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Forex Market Basics – Forex Investing Basics

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Introduction

 

 

The foreign exchange, or forex market, is the world’s largest financial market, and it plays a vital role in the global economy.

Every day, trillions of dollars are exchanged from one currency to another – as this kind of currency exchange is essential for international business.

And in this module, we will be going over the forex market basics – as we cover the important characteristics, aspects, skills, analysis, and well-known techniques that you will need to know in order to consider investing in this asset class.

 

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

 

Forex Market Basics

 

 

Forex market participants include governments, businesses, and, of course, investors.

Governments use the forex market to implement policies.

For example, when conducting business with another country, whether its borrowing money, lending money, or offering aid, a country needs to convert its currency into a foreign currency.

Businesses use the forex market to facilitate international trade.

For example, they may need to convert payments for goods and services bought overseas or to exchange payments from international customers into their preferred currency.

 

 

And investors use the forex market to speculate on changes in currency prices.

Currency prices change almost constantly during the week because the forex market is open continuously from Sunday at 4pm until Friday at 4pm central time.

A trading day starts at 4pm and ends at 4pm central time the following day.

The market has to be open around the clock because of the global nature of the economy.

Let’s go over some basics of how forex trading works.

 

How Forex Trading Works

 

 

When you trade forex, you’re not just trading one product. You’re trading two currencies against each other. This is known as a currency pair.

The quote for a forex currency pair defines that value of one currency relative to the other. The easiest way to understand any quote is to read the pair from left to right.

Let’s look at an example using the Euro versus the US Dollar currency pair.

If the EUR/USD is trading at 1.20, that means that 1 Euro is equal to $1.20 US.

 

 

Here’s another example using the US Dollar versus the Canadian Dollar currency pair.

If the USD/CAD is trading at 1.25, that means $1 US is equal to 1.25 Canadian Dollars.

Even though there are two currencies involved, the pair itself acts like a single entity – similar to a stock or a commodity.

And just like when trading stock, investors profit when they buy a currency pair and its price increases.

Investors can also profit if they sell, or short, a currency pair and the price decreases.

 

 

Let’s look at an example.

Suppose an investor thinks Europe’s economy is going to grow faster than  the United States and as a result, she thinks the euro will strengthen against the US dollar.

She can buy the euro versus the US dollar pair to speculate on her assumption.

If the price of the currency pair rises, she’ll make money.

 

 

Conversely, if the price falls, she’ll experience a loss.

Now that we’ve covered the basics, lets looks at a few key aspects of the forex market.

 

Characteristics Of Forex

 

 

We’ll start with margin.

When you trade on margin, you only need to put up a percentage of the total investment to enter into a position. This
amount is known as the margin requirement.

When you trade other securities like stocks, trading on margin means you’re borrowing funds from your broker.

However, forex trades can only be covered using funds in the investors forex account.

Investors can’t borrow funds to enter a forex trade.

 

 

If they don’t have the funds in their forex account, they need to transfer funds before placing a trade.

Forex margin requirements vary depending on the currency pairs and the size of a trade. Currency pairs typically trade in specific quantities known as lots.

The most common lot sizes are standard and mini.

Standard lots represent 100,000 units and mini lots represent 10,000 units.

Depending on your brokerage firm, you may also be able to trade forex in 1,000 unit increments, also known as micro lots.

Margin requirements can be as small as 2% of a trade, or as large as 20%, but the margin requirement for most currency pairs average around 3% to 5%.

To understand how margin is calculated, lets look at an example using the euro versus the US dollar pair.

Say this pair was trading at 1.20 and an investor wanted to buy a standard lot, or 100,000 units. The total cost of the trade would be $120,000.

 

 

That’s a lot of capital. However, the investor doesn’t have to pay that full amount.

Instead, she pays the margin requirement.

Let’s say the margin requirement was 3%. 3% of $120,000 is $3,600.

That the amount the investor needs in her forex account ($3,600) to place this trade.

 

 

This brings us to another key element of the forex market – leverage.

Leverage enable investors to control a large investment with a relatively small amount of money.

In this example, the investor is able to control $120,000 with $3,600.

The leverage associated with currency pairs is one of the biggest benefits of the forex market, but its also one of the biggest risks.

Leverage gives investors the potential to make large profits – or large losses.

 

 

One more important element in the forex market is financing.

This is the calculation of net interest owed or earned on currency pairs and it happens when an investor holds a position past the close of the trading day.

The US Dollar is associated with an overnight lending rate set by the fed and this rate defines the cost of borrowing money.

Similarly, each foreign currency has its own overnight lending rate.

 

 

Remember, when you trade a currency pair, you’re trading two currencies against each other. Even though the currency pair acts like a single entity, you’re technically long one currency and short the other.

In terms of financing, you’re lending the currency you’re long and borrowing the currency you’re short.

This lending and borrowing occurs at the overnight lending rate of each respective currency.

In general, an investor receives a credit if the currency he is long has a higher interest rate than the currency he is short.

 

 

Conversely, an investor is debited if the currency he is long has a lower interest rate than the currency he is short.

Let’s look at an example.

Suppose an investor has a position in the Australian Dollar versus the US Dollar currency pair.

Say the overnight lending rate for the Australian dollar is 2% and the overnight lending rate for the US dollar is 1%.

The investor is long the currency pair, which means he is long AUD and short the USD.

Since the AUD has a higher interest rate than the USD, the investor will receive a credit.

However, if the investor was short the AUD/USD currency pair, he’d have to pay the debit because he’s short the currency that has a higher interest rate.

 

 

Financing is performed automatically by your brokerage firm. However, its important to understand how it works and its financial impact on the trade.

We’ve reviewed just a few elements of the forex market.

As with all investment opportunities, the forex market has a unique set of risks and benefits.

And education is the first step to determine if this is the right opportunity for you.

 

Quick Recap

Forex Market Basics

 

  • The foreign exchange, or forex market, is the world’s largest financial market, and it plays a vital role in the global economy
  • Every day, trillions of dollars are exchanged from one currency to another – as this kind of currency exchange is essential for international business
  • Currency prices change almost constantly during the week because the forex market is open continuously from Sunday at 4pm until Friday at 4pm central time
  • A trading day starts at 4pm and ends at 4pm central time the following day
  • The market has to be open around the clock because of the global nature of the economy

 

There Are 3 Types Of Forex Market Participants

 

1.) Governments

 

  • Governments use the forex market to implement policies
  • For example, when conducting business with another country, whether its borrowing money, lending money, or offering aid, a country needs to convert its currency into a foreign currency

 

2.) Businesses

 

  • Businesses use the forex market to facilitate international trade
  • For example, they may need to convert payments for goods and services bought overseas or to exchange payments from international customers into their preferred currency

 

3.) Investors

 

  • And investors use the forex market to speculate on changes in currency prices

 

Forex Trading 101

 

  • When you trade forex, you’re not just trading one product. You’re trading two currencies against each other. This is known as a currency pair
  • The quote for a forex currency pair defines that value of one currency relative to the other. The easiest way to understand any quote is to read the pair from left to right
  • Even though there are two currencies involved, the pair itself acts like a single entity – similar to a stock or a commodity
  • And just like when trading stock, investors profit when they buy a currency pair and its price increases
  • Investors can also profit if they sell, or short, a currency pair and the price decreases

 

 

Characteristics Of Forex

There Are 4 Defining Characteristics Of Forex….

 

1.) Margin

 

  • When you trade on margin, you only need to put up a percentage of the total investment to enter into a position. This amount is known as the margin requirement
  • When you trade other securities like stocks, trading on margin means you’re borrowing funds from you’re broker
  • However, forex trades can only be covered using funds in the investors forex account
  • Investors can’t borrow funds to enter a forex trade
  • If they don’t have the funds in their forex account, they need to transfer funds before placing a trade
  • Margin requirements can be as small as 2% of a trade, or as large as 20%, but the margin requirement for most currency pairs average around 3% to 5%

 

2.) Lot Size

 

  • Standard Lots – represents 100,000 units of a currency
  • Mini Lots – represent 10,000 units of a currency
  • Micro Lots – represent 1,000 units of a currency

 

3.) Leverage

 

  • Leverage enable investors to control a large investment with a relatively small amount of money
  • The leverage associated with currency pairs is one of the biggest benefits of the forex market, but its also one of the biggest risks
  • Leverage gives investors the potential to make large profits – or large losses

 

4.) Financing

 

  • This is the calculation of net interest owed or earned on currency pairs and it happens when an investor holds a position past the close of the trading day
  • Similarly, each foreign currency has its own overnight lending rate
  • Remember, when you trade a currency pair, you’re trading two currencies against each other. Even though the currency pair acts like a single entity, you’re technically long one currency and short the other
  • In terms of financing, you’re lending the currency you’re long and borrowing the currency you’re short
  • This lending and borrowing occurs at the overnight lending rate of each respective currency
  • In general, an investor receives a credit if the currency he is long has a higher interest rate than the currency he is short
  • And an investor is debited if the currency he is long has a lower interest rate than the currency he is short
  • Financing is performed automatically by your brokerage firm. However, its important to understand how it works and its financial impact on the trade

 

 

 

 

 

And this was a thorough overview of the foreign exchange (forex) market.

I know that this was a lot of information to swallow in just one lesson, but many of the themes that were explained in this lesson, have either been already explained before or will be explained in greater depth again in other forex articles – so there is no need to worry about not grasping the concepts just yet, as this will take some time for most of you.

Forex is a subclass of the derivatives’ asset class – and is used by investors and traders to “speculate” on price action for immediate, short term profits. And as explained above, they are also used by national governments and businesses who conduct foreign affairs.

Forex is best known – like all the other types of derivatives’ that we have already discussed – are known for their leverage, margin, liquidity, and volatility – making this attractive to those who would like to control a large amount of money for a fraction of the cost (through margin) and with the potential to make great profits and a higher return on investment (ROI).

However, it should be stressed that forex trading, like all derivative day trading, is extremely risky. This should only be used by advanced and sophisticated traders who have years of experience and expertise.

But if you are looking to enhance are sharpen you forex knowledge to trade and invest these assets, Invest In Wall Street has you covered – as you will gain a greater understanding for forex throughout this module.

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

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