Forex Trading Concepts
Even though it has grown tremendously since it was opened and has a great number of small, private investors, forex’s biggest players remain to be the big financial institutions, since investing in foreign exchange is a primordial activity for the big funds, banks and brokers. But although it’s them and the big commercial organizations doing all the big movements in the market, private investors like you can still take advantage of the moves they make in the market.
In order to know when to make a move, to know certain terms and basic concepts of forex trading is crucial. Here are some of the most important concepts you should know when exchanging currencies, and that if used properly, will generate a great advantage for you when trading:
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Understanding Leverage Margins
One of the biggest and most notorious differences between forex and the equities market is Leverage. In the equities market, most traders do not use leverage, and what you have is what you can trade. Due to the extreme liquidity of the forex market, margins are low and leverage is high. With a relatively low deposit, you can control a larger position in the market. For example, if you are using 100:1 leverage on $1,000 invested, you control $100,000 in capital. If you put $100,000 into a currency and the currency’s price moves 1% against you, the value of the capital will have decreased to $99,000 - a loss of $1,000, or all of your invested capital, representing a 100% loss.
The ultra-high leverage of the forex market means that huge gains can quickly turn to damaging losses and can wipe out the majority of your account in a matter of minutes. This is important for all new traders to understand, because in the forex market traders will react quickly to information released into the market, leading to sharp moves in the price of the currency pair.
Understanding Currencies
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Trading in the forex market involves always to currencies: the one you have, and the one you’re trading for. When you trade them, you are practically speculating on the prospect of a currency becoming stronger, when compared to the other. Speculation for profit, which is what you’re doing when you are exchanging currencies, represents 95% of the world’s daily turnover in the forex market. The remaining 5% comes from companies that buy and sell products in foreign countries, plus convert profits from foreign sales into domestic currency. The base currency is always equal to one unit, and the quoted currency is what that one base unit is equivalent to in the other currency. The trade currency is usually the base currency, and the profit or loss will be in the price currency, or quoted currency. Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of the Japanese yen (JPY), which is quoted out to two decimal places. |
Easy Trading
Trading in forex is easy, and hassle free. After you’ve been quoted a spread that is acceptable for your trade conditions, all you have to do is accept it and receive confirmation, and the trade is done. There is no middle-man, or hidden steps necessary in order to complete a transaction, which is a great advantage of the forex market. With the internet and the live streaming prices of the market, it’s easy to have access to the information you need in order to make decisions, and to track the condition of the market and currencies.
Another great aspect of the forex market is that there is no hidden fees, costs or commissions you need to give in order to complete your transaction. The usual dealing spread ranges from 3 to 5 points in normal market conditions.
Trading in differrent ways
Within the forex market, there are basically three ways you can trade. The first one is using the spots market. The spot market is referred as one market that deals with present transactions. This is the most common option used when trading. You are given a quote (a spot price), and if there is no further steps to be taken, the trade will be completed in two business days.
The Forwards and Futures market deal with contracts in which they set conditions for a certain currency type, a specific price, and a future date in which the arrangement will be settled. For commercial customers, there may be a need to convert currencies for international payments, which is an incentive to want to finalize your trade at a later date. Investors will usually swap their trades forward to a time that is convenient for both. Also, the position can be closed out at any time.
Interest rates
It’s important to remember that all currencies have interest rates attached to them, and that they are all different. A currency that pays a high interest rate will be more attractive than one that pays a lower interest rate, which is one of the main driving forces of the market. Fundamentally, if a country raises its interest rates, its currency prices will strengthen because the higher interest rates attract more foreign investors, but you should be careful to notice that the currency with the higher interest rate may not necessarily be the strongest one.
Interest rate policy is a key driver of currency prices and typically a strategy for new currency traders. The significance of interest differentials is best observed in the forex market, because of the high leverage of the market. Although at a first glance the interest rates are all similar, the small differences between them have a greater significance in a highly leveraged position.
Knowing when to quit
FOREX is an extremely versatile market, as shown above. Although there are great opportunities to make a profit by making the right move, there are also high risks involved. Experienced traders experiences could daily have increase or decrease swings of their funds of up to 25%, and it’s always a good idea for inexperienced traders to have a very strict stop-loss policy to protect them in case a situation starts to look bad for them.
With a 24-hour market, it’s relatively easy to react immediately to the fluctuations and drastic changes in the market, which at the same time means a low percentage of situations on which there is nothing you can do about. Still, these situations can happen (and do happen). It’s important that you know of stop-loss orders (A stop-loss order is selling a security when it reaches a certain price, and it’s designed to limit an investor’s loss on a security position), and that you have the ability to apply them, to cut your losses in case they are inevitable.
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