At its simplest, forex trading is similar to the currency exchange you may do while traveling abroad: A trader buys one currency and sells another, and the exchange rate constantly fluctuates based on supply and demand.
A forex trader might buy U.S. dollars (and sell euros), for example, if she believes the dollar will strengthen in value and therefore be able to buy more euros in the future. Meanwhile, an American company with European operations could use the forex market as a hedge in the event the euro weakens, meaning the value of their income earned there falls.
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Like any other market, currency prices are set by the supply and demand of sellers and buyers. However, there are other macro forces at play in this market. Demand for particular currencies can also be influenced by interest rates, central bank policy, the pace of economic growth and the political environment in the country in question.
Because forex trading requires leverage and traders use margin, there are additional risks to forex trading than other types of assets. Currency prices are constantly fluctuating, but at very small amounts, which means traders need to execute large trades (using leverage) to make money.
This leverage is great if a trader makes a winning bet because it can magnify profits. However, it can also magnify losses, even exceeding the initial amount borrowed. In addition, if a currency falls too much in value, leverage users open themselves up to margin calls, which may force them to sell their securities purchased with borrowed funds at a loss. Outside of possible losses, transaction costs can also add up and possibly eat into what was a profitable trade.
If the value of the U.S. dollar strengthens relative to the euro, for example, it will be cheaper to travel abroad (your U.S. dollars can buy more euros) and buy imported goods (from cars to clothes). On the flip side, when the dollar weakens, it will be more expensive to travel abroad and import goods (but companies that export goods abroad will benefit).
Unlike the spot, forwards, and futures markets, the options market does not trade actual currencies. Instead, it deals in contracts that represent claims to a certain currency type, a specific price per unit, and a future date for settlement.
Remember that the trading limit for each lot includes margin money used for leverage. This means the broker can provide you with capital at a predetermined ratio. For example, they may put up $50 for every $1 you put up for trading, meaning you will only need to use $10 from your funds to trade $500 in currency.
These days, you can start trading forex with as little as $1,000 funded in a micro account, but will need significantly more capital for a standard account. Leverage from brokers can allow you to trade much larger amounts than your account balance. Brokers may provide capital at a predetermined ratio, for example, such as putting up $50 for every $1 you put up for trading. This means you may only need to use $10 from your own funds to trade $500 in currency.
The specific minimum deposit will depend on the brokerage you use and the amount of leverage they allow. But in general, forex trading is increasingly accessible even with a small starting balance compared to some other markets.
Forex markets are among the most liquid markets in the world. So, they can be less volatile than other markets, such as stocks. The volatility of a particular currency is a function of multiple factors, such as the politics and economics of its country. Therefore, events like economic instability in the form of a payment default or imbalance in trading relationships with another currency can result in significant volatility.
Forex trade regulation depends on the jurisdiction. Countries like the United States have sophisticated infrastructure and markets for forex trades. Forex trades are tightly regulated in the U.S. by the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC). However, due to the heavy use of leverage in forex trades, developing countries like India and China have restrictions on the firms and capital to be used in forex trading. Europe is the largest market for forex trades. The Financial Conduct Authority (FCA) monitors and regulates forex trades in the United Kingdom.
Currencies with high liquidity have a ready market and exhibit smooth and predictable price action in response to external events. The U.S. dollar is the most traded currency in the world. It is paired up in six of the market's seven most liquid currency pairs. Currencies with low liquidity, however, cannot be traded in large lot sizes without significant market movement being associated with the price.
thinkorswim trading platforms offer a wide range of tools and solutions designed to help forex traders analyze trades and receive real-time updates on profit and loss. In addition, you can access real-time market news and forex charting with hundreds of studies and indicators available.
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Forex, or the foreign exchange, allows investors to speculate on changes in currency prices. Forex is traded in pairs, meaning you are buying one currency while simultaneously selling another. For an in-depth break down of the basics of forex, read our article, "What is Forex trading?"
Narrator: 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. This kind of currency exchange is essential for international business.
Governments use the forex market to implement policies. For example, when conducting business with another country, whether it's 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.
Narrator: Currency prices change almost constantly during the week because the forex market is open continuously from Sunday at 4 p.m. Central time until Friday at 4 p.m. Central time. The market is closed on Saturdays. A market day starts at 4 p.m. Central time and ends at 4 p.m. Central time the following day. At Schwab, forex trading hours are 23 hours a day, opening at 5 p.m. Central time, and closing at 4 p.m. Central time, and closed on Saturdays.
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 U.S. dollar. She can buy the EUR/USD 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.
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 investor's forex account. Investors can't borrow funds to enter a forex trade. If they don't have 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".
Narrator: This brings us to another key element of the forex market: leverage. Leverage enables investors to establish a position in a large investment with a relatively small amount of money. In this example, the investor is able to trade a position worth $120,000 with an initial deposit of $3,600.
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 that you're long and borrowing the currency you're short. This lending and borrowing occurs at the overnight lending rate of each respective currency.
Let's look at an example. Suppose an investor has a position in the AUD/USD currency pair. Say the overnight lending rate for AUD is 2% and the overnight lending rate for USD is 1%. The investor is long the currency pair, which means he is long the 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.
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. 152ee80cbc
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