you need to know how things are set up, and how the trading works. With the currency market, everything is done in pairs. Currency quotes consist of expressing how one currency is doing against another. For example, you might see a quote that looks something like this: GBP/USD 1.6643. As you can see, quotes are often expressed to the fourth decimal place. The exception to the rule is the Japanese yen, as the USD/JPY pair is only expressed to two decimal places. This is because the smallest changes can mean a big difference. You will hear of a “pip“, which is a “percentage in point” — the smallest price change available.
In the quote above, the Great Britain pound is considered the base currency. It is seen as the currency as rising or falling. So, when you are told that GBP/USD is rising, it means that the pound is gaining against the U.S. dollar. The second currency is called the quote or counter currency. The currency quote above indicates that, at the time of the quote, the pound is worth US $1.66. It takes $1.66 to equal one pound, so the pound is valued more highly relative to the dollar.
Here are some of the more popular currency pairs, and the nicknames that you might see when reading forex news:
Currency pairs that do not include the U.S. dollar, such as GBP/JPY, are known as cross currencies. It used to be that all currencies had to be converted to dollars before they could be exchanged. So the pound would have to be changed into dollars, and then those dollars changed into yen. But in recent years, that has changed and it is much easier trade cross currencies.
Forex trading is profitable because leverage is an integral part of the process. Many market makers will offer you the ability to make use of 400 – 1 leverage. This means that $1,000 will control a position that is worth $400,000. You can quickly see how a minuscule change in a currency pair can result in huge profits (or losses). For the most part, forex currency positions are controlled in lot sizes of $100,000. However, there are some forex brokers that offer “mini forex accounts” that allow you to control smaller sizes of $10,000. This can limit some of your losses (and your profits). Most brokers require that you open a regular forex account with $2,500, or a mini account with $250.
Currency trading is quite risky. Political events, economic news and investor perception can change the direction a currency pair is moving quickly. This means that you can find your winning position quickly turning into a losing position. Many people instead choose to limit their risk by investing in currency ETFs or taking small profits as they arise.