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What is forex trading?

What Is Forex TradingFor many people, including financial traders (stocks, bonds and other types of markets) the question of what is forex trading often comes up.

Foreign exchange or forex trading deals with exchanging one currency pair for another at the prevailing price that is set by the markets. The forex or currency markets are one of the largest in the world, estimated to have nearly $5 trillion in daily turnover on average.

Despite the fact that the forex markets clearly overshadow the stock markets, they are largely unregulated as most of the dealing is done over the counter (OTC). The reason behind this is that forex trading still remains in the realms of the interbank markets; the markets where banks deal with each other and the retail trading market share is very negligible in comparison.

The currencies - Majors

In order to understand what is forex trading traders need to know the terminology of the currency pairs that are used. The currencies that are listed in the forex as quoted in a three word format based on the ISO Codes. Examples include:

CurrencyISO CodeCurrencyISO CodeCurrencyISO Code
Euro EUR British pound GBP Australian dollar AUD
U.S. dollar USD Swiss franc CHF New Zealand dollar NZD
Japanese yen JPY Canadian dollar CAD    

Among the above, the EUR, USD, JPY, GBP, CHF, AUD, NZD and CAD are considered to be the major currency pairs. They are called so because of the fact that these are the most popular currencies, marked by the fact that they are very liquid and easy to trade.

The major currency pairs are also characterized by the tight spreads and offer one of the best trading conditions compared to other currency pairs. The most popular majors are: EURUSD, USDJPY, GBPUSD, USDCHF and USDCAD.

According to the Bank for International Settlements (BIS), the most popular currency pairs as of 2013 were, EURUSD, USDJPY and GBPUSD.

major currencies

Major Currency Pairs – 2013 (Source: BIS)

The forex quotes

Unlike stocks, or bonds where traders buy the security when they believe that the price will appreciate and sell the security when they believe that the value will fall, with forex, traders deal with simultaneous buying and selling of the currencies.

Thus, the forex markets are quoted in the format of two currency pairs, for example EUR/USD or EURUSD.

Here, the first currency, (EUR) is known as the base currency and the second currency (USD) is called the quote currency. Thus, when you see a price of EURUSD = 1.0190, it means that 1 euro is equal to 1.0190 U.S. dollars.

However, the forex quotes are not that simple as there are two prices rather than one. These two prices are often different and they are called as the bid and the ask prices.

The bid price in forex is termed as the price at which the trader can sell and the ask price in forex is termed as the price at which the trade can buy. The bid price is always lower than the ask price.

Thus, when you see a price quote such as EURUSD = 1.0190/1.0195, it means that you can sell euros at 1.0190 U.S. dollars or you can buy 1 euro at a price of $1.0195 (U.S. dollar).

The difference in the bid and the ask price is what is known as a spread and this price difference is how banks and brokers make money.

What factors affect the prices of currency pairs?

The forex currency pairs are affected by a number of economic factors, but primarily by interest rates that are based on the economic performance of the country in question. Besides the economic factors, speeches by key personalities such as central bank governors, members from the monetary policy committee, country leaders and other key personnel speeches can move the markets.

In recent times, the forex markets have started to focus more on the political developments as well and not just the economic factors, which is something that traders need to bear in mind.

Most of the economic events are generally scheduled and can be looked at a weekly basis by looking at the forex economic calendar.

How forex trading differs from other markets?

The forex markets differ from other types of markets due to the fact that trading is conducted over the counter. This is quite different from the stocks or futures markets for example where trading is conducted via a centralized exchange.

While OTC trading has its own set of benefits, there are also some risks involved. For one, over-the-counter trading increases the counter-party risk. In other words, there is a risk of the other party not honoring the trades, which is not possible when trading with stocks or futures which are traded at a centralized exchange.

Due to the fact that forex trading is conducted over the counter, there is no leverage restriction on trading, although most of the leverage restrictions are brought upon the financial regulators.

The spot markets are unique because when you trade the long term and keep the positions overnight, there are also additional fees involved such as the swaps, which can be either credited or debited from the trader’s account depending on the interest rate differential.

This is again something which is unique to the forex markets because other markets such as stocks or futures do not have the overnight swaps.

Forex trading is probably one of the unique markets that are available for trading and the relative ease of trading this market makes it the most attractive market compared to stocks or futures which requires higher amount of trading capital.

While forex trading can be lucrative, more and more people are trading to trading without knowing the basics of what is forex trading.

By spending some reasonable time in understanding how the forex markets works and also knowing the factors responsible for moving the prices in the currency pairs, traders can look at building a good trading strategy by focusing on strong risk management principles in trading.

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