Forex
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What is Forex?
Trading forex involves the buying of one currency and simultaneous selling of another. In forex, traders attempt to profit by buying and selling currencies by actively speculating on the direction currencies are likely to take in the future
Overview of the market
The foreign exchange market is a global decentralized market for the trading of currencies. This means that participants are able to trade currencies without meeting in person. It accounts for all aspects of buying and selling currencies at current or determined prices. In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying with some quantity of another currency.
While the main participants in this market are the larger international banks, brokers enable individuals to participate in the market. The virtual nature of the market, and the diverse locations of its participants, allows it to operate around the clock, with the exception of weekends.
Currencies are always traded in pairs. As such, the foreign exchange market does not set a currency’s absolute value. Instead, it determines its relative value by setting the market price of one currency if paid for with another. This enables economic growth and development beyond national borders, through international trade and investments.
Currency pairs
Terminology
The bid price is the price a trader is willing to sell a currency pair.
The ask price is the price a trader will buy a currency pair.
The difference between the bid and ask price is known as The Spread.
Market sentiment gives a view of the performance of a particular market or the stock market overall.
When Market sentiment is Bullish, this means the price is going up.
When Market sentiment is Bearish, this means the price is going down.
An easy way to distinguish the difference is that bulls have horns and toss things in the air when provoked. Prices rising.
When bears are provoked, they get on their hind legs and tear things down. Prices decreasing.
There are 180 recognized currencies in circulation being used in 195 countries. As traders, we can speculate on the performance of a certain currency by using a range of analyses and research to determine how that currency will perform in the marketplace. How we trade these currencies is based on one currency’s performance against another – Forex Trading. When selecting a currency to trade, you will notice that these come in pairs. Let us use EUR/USD as a case study.
If you were to ‘buy’ EUR against USD, you would be betting that the Euro is going to perform more strongly than the US Dollar.
Pairs are categorized into 3 core groups:
Major Pairs – The 8 common pairs all of which contain USD as the base currency or counter currency and one of the following – EUR, CAD, GBP, CHF, JPY, AUD, NZD.
Cross Pairs – These are any 2 major currencies which do not contain the US Dollar as the base or counter currency. These are deemed more volatile than Major Pairs. Examples include GBP/AUD, EUR/CAD, and NZD/CAD to name a few.
Exotics – These are lesser-known currencies which can be extremely volatile in the market. These include South African Rand, Hungarian Forint and Polish Zloty.
Going long or buying a currency means that you expect the price to rise. When a trader is going long on a currency pair, the first part of the pair is bought while the second is sold.
Going short is ‘selling’ one half of a currency pair in the hopes that the price will decrease.
When a trader is going short the first currency is sold while the second currency is bought.
Leverage is, in essence, borrowed money from within a trading account. Trading with leverage allows a trader to open a position with a high contract size with less expenditure.
High leveraged trading is an effective way to trade your favourite Forex pairs, cryptocurrencies and much more without investing vast amounts of capital.
A Lot in Forex trading is the size of trade/position that you will open.
1 Lot in standard Forex trading on a currency pair is the equivalent of 100,000 units of the base currency of the pair.
If we look at EUR / USD, this means that opening a trade in USD would mean the trade size is $100,000.
EUR being the base currency.
1 standard PIP is worth $10
This means a 10 PIP incremental movement in a buy trade, this would represent a $100 gain.
Margin is the initial capital that a trader needs to put up in order to open a position. Margin also gives a trader the opportunity to open a larger position size.
When trading with margin, the trader only needs to put forward a percentage of the full value of a position in order to open the trade.
Margin opens the door to leveraged trading but, be wary, margin magnifies both profits as well as losses.
The acronym PIP stands for Percentage In Point.
PIP is the smallest movement reflected in an exchange rate on a currency pair. The PIP is the 4th decimal on a price quote for a currency pair. It is used to measure value.
How the market works/is affected
Changes in currency prices are driven by two main forces: supply and demand. When the value of a currency increases, the demand is greater than its supply. When a currency decreases value, its supply is greater than its demand.
What factors influence the supply and demand of one currency?
The two main factors that influence the movements in one exchange rate are:
1. The capital flows
2. The trade flows
These two components constitute what economics call balance of payments. The balance of payments serves to quantify the demand and supply for a currency of one country, over a period of time.
Balance of Payments = Capital Flows + Trade Flows
A negative balance of payments indicates that the capital leaving the country is greater than the capital entering the country.
A positive balance of payments means that the capital entering the economy is greater than the capital leaving the economy
Theoretically, a balance of payments equal to zero indicates the right value of one currency.
Capital Flows
Capital flows is the net quantity of currency traded (bought or sold) through capital investments. It can be divided into: physical flows and portfolio investments.
Physical Flows – They occur when foreign entities sell their local currency and buy foreign currency to make foreign direct investments (for joint ventures, acquisitions, etc.) Increased foreign direct investment is an indicator of good economic health in the economy where it is invested.
Portfolio investments – These are investments made on global markets, variable and fixed income market investments (Forex, stocks, T-bills, etc.)
Purchasing Power Parity (PPP)
This theory states that exchange rates are determined by the relative prices of a similar basket of goods in different countries. The ratio of prices of a basket with similar goods of two countries should be similar to the exchange rate.
The major weakness of this theory is that it assumes that there are no costs related to the trade of goods (tariffs, taxes, etc). Another weakness is that it does not consider other factors that might influence the exchange rate (i.e. interest rates etc)
Interest Rate Theory
This theory states that interest rates differentials neutralize the increase or decrease of any currency against another currency. Therefore, there are no opportunities to take advantage of differences in currency prices.
Trade Flows
Trade flows measure the net exports and imports of a given country.
Countries that export more than they import are more likely to depreciate their currency. On the other hand, countries that import more than they export, are more likely to appreciate their currency since they need to sell the local currency and buy foreign currency in order to purchase goods and services.