The term “Forex Trading” is extremely popular in retail circles.
But are you wondering what this means?
In very simple words, it stands for the trading of currencies.
There are many different types of currencies across the world.
When they are traded primarily to make money, you get a forex trade.
Forex is actually the short form of foreign exchange.
The foreign exchange market by far is the largest and fastest in the world.
Forex trading till date has largely been the domain of influential financial players.
Average traders can now buy-sell currencies by the simple click of a mouse.
It is, in fact, quite similar to trading stocks at the moment.
But what is very different is the extent of price movement.
The daily price movement in currency is minimal.
At the most, it is just a couple of pips here and there.
What is striking is the level of volatility as a result.
Positions can be closed or even initiated in seconds.
But the prices are essentially the function of supply-demand dynamics.
In this context, even the largest players like banks cannot tinker with prices.
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Approach to Forex Trading
Most times, when you start off forex trading, there are two ways.
One option is simply selling and buying of forex positions.
You choose any specific currency pair and then go long on one and short another.
The second option is choosing to trade Futures.
This is exactly where the difference between spot and futures market comes handy.
But we will go into those details a little later.
Whether you choose to transact in currency pair or futures, they are similar to stocks.
So when you go long against a currency, you expect prices to rise.
Going short will mean the reverse, the prices may slip.
Most times, for this, you have to calibrate the markets carefully as well.
Of course, it goes without saying that Futures trades are used by veterans.
But when you begin forex trading, it is important to know a little bit about all of these.
This is exactly why you also have to understand the two types of forex markets.
A detailed understanding of these will help you decide your approach to forex trading.
Broadly, it is essential that you set your target for forex trading.
This is similar to how equity market operates.
You can undertake self-study or join some courses about forex trading.
These will help you understand how to prioritize your trade.
You will get a realistic idea about how to approach trade.
Think about an equity market trade.
You read the newspaper, watch the TV and decide on a plan of action.
In between, you constantly check with experts and market players for additional guidance.
Even in case of forex trading, the same approach is important.
But the risks are much higher, so you need to be very alert.
Understanding the Forex Market
But before we delve any deeper in forex trading, it is important to understand the market.
The forex market is essentially the result of the need to exchange currencies.
This is what makes this market extremely volatile and liquid.
The average traded volume exceeds a trillion dollars a day.
In fact, you do not even have a central marketplace to trade this.
Trade happens throughout day and night in different corners of the world.
Forex trading happens primarily electronically and over the counter.
Computer networks of currency traders from across the world are connected.
Whenever a market shuts down in one end of the world, another opens somewhere.
Typically, the forex markets can be divided into two broad categories.
This is primarily on the basis of the kind of investors who put in their money.
- Spot Market
- Forwards & Futures Market
Needless to mention, that the spot market is one of the largest.
This is primarily the main asset.
The underlying value is derived from this main market.
Electronic trading brought further impetus to the spot market.
The overall trade volume surged to a huge extent, and it even exceeded the futures market.
The maximum amount of retail trade is undertaken in these spot markets.
Most times, you will see the Futures market is primarily a domain of corporates.
The currency forwards market is used to create forex hedges.
So, corporates use this market relatively more often.
The average retail trader deals more with the spot trades.
Understanding the Spot Market
So, if you want a better handle on forex trading, it is important to understand spot trade.
The spot currency market is the place where different currencies are traded.
Though there is no common stock exchange, it is as close to that as possible.
Currently, spot trade happens electronically across the world.
The price is often a function of the supply-demand matrix.
But the parameters that decide the demand-supply matrix is crucial.
There are many factors that decide the demand and price dynamics.
- The rate of interest
- Economic indicators
- Geopolitical scenario
- Future performance expectation
That apart, there are many other related factors.
Often the performance of the other asset classes affects prices.
Key economic or political events also have a bearing on prices many times.
When you finalize a deal in spot markets, it is called a spot deal.
This is primarily a point where the exchange rate is decided upon.
The position is closed at that specified price.
The settlement in spot market mostly happens in cash.
In fact, you can draw corollaries with the spot market in case of equities.
There is a direct exchange of assets and money.
The settlement, however, takes good 2 days in the spot market.
The Forex Futures Market
One of the biggest difference with the spot market is there is no actual currency.
The trade does not involve actual currencies.
You predominantly have contracts with underlying value.
The value of these contracts is derived from the actual currency rates.
The contract is essentially an agreement between the buyer and seller.
Normally there are set units of these contracts that you can buy.
These can be bought through any of the Futures exchanges globally.
Some of the most common Futures exchange include Chicago Mercantile Exchange, NFA
But you must remember the Futures contracts come with an expiry date.
So, you have to undertake these transactions before they expire.
This kind of forex trading is normally taken up by corporates.
It offers these businesses protection against future risk.
But there are many speculators in this market as well.
They speculate on possible future currency direction and make money on that bet.
So to play the futures market effectively, you also need sufficient know how.
Without a definite understanding of the market and the trends, you cannot take the position.
As a result, you do not see too many retail investors in this market.
Mostly, you have seasoned traders or active corporate investors.
The average retail investors prefer the spot market.
It provides them possible returns without the potential risks.
The risk is taking a call on future price movement.
So, you cannot take the call without sufficient exposure in the market.
Catalysts for Growth in Forex Trading
Well, that defines the broad variants of the types of forex trading.
But the next interesting factor about forex trading is its rising popularity.
You will notice that there is a sudden pick up in interest and action across forex markets.
So the question then is what resulted in this sudden popularity in forex trading?
Well, there is a school of thought that believes the high liquidity is a key reason.
The availability of very high leverage rates is also another trigger for this.
These two factors have single-handedly worked towards enhancing user interest.
It also goes without saying that the type of returns also aided response.
Given the doldrums that stocks got into post-2008, forex trading was a convenient option.
It provided traders with a convenient opportunity to make money.
Most of us are not George Soros to make the pound bow to us.
But forex trading surely provides opportunities to deliver reasonable gains.
Moreover, currency prices are dependent on supply-demand matrix.
Given the size of the currency market, it is not simple to manipulate these.
Even the role of the central banks is fairly limited in determining currency rates.
They can, of course, increase-decrease rates or tinker the money supply.
But you must understand that those are not so simple.
They have huge economic implications too.
As a result, you will notice that forex rates are fairly stable.
But that also means you have to understand the markets better.
This is exactly why it involves in-depth study.
You have to take a call on the market to trade it.
This will help them understand the operational basics.
Given the huge popularity, many forex brokers offer demo accounts.
These help investors in getting a hang of the trading basics.
Forex Trading: How to Open an Account
Therefore the next step in forex trading is opening an account.
This procedure is fairly simple and similar to stock market trades.
Just like in stocks, you need to open a trading account.
But the equity and forex trading accounts are different.
So always undertake complete research before opening an account.
You must be careful about the services offered by the account.
At the same time, you also need to consider the rates carefully.
The commission and fees are very crucial elements to consider.
If you are not careful, you may end up using your profit for paying fees.
A trading account can be extremely beneficial in this context.
This will help you in forex trading on a commission-free basis.
This is a big difference compared to equity trading account.
In case of equity trading, you have to pay a brokerage for every trade.
But in case of forex trading, you are dealing directly with market players.
You are not approaching them via a broker.
As a result, you don’t have to pay any such fees either.
However, that said, it does not mean that the broker is offering it for free.
In this case, the market players are making money on the trade that you make.
For every forex trade, there is a bid and ask price.
So the difference between the two is the spread.
Often market players make money on this spread.
The difference might be a few pips, but given the volume of trade, it becomes a big amount.
When you are opening an account, always find out the pip spread.
Though it is just a few points difference, it can be huge on high volume.
Leverage is another cardinal requisite of forex trading.
In very simple terms, leverage is the amount of exposure to the market.
In many ways, it also defines the extent of risk you have in the market.
So, in this case, you have the ability to control the huge sum of money.
But in reality, you are not holding that kind of money.
It is a position and call on the market that you take.
The problem is if the trade falls through, you have to cough out this amount.
Therefore, leverage also determines your margin in forex trading.
Different types of accounts have different degrees of leverage.
One of the most types of leverage is 50:1.
This means if you have $100 in your account, you can control $5000.
But there are some with extremely leveraged account.
Sometimes, it can be as high as 250:1.
As a result, the high leverage is seen as the primary benefit.
You can make huge gains using very little initial capital.
However, at the same time, the losses can also be huge.
After all, the maximum part of your trade is based on notional value.
So, if the trade does not pan out the way you have planned, your loss will be huge.
This is exactly why most times brokers introduce stop losses in the market.
These are like speed breakers.
In case of a downward spiral in trade, it reduces the extent of losses.
Risks & Benefits of Forex Trading
That brings us to the final lap of this article about forex trading.
In many ways, the leverage becomes one of the greatest risks in forex trading.
Surprisingly it is one of its biggest advantages as well.
It helps you bet on huge profit and amass strong returns.
In many ways, it is the strongest lure for forex trading as well.
It attracts many small and new investors to this market as well.
– The Benefits
This market has very high liquidity at all times
This means investors can place huge orders without altering prices.
2. Low Margin
The huge leverage means that trade is executed at a lower margin.
Also, the fees and commission for trade are almost non-existent.
3. Large Profit
Higher leverage, liquidity and low margins mean high profit.
Investors are able to place very large bets.
This means that they can pocket strong profit even if there is a few pip difference.
4. Open 24×7
This is also one of the markets which are actually open 24×7.
Whatever the time of the day might be, this market is operational in some corner.
So they are able to take into consideration a variety of global development in a day.
– The Risks Involved
1. High Leverage
As I mentioned, the leverage is a double edged sword.
It undeniably increases the risk profile of your investment.
It also increases the overall risk exposure.
2. Huge Loss Potential
As a result, if the trade reverses, you can book huge losses.
A maximum part of your trade is based on assumption.
If it falls through, you have to cough up the entire amount.
3. Strong Correlation To Politics
The forex markets are functioning day and night.
As a result, even the smallest geo-political development impacts currencies.
From a bomb blast to political unrest, everything has a bearing in prices.
As a result, investors have to be very careful.
So, What Is Forex Trading?
Therefore, we can conclude that forex trading is ideally for serious traders.
The stakes are significantly higher in this case.
So you have to take a well thought out decision.
Unlike convention equity traders, forex trading involves very large leverage.
That also means investors need to be extremely careful.
They have to be alert about global developments and tweak trade accordingly.
However, on the positive side, these yield a very large profit.
So your relative returns from forex trading are huge.
If you are a new entrant, remember to keep stop losses to limit damage in forex trading.
Also make sure that you trade the currencies the right way:
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- Forex Trading through a Bank Account
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And finally, here is how the right way of making money through Forex trading is explained: A Short Term Investment Strategy That Makes You a Millionaire