Forex Trading - How It Works

For many people traveling internationally, the first concern is about getting their currency exchanged when they land on the foreign ground. This is the very reason why you see so many foreign exchange currency providers on airports all over the world. The usual trade of $100 can earn these money exchangers a couple of bucks. Now think of this on a larger scale, a company that is headquartered in the United States and has branch operations in Europe. Such a company would need to exchange hundreds of thousands of USD to EURO every month. There could be many reasons for this trade including paying their foreign staff or managing their monthly administration budget. 

Now start thinking about forex trading as a global phenomenon, where a country starts to devalue its currency to attract foreign exchange. People from all over the world start selling that currency and buy a universal currency like USD. This is a great investment for the future. Now we are talking about millions of dollars being traded for another currency. Today, foreign exchange market volume exceeds $5 trillion, making it the largest trading platform in the world. 

How Forex trading works

Like any other exchange, whether it is a stock exchange or a cryptocurrency exchange, trading takes place when a buyer meets a seller of the desired commodity. If both parties agree on a price, the transaction takes place, and the trade is complete. Forex traders have one major advantage over any other commodity traders. For forex traders, the buyers or sellers are much easier to find and the process is quick, convenient, and easy. Here are some simple notations people use in the forex market:

The trade is usually notated by a Base currency / Trade currency. If you see a forex pair marked as EUR/USD with a trade price of 1.03. This means that for every Euro, you can get 1.03 Dollars. 

The gain that you make on a foreign currency trade is called the spread. So, in the example above, if you buy 1.03 USD for 1EUR, your gain or spread is 3 pennies. Exchanging a hundred Euros will earn you 3 Dollars and so on.

The money makers in the foreign exchange market usually trade on leverage. What this essentially means is that they borrow the base currency from liquidity providers like banks and make trades to earn their margin. Once the trade is complete, they retain the profit and return back the leveraged or the borrowed amount.

Factors affecting the foreign currency prices

Exchange rates are one of the major determinants of a country’s economy. A lower value currency means foreign investors may purchase goods at a lower price which translates into an increase in exports. On the other hand, if a country’s currency increases in value, foreign investors are reluctant to purchase goods from them, hence, their exports go down. Countries that export more than what they import have a trade surplus. On the other hand, countries that import more than what they export, have a trade deficit. Countries with some of the largest trade deficits in the world end up taking debts to pay-off their trade deficit. Therefore, maintaining appropriate value for their local currency is vital for every country’s economic growth. The factors that affect that forex prices include:

Inflation Differential

If a country’s inflation rate is lower than in other countries, the purchasing power of its people increases as well. This means they can buy more commodities from the local market. This gives rise to new projects, foreign investments, and enhances the welfare of society. All these factors raise the local currency value above other currencies. On the other hand, if there is a continuous increase in the inflation rate of the country, then people lose their buying power. This means that local manufacturers are at a loss and market shows a higher supply than demand. This lowers the local currency value and increases the trade deficit of a country as well.

Interest rates

Interest rates are a great way to determine how a country’s economy will perform in the near future. Rising interest rates suggest that lenders such as banks and other financial institutions will earn more money. Since the lenders earn extra margin on the amount lent to borrowers, they provide higher returns to their investors. This attracts foreign investment as well and raises the value of local currency. However, federal banks are usually cautious while raising their interest rates since it can trigger inflation well. To mitigate this domino effect, countries usually introduce policies that encourage the financial institution to invest in a project that strengthens the country’s infrastructure as well. 

The deficit in Country Current Account

The current account of a country shows whether it is running in a surplus or facing a trade deficit. Current account shows all the transactions including purchase and sale of goods, along with interest and dividend payments. As the currency of a country devalues, it has to pay more for its imports and receives less for what it exports. To manage this trade deficit, countries start taking a loan from foreign sources which further devalues the local currency. Eventually, the country starts losing its economic strength.

Government debt

To finance public projects, the government may issue large public debts. Although this may provide some relief in the short term, it raises the Government’s overall debt. To pay off the Government’s debt, the central bank may print more money which eventually gives rise to inflation. A country with a high inflation rate and a foreign trade deficit is not attractive for foreign investors. With minimal investments from abroad and high debt to income ratio, countries lose the value of their currency. 

Terms of Trade

It is the ratio of prices of exports to prices of imports and determines how strong or weak a country’s economy is. If the price of a country’s exports are higher than the price of its imports the terms of trade ratio goes up. Revenues from exports strengthen the local economy and reduce inflation. This gives rise to local currency value in the foreign market. 

Stability in a political environment

Political stability means the local economy will flourish and wealth of the people will grow over time. When countries have the same leaders run the government for long, the economic policies are defined for longer terms. Investors are always looking out for growing economies where they can preserve and grow their wealth over a long period of time. This allows the local economy to attract a large amount of foreign investment from all over the world, increasing jobs and also the value of local currency.

Different types of Forex Markets

Since forex trading is one of the most popular forms of trading around the globe, investors trade currency in futures as well. The spot market is the most commonly used platform for foreign exchange trades. The three platforms that are used by brokers such as 4XFX and currency holders to trade their currency include:

Spot Market

These markets are those where foreign currency trades take place in real time and ‘real assets’ are either bought or sold. The price of a currency in the spot market is determined by geopolitical situations around the world. As explained earlier, a currency may rise and fall under inflationary pressure. 

Future Markets

Future markets are used to trade contracts that are based on future currency prices. Since these contracts are sold based on how a particular currency will perform in the long and short term, investors perform thorough research before investing in future contracts. If an investor wants to invest in a future contract for Japanese currency, they would study how the currency will perform over time. They may take into consideration the international relations and local government policies of the country before investing in that particular trade.

Forward Markets

Currency forwards are over the counter trading instruments that can be bought or sold in advance at a particular price for a future date. Since the price is fixed, the investor does not have to pay a premium for any loss in the exchange rate. Since they protect owners from declining forex markets, they are also considered as a useful hedging tool. Another benefit of currency forwards is that they can be settled for cash or delivery basis.

Unlike currency futures or stock option contracts, currency forwards do not require any upfront payment. Investors do have to pay a certain premium to avail this facility in the form of ‘locked in’. This means that once invested, the buyer cannot opt out from the currency forward deal.

Benefits of Forex Trading

Foreign currency trading is accessible to any type of user whether they are consumers, corporate, or government agencies. Due to the swift nature of foreign currency transactions, they are used as a form of investment all over the world. Here are some useful benefits of forex trading:

Immense Liquidity

There is no asset class that is as close to hard cash as a foreign currency. No matter which part of the world you are in, you can trade your foreign currency within seconds. All you need to do is approach a money changer and your trade will be completed within seconds. Unlike many other forms of trading that require certain prerequisites such as creating accounts and subscribing for a central depository, forex trading can start immediately. If you feel that you do not have access to a central exchange or a brokerage house to exchange your currency then you can perform direct trades as well. All you need to do is put up your sale price through online resources or through word of mouth and liquidate your forex investment.

No commission

To conduct your forex trade, you do not necessarily contact a broker. In fact, you do not need a foreign currency deposit account as well. This saves the foreign currency investors a lot of cost and time to complete their trade. However, people can ask questions as to how forex companies and banks make money on a currency trade? Well, they keep their spread called ‘parity’ in the currency value itself. To explain this further consider you want to sell 100 dollars in exchange for Euros. For the money exchanger, the buying rate of 100 dollars would be 99 Euros. However, let's reverse the situation for a second, what if you want to Buy 100 dollars from a money exchanger by giving them Euros. This time, they would ask you for 101 Euros to sell you 100 dollars. The disparity between their buy and sell creates their gain.

No binding contract

For any type of trade or any type of investment that you make anywhere in the world, you will need to sign a contract. Whether you open an Individual Retirement Account to increase your retirement wealth or invest money in hedge funds, you will need to complete a considerable amount of paperwork before you can gain access to their portfolio. Not only that, these fund managers would require that you keep your money with them for a certain period of time before you can withdraw your investment. In case you want your cash back before the maturity period, you will have to pay an early withdrawal fee. Forex trading, on the other hand, does not bind you to a contract. If you want to get rid of a foreign currency you just trade it for a local one.

Mode of Diversification

Forex is a great way to diversify your portfolio into different forms of assets. If you have invested all your wealth in stocks, you risk reducing your investment size in case the market crashes. One of the most popular ways to ‘hedge’ your investments against a downside trend is to diversify your wealth into different asset classes. Therefore, you should keep a certain amount of your investment in Foreign currency as well. 

Forex trading is a great way to earn from the geopolitical changes around the world. It is easy to start and does not require much time and effort to manage foreign currency trade. Anyone looking for a lucrative asset class to invest cash in should definitely consider foreign currency trading.

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