"Now that we have progressed quite a bit in our beginner’s section, it is time to dive deeper into the world of the foreign exchange markets. In this article, we start with explaining to you how the forex markets are traded. The financial markets in general trade based on the same principles. However, the forex markets are traded a bit differently. You may not see these differences if you just glance through the forex markets. This article will outline to you the concepts and the terminology that will be used every day when you trade the currency markets. We will outline the basic things that you need to keep in mind and give you examples and compare forex to stock trading to illustrate the uniqueness of forex trading. By the end of this article, you will gain a bit more knowledge about the currency markets and a basic idea of how to trade these markets."
Unlike most other markets, the forex or the foreign exchange markets trading is slightly different. But this should be somewhat of an obvious thing to guess. You are after all dealing with the world of currencies. Each of these currencies are valued differently.
In this article, we take an in depth look at how you trade forex and the key terms that you are very likely to come across when trading.
The forex markets, as you might already know deal with trading of one currency to another. Therefore, unlike in stocks or futures, where the value of the transaction is the same (the U.S. dollar), with forex it is somewhat the same, but with a twist.
Let’s take the example of a stock. Say you are purchasing a few shares in Apple Inc. (APPL). What this means is that when you close your position, the profit you make is in U.S. dollars.
When you are purchasing the shares of Apple, you are basically betting that the value of the stock will rise. The value here is of course measured in U.S. dollars. This is but expected. After all, Apple Inc. is a U.S. based company that is publicly listed.
On the other hand, if you were to purchase shares in a London stock exchange, let’s say Vodafone, then your value is measured in the British pounds. This is because Vodafone is a company that is listed in the UK markets.
How does trading work in forex?
With forex, because you are trading one currency relative to the other, your trade is valued initially in the base currency. Sometimes you might end up trading a currency pair that is totally different and does not involve the U.S. dollar at all.
If the term, currency pair is a bit confusing to you right now, don’t fret. We will give you a detailed explanation on the concept of currency pairs in the next chapter.
Getting back to our topic, of how trading works in forex, let’s say you want to speculate on the performance of the EUR against the GBP. Notice here that the currencies involved are not USD.
So, what happens in such cases?
Let’s say you bought EUR/GBP at 0.7500 and sold your position at 0.8000. That’s a 500-point increase in the currency rate. But now comes the question of whether this 500-point increase will show up in euro?
Not really. Once you close your position, the 500-point profit is automatically converted at the spot rate of the EUR and the USD. This is the common scenario when you are trading cross currency rates.
Again, don’t pay too much attention to the term cross currency rate as we will cover this in detail in the next chapter.
Now going back to our example, let’s say you are trading EUR/USD this time. You are buying a position in the EUR/USD at 1.1200 and you sold your long position at 1.1250. This is a 50-point gain in your trade. But does it mean that you will get the 50 point equivalent in euros debited to your trading account?
No! Again the 50-point profit is automatically converted into the equivalent value in the U.S. dollar.
Factors to consider when trading forex
The above point illustrates how forex trading is somewhat different to trading stocks or futures, where everything is automatically valued in USD. But with forex it is different.
Besides the point above, there are a few things that you should consider when trading forex. These are listed below.
- Leverage – This is the lever or the margin that you can use. Using leverage, you can control large positions in the currency markets. Without leverage, you will need to have a deposit of at least $100,000 in order to make any meaningful profits in the forex markets.
- Margin – Besides leverage, in the forex markets you also need to pay attention to your margin. Brokers typically allow you to trade on margin with a forex account. But you need to maintain a certain margin level in your account at all times. When your account falls below the minimum margin requirements, you can be margin called. A margin call is where a broker requires you to add additional funds to your trading account to meet the margin requirements. Failure to do so could lead to your position being liquidated regardless of whether the position was in profit or in a loss.
- Fees – There are also fees that you should pay attention to when trading forex. The fees in forex is usually simpler to understand compared to stocks. In stocks for example, you will have to pay transaction fees, software fees, data fees and so on. In Forex, you will simply pay a transaction fee and for your positions that are kept open overnight, you are also charged an overnight swap fee.
In conclusion, forex trading as you can see is somewhat easier compared to other markets. But it is unique in some aspects. You may or may not have previous trading experience, but as we go along you will discover the forex markets more intimately.
