What Is Foreign Exchange?
Foreign exchange (FX) is the largest, most liquid, market in the world. Larger than the shares and futures markets combined, every day over $5.3 trillion of FX transactions is traded globally.
In addition to trading for profit - also called speculative trading, FX is traded typically to diversify investment portfolios and to hedge against exposures in other assets.
A key difference between FX and equity trading is the size of transactions; FX transactions tend to be significantly larger in value and size.
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To properly understand what Forex trading is, first you’ll need to know it’s inner workings. If you’ve ever been to a Bureau de Change, you’ve already traded foreign exchange. It means, simply, “exchanging” (buying or selling) one currency for another, for example, selling GB pounds to buy US dollars, or Euros.
FX transactions always involve two currencies e.g. Euro and US dollar or EUR/USD, called currency pairs.
Bid, Offer & Spread
For all FX currency pairs, there is a bid price - the price at which Prime Markets will Buy currency from you (in exchange for the other currency) and an offer (or “ask”) price - the price at which Prime Markets will Sell to you (in exchange for the other currency). The difference between the bid and ask is called spread.
Typically, the first currency is the “base” currency and the tradable “rate” shows the comparative value of the second displayed currency against the base currency. In other words, in the price shown below, EUR/USD1.08 means 1 euro is worth 1.08 dollars.
The numbers after the decimal point are called pips (“price interest points”). A pip measures the change in the exchange rate for a particular currency pair. The value of a pip is dependent on the currency pair being traded, the size of the trade, and the exchange rate.
Prime Markets quotes FX prices to the fifth decimal place (1/10,000 or 0.00001). The difference between a bid and offer price is called a spread. So in the example of EUR/USD1.07560/1.07562 the spread is 0.2 pips.
In FX trading, small movements of even a single pip can have a significant impact on the overall value of an open position. When trading FX, you will be looking to anticipate both the absolute movement of a currency - in either direction - and to take advantage of the difference between what you paid to BUY one currency and what price you can SELL it at (the bid/offer spread).
FX Trading “Lots”
FX is traded in lots. Prime Markets offers standard lot size of 1 lot = $100,000 (or currency equivalent).
As with equity transactions, you can hold “long” and “short” FX positions. Being long simply means buying the first currency and selling the second in any currency pair. So, if you expected the euro to strengthen against the dollar you would Buy EUR/USD. Conversely, if you anticipated a market fall, you might Sell a currency before the anticipated fall, with the aim of buying it back at the lower price.
Margin, or leverage, is a means of increasing your exposure in an FX position. For example, a 500:1 margin would mean that $1000 is used to control a $500,000 position. Similarly leverage of 100:1 means the same $1000 controls a $100,000 position.
Margin is a double-edged sword; while it can result in significantly larger gains if the market moves in your favour, if it moves against you it can increase your potential losses accordingly.
Example Of A Forex Trade
1) An investor deposits $3,000 in Prime Markets Trading Account. The account is set to 1% margin or 100:1 Leverage. What that means is that for one lot opened of 100,000 the investor must maintain at least $1000 in Margin (100,000×1%=$1,000).
2) If the investor expects that Euro is going to rise against the US Dollar, he will buy $100,000 of the EUR/USD pair as shown below.
3) The market quotes EUR/USD 1.07883/1.07885. The investor buys EUR at 1.07885 against USD.
4) By taking this trade, the investor commits in the simultaneous buying of EUR 100,000 (1lot of $100,000) and the selling of USD 107,885 (100,000×1.07885) by using $1,000 as a Margin (100,000×1%) and borrowing 99,000 from Prime Markets.
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RISK WARNING: CONTRACTS FOR DIFFERENCE (‘CFDS’) ARE COMPLEX FINANCIAL PRODUCTS THAT ARE TRADED ON MARGIN. TRADING FOREX AND CFDS CARRIES A HIGH LEVEL OF RISK SINCE LEVERAGE CAN WORK BOTH TO YOUR ADVANTAGE AND DISADVANTAGE. AS A RESULT, FOREX AND CFDS MAY NOT BE SUITABLE FOR ALL INVESTORS BECAUSE YOU MAY LOSE ALL YOUR INVESTED CAPITAL. YOU SHOULD NOT RISK MORE THAN YOU ARE PREPARED TO LOSE. BEFORE DECIDING TO TRADE, YOU NEED TO ENSURE THAT YOU UNDERSTAND THE RISKS INVOLVED TAKING INTO ACCOUNT YOUR INVESTMENT OBJECTIVES AND LEVEL OF EXPERIENCE. PAST PERFORMANCE OF FOREX AND CFDS IS NOT A RELIABLE INDICATOR OF FUTURE RESULTS. MOST CFDS HAVE NO SET MATURITY DATE. HENCE, A CFD POSITION MATURES ON THE DATE YOU CHOOSE TO CLOSE AN EXISTING OPEN POSITION. SEEK INDEPENDENT ADVICE, IF NECESSARY.
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