What is Forex and How do I Trade it?
What is Forex?
Forex, Foreign Exchange or simply FX are all the same thing, they are basically currencies. When dealing with currencies you essentially always work with a pair. The FX market is the biggest market in the world where people trade one currency against another. This market is traded OTC, over-the-counter, meaning there is no centralised exchange. The price generated in the market derives from a group of banks offering their best price, rather than a centralised exchange like the London Stock Exchange. Please take a look at the example below, which demonstrates how this price is generated by your broker.
HSBC 8 12
RBS 9 13
Barclays 10 14
Your Broker 10 12
This table is simplified but your broker will take a bunch of different price feeds and offer you the best sell price and the best buy price. In the example above you can see that you would buy from HSBC at 12 and sell to Barclays at 10. Prices you get can differ as your broker can choose who they work with, but these differences are minimal for most retail traders.
Forex Currency Pairs
As stated in the name FX currency pairs, these are two currencies traded against each other. Most people will recognise these from going abroad and exchanging their own money to receive local currencies. The most traded FX pair in the world is €/$, this is due to the huge amount of trade and investment deals that are executed between the USA and the EU. The Euro versus the US Dollar is currently around 1.1242, meaning for each Euro you get $1.12. You could also show the same pair as USD/EUR, meaning $1 = 0.89EUR. The value is exactly the same but the FX industry has agreed to quote currency pairs in a certain order, in this case EUR/USD.
You have two options when trading, buying the pair or selling it. You could formulate these actions in a few different ways but in essence one currency is appreciating, while the other is depreciating against the other. I have illustrated this using a few examples below.
Forex Pair Example A
• Currently EUR/USD = 1.1242
• I believe the Euro will strengthen (go up) in price
• Therefore I buy EUR/USD
Why do I buy the pair? Because I believe that the price will go up, meaning if it goes to a price of 1.2000 I now get more USD for the same amount of EUR. Depending on the amount you invested you would make a profit.
To simplify, all I did is trade my $1.12 to buy 1€ and at a later point in time traded my 1€ back into USD and received $1.20 back. Therefore I made a profit of 8 US cents.
Forex Pair Example B
• Currently EUR/USD = 1.1242
• I believe the USD will strengthen (go down) in price
• Therefore I sell EUR/USD
Another way of looking at the USD strengthening is that currently the Euro is worth more than the Dollar (I receive more Dollars for one Euro). If I believe this difference will decrease I am speculating the Dollar will become worth more (which is the same as saying the Euro will become worth less).
If the price were to go down far enough, it could reach parity, meaning 1€ = 1USD.
Summery and Terminology
• (EUR/USD = 1.1242) = (USD/EUR = 0.8929)
• I believe USD will strengthen = I believe EUR will weaken (against each other)
• I believe EUR will strengthen = I believe USD will weaken (against each other)
Base Currency vs Variable Currency
The first currency is known as the base currency meaning it does not change, while the second does changes.
• 1€ = variable USD amount
• First/base currency
Tomnext is what is used to calculate funding for a currency pair.
Buying vs Selling. Which Direction?
• I think the EUR will get stronger = Buy the pair
• I think the USD will get stronger = Sell the pair
• I think the EUR will get weaker = Sell the pair
• I think the USD will get weaker = Buy the pair
• Buying the pair EUR/USD = Selling the pair USD/EUR
We have not yet covered everything about Forex, but have explored some of the fundamentals to help get you started. FX trading is hugely popular as a product and at first glance might seem a bit overwhelming. My advice is as always to start local. Start with your local currency against another currency that you think is doing significantly better or worse in comparison.
If this sounds like an interesting proposition to you, then click on the link below to learn more about our preferred FX Broker and get started.
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