When you are traveling across the world, you might think that exchanging currencies isn’t worth much. That’s not the case as some currencies are stronger than others. What you may not realize is that you can make a profit out of selling certain currencies. With the Forex Market (short for Foreign Exchange Market), you are given the opportunity to do so. So you might be wondering what happens in Forex, well don’t worry as we’ll explain what it is and how it works.
Largest Market in the World
Forex is a marketplace where various national currencies are exchanged. It is the largest, most liquid market in the world. Forex is much larger than the NYSE (New York Stock Exchange). The average daily trading volume from the NYSE is about $22.4 billion, while Forex trades about $6.6 trillion in daily trading volume. The exchange is done on an electronic network, meaning there is no central location and it is mostly done between banks and brokers. The market is in constant flux as the exchange rates are changing every second.
Easily Accessible
Forex is accessible to everyone. It used to be limited to governments and large corporations. Investment firms, banks, and brokers give people the opportunity to open an account so they can start trading. Forex is open five days a week and exchanges of currencies can be done 24 hours a day (depending on the country, the market is closed on holidays).
This means that Forex doesn’t close at the end of the business day compared to the stock or bond markets. Forex has fewer rules and does not have a governing central body and no Clearinghouses. Additionally, there are no fees or commissions compared to other markets. You can buy as much currency based on the size of your trading account.
Rollover Rates
Rollover Rates are a trader’s overnight net interest return of a currency position. This occurs when an investor borrows one form of currency to buy another one. The interest that was paid or earned overnight for holding that position is what leads to a Rollover Rate. To have a currency position held overnight, it has to be open after 5 p.m. To calculate your rollover rate, you need to subtract the base currency’s interest rate from the quote currency’s interest rate. Once you do that you then divide that amount by 365 and then you multiply that amount by the base exchange rate.
Institutions and investors use Forex to buy and sell currencies. They post orders of buying and selling certain currencies on the network at certain rates of exchange and interact with other parties. Additionally, they can use Forex for speculation purposes.
For example, the movement of a certain pair of currencies (the US Dollar versus the European Euro; USD/EUR). The markets will determine the value of a currency versus another currency and this can reflect the current and future health of that country’s economy. Two currencies are traded in pairs. You sell one currency in order to buy another currency hoping that will be sold at a higher price in the future. Profits are made based on differences in your transaction prices.
Mind you, the currency movement can be volatile. The short-term movement is based on technical trading which focuses on speed and direction. While the long term movement refers to the relative interest rates and economic growth of the pairs of currencies involved
Leverage
Leverage in Forex can be enormous, as much as 50 to 1 by some brokers. It is very common and plays a major role. Leverage is the use of borrowed money to invest in the selected currency. These leverages are borrowed from brokers so the investors can trade large positions for a currency. However, leverage acts as a double-edged sword as the movement results can lead to a return having massive gains or losses. It is best that investors learn to manage leverage and risk management.
Example
Traders will take a position with a certain currency with no physical contact. Let’s say one trader wants to trade the US Dollar versus the British Pound. If GBP/USD is trading at 1.32179 this means that a buyer would pay $1.32179 to purchase 1 British Pound and a seller would receive 1 U.S. Dollar for selling 1 GBP. The buyer wants the GBP to appreciate in value and the seller of the pair of currencies wants the GBP to depreciate. In other words, the buyer is investing in a “share” of the British economy hoping that it will do well.
“Pips” and “Lots”
In the FX Market currencies trade-in “pips” and “lots” not ticks and shares like stocks. A “pip” is an acronym for “price in percentage” and is the smallest agreed-upon price increment a currency pair can move. A pip is 1/100 of 1% or .0001. FX currency pairs trade in “lots.” There are micro, mini, and standard lots. A micro lot is 1,000, a mini is 10,000 and a standard is 100,000 a given currency.
The major currencies in the world include the US Dollar (USD), Canadian Dollar (CAD), Australian Dollar (AUD), New Zealand Dollar (NZD), British Pound (GBP), European Euro (EUR), Swiss Franc (CHF), and the Japanese Yen (JPY). These currencies represent some of the world’s largest economies and receive the most trading activity. The most traded currency is the US Dollar, it is often paired with the Japanese Yen, the European Euro, British Pound, or the Australian Dollar.
Conclusion
To wrap up, the pros for Forex is that it is online and decentralized with few rules and regulations, it is open five days a week and twenty-four hours a day, it is highly liquid, there are no commissions although most brokers widen their Bid/Ask spread to earn a profit, and Forex brokers allow for a great deal of leverage. Forex is accessible to everyone.
The Cons for Forex, however, is that exchange rates are constantly changing and can be extremely volatile. There is no central location for trading. Leverage can be a double-edged sword and trading losses can be extreme if the risk is not properly managed. Depending on what country you reside in, Forex is closed on holidays.
Forex is another market for people to trade in. The easy access to the market can help you speculate and plan what pairs of currencies you want to buy and sell. Being open to anyone at any time can be encouraging for all. But be careful, the constant fluctuations in currency pairs may cause large losses so be mindful of your risk parameters.
Expert Tip:
Look for a broker that doesn’t utilize a Dealing Desk. This means that your FX order goes straight to the market and not through a middle man. Also, find a broker with competitive spreads no wider than 1 pip or so during major sessions on major currency pairs such as the EUR/USD.
References:
BabyPips.com. (2011, April 18). What Is Traded In Forex? Retrieved November 06, 2020, from https://www.babypips.com/learn/forex/what-is-traded-in-forex
BabyPips.com. (2018, July 04). What is Forex? Retrieved November 06, 2020, from https://www.babypips.com/learn/forex/what-is-forex
Chen, J. (2020, August 28). Foreign Exchange (Forex) Definition. Retrieved November 06, 2020, from https://www.investopedia.com/terms/f/foreign-exchange.asp
DailyFX. (n.d.). EUR/USD. Retrieved November 10, 2020, from https://www.dailyfx.com/eur-usd
Hargrave, M. (2020, August 28). How the Rollover Rate (Forex) Works. Retrieved November 11, 2020, from https://www.investopedia.com/terms/r/rollover-rate.asp
Mitchell, C. (2020, November 05). Forex (FX) Definition and Uses. Retrieved November 06, 2020, from https://www.investopedia.com/terms/f/forex.asp
Momoh, O. (2020, August 28). How Leverage Works in the Forex Market. Retrieved November 11, 2020, from https://www.investopedia.com/ask/answers/06/forexleverage.asp
