In any financial market in the world, you can find a seemingly endless list of commodities available for purchase, each with its own price. While there are many factors that determine these prices and the way they change, there is one market in particular that goes a step further in determining the underlying values of those prices in all the different currencies present worldwide; the forex market. Thus, in order to understand what forex trading is, we must first consider the numerous different currencies present in the world, as well as the relationships they have with one another.
If you’ve ever been on vacation to a foreign country, chances are you’ve had to exchange your home country’s currency for that of the country that you were visiting. Keeping this idea in mind, you probably know that the exchange rates between those currencies—or any for that matter—are also always changing. These changes happen as a result of many different factors, and are also what allows forex trading to be possible.
The word forex itself, as you may already know, signifies foreign currency exchange. While international commerce and tourism are huge contributors to currencies being exchanged in the first place, forex trading has certainly become a big player as well. The reason for this is that forex essentially allows anyone to take advantage of the aforementioned changes in rates by buying and selling units of the currency in correspondence to the changes in value. Now the question is, how does that work?
How Forex Markets Work
Unlike other financial markets in which assets are sold individually, the forex market functions exclusively on pairs. That is to say, when working with exchange rates in the forex market, the only way to really evaluate the worth of a currency is to compare it to another, which is where currency pairs such as EUR/USD come about. Taking this into consideration, the most important thing to understand is the nature of these relationships within the forex market, through which all national currencies are exchanged and evaluated via comparisons to one another constantly.
Once we have an understanding of this pairing system, we can delve further into what a currency pair actually signifies as well as how traders operate with them. In terms of understanding the value of the pair in the first place, it is necessary to understand the difference between the base and quote currency.
Firstly, in any currency pair, the base currency will always be the first listed, followed by the quote currency. Now, the nature of their relationship is actually quite simple. Considering the purpose of the pair is to express the exchange rate, the value of the pair is what indicates how much of the quote currency is necessary to purchase the base currency. For instance, in the case of EUR/USD the quote currency is USD, which means that if the price for the pair is 0.90, it costs $0.90 to buy €1. Additionally, keep in mind that because this is always an exchange, the base currency will always be the currency that you are purchasing when you make a trade, while the quote currency is that which is being sold—and vice versa in the event that you are selling.
Moving on to operating with these pairs as a trader, there are a few other concepts to consider, starting with the bid price vs. the ask price. Each of these represent two factors that determine what prices you will be acting on when making a trade. Starting with the bid price, this is essentially the amount your broker will want to pay for the pair, as well as what you will get by selling the pair. Conversely, the ask price is the point at which your broker will be willing to sell, as well as the price you will need to pay in order to purchase the base currency.
Lastly, it is of high importance to consider lot sizes and leverage when discussing operations in the forex market. The reason this is important to note is because the standard lot size in this market is 100,000 units of the base currency. There are however other options that allow traders to be able to operate with smaller quantities. The inclusion of micro, mini and nano lots is one example of this, which break down the standard lot size to 10,000, 1000 and 100 respectively. Additionally, it is important to note that since currency pair operations normally deal with small movements of ticks and pips, forex markets are consequently highly leveraged as well. The combination of these factors not only aid in making forex trading more accessible, but also provide the opportunity to capitalize on price movements in a way that is appropriate for each trader.
What moves the market
When trading forex, it is important not only to understand what the currency pairs mean and how they are traded, but also the elements that influence changes in the values of the currencies, and how that affects the pairs accordingly. To start, prices themselves are by and large a product of global supply and demand. This may seem like common knowledge seeing as all commodities in the world are governed largely by this rule, but since the prices of those commodities are dependent on the currencies, it is crucial to recognize that there are other sources of influence that play a particularly influential role in the valuation of currencies, and consequently currency pairs in the forex market. This is including and not limited to factors such as interest rates, political events and situations, national economic performance, and even projections of the performance of a given currency pair.
To provide an example of this at work, we can consider what impact an increase in interest rates in the US could have on the currency pair CAD/USD. Considering higher interest rates are a strengthening factor for the corresponding currency, the change in this case will be detrimental to the CAD/USD pair, as a result of the US dollar strengthening in comparison to the Canadian dollar. In other words, following the increase in interest rates in the US, it will cost less USD to purchase $1 CAD, and since CAD is the base currency, the pair will be devalued.
As a result of situations like these, it is always advised that you educate yourself on the economic status and events related to the countries the currencies you are trading belong to in order to have a sound understanding of what is driving the movement of that given currency pair.
Appeal of Forex Trading
In contrast to the factors mentioned above, there are quite a few reasons as to why forex trading is so popular. For example, one of the biggest benefits of the market is accessibility. As a result of the interconnected nature of the relationships between currencies, the forex market is open for trading 24 hours a day, 5.5 days per week, is available globally in almost all financial centers and is consequently always highly active. In addition to this, while spot trading is the most popular style of forex trading considering it is essentially what all other futures and forwards markets are based on, forex markets do still provide the opportunity for alternative such as derivatives, which of course expands accessibility even further.
To summarize the functionality of the forex market, the most important thing to understand above all else is that all currencies are interconnected and have strong relationships that influence one another. From here, we can begin to break down the nature of these relationships to gain insight on how price changes happen as a result. Finally, always keep in mind the different economic and political events occurring in the countries whose currencies you plan on trading, and assess in detail what combination of lot size and leverage is most appropriate for you when trading forex. With all of this in mind, you should have the right foundation and mindset to begin to tackle trading in the world of forex.