The foreign exchange market (FX) is a continuous market for currency exchange. Often perceived as very complicated to trade in, the FX market remains the largest market in the world. So how does it work, and is it lucrative?
What is Forex Trading?
Like most financial markets, fluctuations in price happen because of supply and demand. Traders are buying currency pairs and selling others while exchange rates fluctuate constantly. Banks and fund managers often hedge or speculate against fluctuations with accessible funds.
Unlike other financial markets, the FX market is open 24 hours Monday through Friday, where trades happen over the counter (OTC). Over-the-counter trading is a direct trade between two private parties rather than a centralized exchange.
What influences the price of a currency pair?
Supply and demand cause the main price changes in the FX market. For example, a trader might expect the EUR to strengthen in value concerning the USD. Also, macro-economic changes like interest rates, economic growth, and political circumstances can influence the strength of a currency.
How do I trade Forex?
Forex is traded in three different ways, not to exchange currencies for your holidays abroad, but rather to speculate about forex price movements. Forex traders want to buy currency they expect to decrease concerning other currency.
In the spot market, financial instruments have immediate delivery. Moreover, the so-called spot price determines the current price for which a currency is trading.
Instead of trading at the spot, forex traders may choose to enclose a binding contract that locks in an exchange rate they will have to buy at a future date, called the forward market.
A futures contract, traded in the futures market, is based on the delivery of an underlying asset (currency) at a future price, much like the forward market. This market is mainly used for forex trading and is seen less in trading commodities.
What are the risks?
Trading currency never comes without risk. Many previous studies suggest that 70-90% of traders eventually lose money when trading FX. The leverage risk associated with forex trading is where small price fluctuations result in margin calls. Price fluctuations require the investor to pay an additional margin, which can be detrimental for your initial investments.
As mentioned previously, you can often use macro-economic circumstances to profit from currency. For example, hiked interest rates can have a massive effect on currency prices globally. Sometimes, this comes without any prior notice, causing the currency to fluctuate heavily.
Some countries’ currencies are heavily dependent on a political leader or an entity that makes major decisions on key economic measures. For example, Putin’s decision to invade Ukraine caused the Russian rouble to collapse relative to major global currencies. Another example is Erdogan’s decision not to raise interest rates to stem capital outflows and thereby depreciate the Turkish lira’s value to other currencies.
When trading FX, the trader must be aware of the risks associated with traders moving out of a country, causing the risk of devaluation. Sometimes, governments even devaluate their currency intentionally, which makes export cheaper. It might be difficult for a trader to comprehend whether this is intentional or unintentional.
To conclude, forex traders must be aware of macro-economic influences, emotions, and political stability. A successful trader must understand the mechanics of the FX market. Trusting your analysis and building a comprehensive trading strategy is key to making proper decisions in difficult situations.