Why do people trade Forex?
The foreign exchange market is not limited to speculation. Banks, companies, and other parties that need access to foreign currency engage in foreign exchange trading to facilitate international transactions. Companies also agree on foreign exchange rates in advance to determine the costs of exchanging currencies in the future, which is known as hedging. Another use case is for governments to build reserves and achieve economic goals, including pegging a currency or boosting imports/exports.
For individual traders, there are attractive features of the Forex market as well:
Leverage allows even small traders to invest larger amounts of capital than they would have direct access to.
Entry costs are low, as it is possible to buy small amounts of currency. Buying a share in the stock market can cost you thousands of dollars, compared to entering the foreign exchange market for $100.
You can trade at almost any time, making Forex suitable for all schedules.
There is high liquidity in the market, as well as low spreads between bid and ask.
Options and futures are standard products. Short selling in the market is possible for traders who do not just want to buy and sell immediately at the current market price.
Where do people trade forex?
Unlike stocks, which are traded primarily on centralized exchanges such as the New York Stock Exchange or the Nasdaq, foreign exchange trading takes place in centers around the world. Participants can transact directly with each other through over-the-counter trades or tap into a vast network of banks and brokers in the interbank market.
Overseeing international currency trading can be challenging due to the different regulations for each currency. While many jurisdictions have agencies that oversee trading within the domestic market, their international reach is limited. While you may need to obtain a license or go through an authorized broker to trade forex, this does not prevent traders from using other, less regulated markets for their activities.
Most of the forex trading volume is made up of four main areas: New York, London, Tokyo and Sydney. Since there is no central point for the forex market, you need to find a broker who can help you trade forex in different parts of the world.
There are a variety of options available for online brokerage services that are usually free. You won’t pay a commission directly, but Forex brokers will keep the difference between the price they quote and the actual market price. If you’re a beginner, choose a broker that allows you to trade mini lots. We’ll cover this later, but it’s the easiest way for you to get started with Forex trading.
What makes Forex trading unique?
The Forex market has many aspects that make it different from other financial markets:
This currency has a wide geographical coverage, with 180 foreign currencies recognized around the world, creating markets for it in almost every country.
It is very liquid and has a huge trading volume.
Market prices are influenced by many global factors, including politics, economic conditions, speculation, financial transfers, and more.
It is open for trading almost 24 hours a day, five days a week. Because the market is not completely centralized, the exchange or brokerage is always open for use. The markets are closed on weekends, but after-hours trading is still available on some platforms.
Profit margins may be low unless large volumes are traded. Profit can be made from small differences in the exchange rate through large trades.
How do people trade Forex?
There are a few options that individual traders can take when it comes to the forex market. The simplest method is to buy a currency pair on the spot market and hold it. For example, you can buy the euro in the USD/EUR pair. If the counter currency rises in value, you can sell it for the base currency and make a profit.
You can also leverage your own money to increase the amount of capital available to you. In this case, you can trade using borrowed money as long as you cover your losses. Another possibility to consider is forex options, which allow you to buy or sell a pair at a specific price on a specific date. Futures contracts are also popular, obligating you to enter into a trade at an agreed price in the future.
One of the exciting aspects of forex trading is the potential to profit from interest rate differentials. Central banks around the world set different interest rates that provide investment opportunities for forex traders. By exchanging your money and depositing it in a foreign bank, it is possible to make more money than leaving your money at home.
However, there are additional costs, including transfer fees, bank fees, and various tax systems. You must consider all the potential additional costs to make your strategies successful. The opportunities for arbitrage and gains are often small, so your margins will be tight. Unexpected fees can wipe out all of your expected gains.
What is the point?
A pip (percentage in points) is the smallest possible price increase that a currency pair can make in the Forex market. Considering the GBP/USD currency pair again:
A move up or down of 0.0001 would be the minimum amount the pair can move (one pip). However, not all currencies are traded with four decimal places. Any pair with the Japanese Yen as the base rate would have one pip of 0.01 because the currency has no decimal place.
Straws
Some brokers and exchanges break this norm and offer pairs that have more decimal places. For example, the GBP/USD pair will go to five decimal places instead of the usual four. The USD/JPY pair usually has two decimal places but can go to three. This extra decimal place is known as a straw.
What is a lot in forex trading?
In forex trading, currencies are bought and sold in specific quantities known as lots. Unlike stock markets, these lots of forex are traded at specific values. A lot is usually 100,000 units of the base currency in a pair, but there are smaller quantities you can buy as well, including mini, micro, and nano lots.
a lot
Units
standard
100000
Mini
10000
Micro
1000
nano
100
When working with contracts, it is easy to calculate your gains and losses through point changes. Let's look at the EUR/USD currency pair as an example:
If you buy one standard lot of the EUR/USD currency pair, you have bought 100,000 euros for $119,380. If the price of the pair increases by one pip and you sell your lot, this is equivalent to a change of 10 units of the quote currency. This increase means that you will sell 100,000 euros for $119,390 and you have made a profit of $10. If the price increases by ten pips, the profit will be $100.
As trading becomes increasingly digital, the popularity of standard contract sizes has declined in favor of more flexible options. At the other end of the spectrum, large banks have increased their standard contract sizes to 1 million contracts to accommodate the large volume they trade.
How does leverage work in Forex trading?
One of the unique features of the Forex market is the relatively small profit margin. To improve your profits, you will need to increase your trading volume. Banks can do this fairly easily, but individuals may not have access to sufficient capital and may instead use leverage.
Leverage allows you to borrow money from a broker with a relatively small collateral. Brokers quote leverage amounts as a multiple of your invested capital, for example, 10x or 20x equals 10 times or 20 times your money. $10,000 with 10x leverage will give you $100,000 to trade.
To borrow this money, traders keep a margin amount that the broker uses to cover potential losses. A 10% margin is 10x, a 5% margin is 20x, and a 1% margin is 100x. By taking advantage of leverage, you can experience losses or full gains on your investment based on the total amount being leveraged. In other words, leverage amplifies your profits and losses.
Let’s look at an example of the EUR/USD currency pair. If you wanted to buy one lot of this pair (100,000 euros), you would need approximately $120,000 at the current price. If you are a small trader who does not have access to this amount of money, you might consider taking a 50x leverage (2% margin). In this case, you would only need to have $2,400 available to reach $120,000 in the forex market.
If the pair drops by 240 pips ($2,400), your position will be closed, and your account will be liquidated (you will lose all your money). When using leverage, small movements in price can lead to sudden and large changes in your profits or losses. Most brokerage firms will allow you to increase the margin in your account and increase it as needed.
How do hedging work in Forex?
With any floating currency, there is always a chance that the exchange rate will move. While speculators try to profit from volatility, others value stability. For example, a company planning to expand internationally might want to fix the exchange rate to better plan its expenses. They can do this quite easily through a process called hedging.
Even speculators may want to lock in a specific exchange rate to protect against an economic shock or financial crisis. You can start hedging foreign exchange rates using different financial instruments. The most common methods are using futures or options contracts. With a futures contract, an investor or trader commits to trading at a specific price and amount at a future date.
Futures
Let’s say you entered into a forward contract to buy one lot of USD/EUR at 0.8400 (buying 100,000 USD for 84,000 EUR) in one year. Perhaps you are selling in the Eurozone and want to repatriate your profits in one year. The forward contract removes the risk of the USD appreciating against the EUR and helps you better plan your finances. In this case, if the USD appreciates, each Euro will buy fewer dollars when you repatriate the money.
If the US dollar appreciates and the USD/EUR exchange rate reaches 1.0000 in a year, without a forward contract, the spot rate would be 100,000 USD for 100,000 EUR. But instead of that rate, you would enter a pre-agreed contract for one lot of USD/EUR at 0.8400 ($100,000 USD for 84,000 EUR). In this simple example, you would save a cost of 16,000 EUR per lot, excluding any fees.
Options
Options provide a similar way to reduce risk through hedging. But unlike futures, options give you the option to buy or sell an asset at a predetermined price on or before a specified date. After paying the purchase price (premium), the option contract can protect you against an unwanted rise or fall in the value of a currency pair.
For example, if a UK company sells goods and services in the US, it can buy a GBP/USD call option. This allows it to buy GBP/USD in the future at a predetermined price. If the value of the pound rises or stays the same when the payment is made in US dollars, the company only loses the price paid for the option contract. If the value of the pound falls against the dollar, it has already hedged its price and can get a better price than the market is offering.
To learn more about futures and options, see
*What are futures and futures contracts? What are options contracts?*
Covered Interest Rate Arbitrage
As interest rates vary globally, forex traders can arbitrage these differences while offsetting the risk of exchange rate movement.
One of the most common ways to do this is through covered interest rate arbitrage. This trading strategy hedges against future price movements in a currency pair to reduce risk.
Step 1: Find an arbitration opportunity.
For example, take the EUR/USD pair with an interest rate of 1.400. The interest rate on deposits in the Eurozone is 1%, while in the US it is 2%. So investing €100,000 in the Eurozone will earn you €1,000 in profit after a year. However, if you could invest the money in the US, it would earn you €2,000 in profit if the exchange rate held up. However, this simplified example does not take into account fees, banking costs and other expenses that you should also consider.
Step 2: Hedging the Foreign Exchange Rate
By using a one-year EUR/USD forward contract with a forward rate of 1.4100, you can benefit from the improved US interest rate and ensure a fixed return. The forward rate is the agreed foreign exchange rate used in the contract.
The bank or broker calculates this rate using a mathematical formula that takes into account different interest rates and the current market rate. The forward exchange rate adds a premium or discount compared to the current market rate depending on market conditions. In preparation for arbitrage, we enter into a forward contract to buy one lot of EUR/USD at 1.41 in one year.
Step 3: Complete the arbitration
In this strategy, you sell one lot of EUR/USD at 1.400 on the spot market to make $140,000 with a cost of 100,000 euros. Once you have the money from the spot trade, you deposit it in the US for a year at 2% interest. At the end of the year, you will have $142,800 in total.
The next step is to convert $142,800 into euros. Using a forward contract, you sell $142,800 at the agreed price of 1.4100, giving you approximately €101,276.60.
Step 4: Compare Profits
Let's compare the profit you get here with and without hedging the price, assuming everything else is correct. After following the US covered interest arbitrage strategy, you would have €101,276.60. If you didn't hedge, you would have €102,000, as mentioned before. So why do people hedge if it results in lower profits?
First of all, traders are hedging to avoid the risk of exchange rate fluctuations. A currency pair rarely remains stable throughout the year. So, while the profit is €723.40 less, we have at least secured €1276.60. Another factor is that we assume that the central bank will not change the interest rate throughout the year, which is not always the case.
Closing thoughts
For anyone interested in international economics, trade, and world affairs, the forex market offers a unique alternative to stocks and bonds. Forex trading may seem less accessible than cryptocurrencies or stocks for small investors. But with the rise of online brokers and increased competition in providing financial services to the masses, forex is no longer out of reach. Many forex traders rely on leverage to make decent profits. These strategies carry a high risk of liquidation, so make sure you understand the mechanics well before taking the risk.
