What’s foreign exchange trading all about, anyway?

Sat, Jan 28, 2012

Financial Advice, Investment

The stock market is no longer the sole playground of the rich and famous, with an increasing number of part-time investors opting to dabble in trading. However, rather than sticking to conventional stocks and shares, the world of foreign currency trading is becoming an attractive proposition for many.

Foreign currency trading, or forex as it is more commonly known, involves betting on the movements of two different currencies against each other. A trader must pick which currency will rise and which will fall. If the market moves in the right direction, a profit can be earned. Predicting that one currency will rise is known as `going long` while the one that is predicted to fall is known as `going short`.

It is not possible to trade on the market directly, so every investor needs to find a broker to execute the deal. One of the major advantages of forex is that, unlike stocks and shares, brokers do not charge fees or commission. This may sound strange but they earn their money in a completely different way.

As mentioned above, each trade involves one currency going up and the other going down. The investor is in essence, buying the currency that they think will increase and then selling it when they close the deal. The reverse is true for the currency predicted to fall; the investor is selling it when the trade is opened, but `buying` it when the trade is closed. Each broker has two different prices, with one for buying and one for selling. The price an investor buys a currency for is known as the ask price and the amount they sell it for is known as the bid price.

There will be a bid and an ask price for each currency and the difference between the two prices is known as the spread. If you have chosen to go long, the ask price will be higher than the bid price and the reverse if you have opted to go short. This means that in order to make a profit, the market must move sufficiently for the bid price to move past the offer price and until it does that, you will not have made any money. The spread is how brokers make their money and finding one with a tight spread is one way to help maximize your chances of making a gain.

It is possible to trade with a wide range of currencies; most brokers offer up to 80 different pairings. However, the most popular ones to choose are the US dollar, the euro, sterling, the yen, Canadian dollar, Australian dollar and Swiss franc. These are known as the majors and are the most commonly traded currencies. Other currencies are known as the minors and there are those on the fringes, such as the Brazilian real, which are usually called `exotics`.

The forex market is truly a 24-hour one and only shuts for a few hours at the weekend. Because of the international nature of its trade, there is a huge amount of liquidity and there is no chance of the market being deliberately manipulated by rogue investors.

Forex offers huge potential for gains, but due to its volatility and rapid movements, it is possible to lose large amounts of money very quickly. For this reason, it is recommended to limit each trade to no more than 5% of your account balance and to use a stop-loss order. This is an automatic block that closes the deal as soon as the market reaches a certain level and can be a lifesaver when a currency takes an unexpected plunge.

Forex is a huge subject and it is recommended that anyone considering dipping a toe in should first thoroughly research the subject and practice before entering a live market. However, with patience and a willingness to learn, it can offer substantial returns, even when the economic outlook is not so rosy.

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