This article aims to provide an introduction to the basics of forex trading, helping you understand how it works and familiarize you with important terms used in daily trading.
What is Forex in the financial markets?
Forex trading involves speculating on whether one currency will strengthen or weaken against another currency. For example, at the current exchange rate, 1 Euro can be exchanged for 1.39 US dollars. However, this exchange rate is subject to change as it is influenced by the supply and demand dynamics managed by banks.
To illustrate, let’s say we believe that the Euro will strengthen against the US dollar. In this case, we would buy the EUR/USD pair. It is important to note that when we anticipate one currency rising against another, we buy the stronger currency and sell the weaker currency. In most cases, the actual transaction of selling the currency is handled by an external brokerage company, so all we need to do is buy the EUR/USD pair.
Alternatively, we can also sell the Euro against the Dollar if we anticipate the Euro weakening against the Dollar.
Why do Forex exchange rates fluctuate rapidly?
Interest rates play a significant role in the movement of Forex exchange rates. Different currencies have varying interest rates. For example, your local bank in Paris may offer an annual interest rate of 3.5% on your Euro deposit, while a friend in London may earn 5.5% interest on their Sterling deposit. To take advantage of the higher interest rates offered by the British pound, you might decide to sell your Euros and buy British pounds. If many individual investors and banks engage in the same transaction, selling Euros and buying pounds, the Euro will weaken in comparison.
Benefits of decentralized regulation in Forex
Although the decentralized structure of the Forex market may initially seem confusing, it provides significant opportunities for retail traders. The competition between institutions and market players ensures that everyone has access to the best possible pricing deals.
The Forex market is structured with the interbank market at the top, consisting of major banks and some smaller regional banks and institutions that trade directly with each other using electronic brokerage services such as the European Central Bank or Reuters. Below this level, there are hedge funds, retail market makers, and trading institutions. Foreign investment, whether for global business operations or speculative purposes, takes place at this level.
Key differences between Forex and the stock market
Many trading techniques used in Forex are applicable to trading stocks and shares. The skills you develop as a Forex trader can be easily transferred to trading other securities. However, there are some key differences between Forex and stock trading:
- 24-Hour Market: The Forex market operates around the clock, allowing traders to trade at any time.
- High Liquidity: The Forex market is highly liquid due to its global nature and commission-free trading. This means there are always active buyers and sellers in the market.
- Identifiable Trends: Forex traders have easy access to market news and can take advantage of identifiable trends to maximize potential returns.
Understanding currency pairs in Forex
In Forex trading, currencies are always traded in pairs. Each pair consists of a base currency and a quote currency. When you make a foreign exchange transaction, you are buying one currency and selling another. The exchange rate indicates how many units of the quote currency are needed to buy one unit of the base currency. Conversely, when selling, the exchange rate tells you how many units of the quote currency you can get for each unit of the base currency sold.
