What is Forex Trading?
Many investors may be asking “what is forex trading?” Foreign exchange is known as forex, FX or currency trading. Forex trading is essentially a marketplace where you can trade currencies from different countries. You have probably heard of people making millions through currency trading and wondered how it works. Since the forex market’s trading volume tops $6.6 trillion per day, there is a huge potential to earn money if you know what you are doing.
What Is Forex Trading?
Imagine you own an oil tanker. After leaving the Middle East with a shipment of oil, you drop it off in the United States. The buyer pays you in American dollars, but your company is based in Europe. In order to bring your profits home, you have to convert your dollars into euros.
Forex trading was originally a way to help companies exchange goods between different countries. Over time, savvy investors realized that they could make money by investing in different currencies. Because of changes in a country’s economy and monetary policy, a currency’s value can increase or decrease over time. For example, a single United States dollar was worth 226.63 Japanese yen in 1980. In 2020, a dollar was worth 105.59 Japanese yen. This means an investment of $1,000 in Japanese yen in 1980 could be exchanged for $2,146.32 today.
When you exchange currencies, you are always working with something known as a currency pair. You sell one currency while you buy another currency. These currencies are represented by a three-letter code. For example, the Japanese yen is represented by JPY, and USD stands for the United States dollar.
Meanwhile, EUR stands for the European Union’s euro. The British pound is represented by GBP. Along with the yen and dollar, the euro and pound are the most commonly traded currencies. Because of this, you will often see currency pairs like USD/JPY, GBP/USD, GBP/EUR and EUR/USD. If you buy the USD/GBP pair, you are basically purchasing the United States dollar by selling the British pound.
The following are the four main kinds of forex pairs.
- Major pairs: The major pairs are made up of seven different currencies. Roughly 80% of forex trades consist of these currencies.
- Minor pairs: These pairs are not traded as often. Often, they involve the major currencies trading against each other instead of trading against the United States dollar. This includes currencies like the Canadian dollar, which is represented as CAD.
- Regional pairs: These pairs are classified according to where they are in the world. For example, one collection of regional pairs is from Scandinavia.
- Exotic pairs: Exotic pairs involve trading a major currency for a currency from an emerging economy or a small economy.
Is Forex Better Than Stocks?
Choosing whether you invest in the forex or the stock market depends on your risk tolerance and trading style. Each market has a different level of volatility. Equities tend to work better for buy-and-hold investors, but the forex market is popular among active traders. Forex is better than stocks in some cases, but it all depends on your personal situation.
Volatility is a key difference between stock markets and forex investments. A stock has high volatility if the price swings drastically in a short amount of time. Traders typically use the forex market’s volatility to make short-term profits.
Unlike the stock market, the forex market is always open. Normally, the stock market is only open during the daytime on weekdays. If you want to trade throughout the day and night, the forex market can offer more flexibility.
With the forex market, you can use leverage to earn higher profits. Investors can normally get 2:1 leverage for stocks. Meanwhile, the forex market can offer 50:1 leverage. This means you can leverage an investment of $1 like it is worth $50. If you make a profitable trade, you will get substantially more in profits. Although, leverage can be a double edged sword and can lead to larger losses as well…
Is It Safe to Do Forex Trading?
Any investment involves some degree of risk. Forex trading can be risky if you use a significant amount of leverage. With leverage, it is possible to lose your entire investment and more if you’re not careful. Because of this, you should do your research and use practice accounts before you trade with real money.
How Do I Start Trading Forex?
When you trade in the forex market, you are buying one currency while selling another currency. On your last vacation, you probably conducted a forex trade without realizing it. When you arrived in another country, you might have exchanged your currency at a foreign exchange kiosk. Fortunately, you can also find online kiosks that allow you to take a position in a certain currency. Then, you can earn a profit if the change in prices moves in your favor.
Spot transactions are deals that are delivered within two business days or less. With the USD/CAD pair, spot transactions settle in just a single business day. These trades occur at the prevailing market rate.
In general, most retail traders do not actually want to receive the currencies they purchase because they are just trying to earn a profit. Because of this, retail brokers will normally rollover trading position at the end of the day or close and settle the difference. When the trader eventually decides to close their trade, they can realize their profits or losses.
A futures contract is when you make an agreement with someone else to deliver a certain amount of a currency at a set date. This date is known as the expiry. Once you agree to the contract’s terms, they are non-negotiable. Often, people buy and sell these contracts before they expire to realize the profits or losses right away.
Forex Forward Transactions
When a transaction is settled later than the spot transaction, it is called a forward transaction. These prices are determined by changing the spot rate to accommodate the difference between each currency’s interest rates. Because a forward can be completely customized, you can change the amount of money or use a holiday as your settlement date.
The Advantages of Forex Trading
While there are downsides to any investment vehicle, forex trading offers a number of useful benefits.
- Forex marketplaces are open 24 hours a day.
- You can go long or short on any position.
- High volatility gives you many trading opportunities.
- You can get more out of your investment by using leverage.
- You can pick a variety of currency pairs.
Forex trading has risks, so it’s important to do your research before you get started. Many brokers offer demo accounts you can use to practice trading before you use real money. Once you start trading, you can use leverage to increase your profits as you buy and sell currency pairs.
What is Forex Trading? Find Out More
Hopefully now you know the answer to “what is forex trading?” At Investment U it is our goal to provide you with all of the tools you’ll need to become a smarter and more profitable investor. Signing up for the Trade of the Day e-letter is the first step toward accomplishing this goal. At 5 p.m. ET, Monday through Friday, you’ll receive a quick recap of one of the most important trades we’re tracking. These are often the trades that could lead to substantial wealth creation – and you’ll know about them well before anyone else.
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About Ben Broadwater
Ben Broadwater is the Director of Investment U. He has more than 15 years of content creation experience. He has worked and written for numerous companies in the financial publishing space, including Charles Street Research, The Oxford Club and now Investment U. When Ben isn’t busy running Investment U, you can usually find him with a pair of drumsticks or a guitar in his hand.