What is Forex Trading? Understanding the Basics

You don’t have to have spent much time on the internet to have run into adverts about Forex or ‘FX’ trading – the adverts usually give an indication that there’s a lot of money to be made by every day people like you and I.

If you’re curious about Forex and maybe even considering using the Elliott Wave theory to help you with trading and forecasting then we’ll give you an overview of what it is, how it works – and exactly how it can impact your wallet or savings account – for better and for worse…

What does Forex mean?

Forex or FX trading is the name given to the activity of trading on the foreign exchange currency markets. Essentially, choosing a pair of currencies and taking advantage of the fluctuating exchange rate between them.

If you’ve ever been on holiday you’ve effectively already traded currency – although rarely to any substantial gain. Here’s an simple example:

You’re a UK resident going on holiday to France. You buy £500 worth of Euros – which at the time of exchanging equals €575. When you’re in France, you decide not to spend any of your money and return to the UK 2 weeks later with €575 still in your wallet.

When you exchange your Euros back to Pounds Sterling, you find the exchange rate has worked in your favour – and your €575 is now worth £525. So effectively, holding on to the money has made you £25 – owing to the weakened position of the GBP versus the EUR.

Now, that example is a little flawed, as doesn’t consider that you will often pay broker fees for exchanging the money and so forth – but it’s a quick showcase of how Forex works. In reality, the fluctuations in currency value are rarely that large over a short period of time – so exchanging large amounts of currency is usually required to make any significant gain.

Who trades Forex?

It’s possible for anyone to trade currency – although the largest trades are generally made on behalf of banks and large financial institutions – who trade currency between themselves and for clients. Central banks that are responsible for the currency is any given country will also trade to in an effort to stablise or increase their country’s financial standing.

The next biggest players in the FX markets are investment and hedge fund managers – individuals tasked with trading currencies to bolster the profits of large accounts – such as pension funds and endowments.

Corporations and businesses make up a smaller amount of the daily Forex trading – although still significant sums. Business trading is generally required when a company works internationally and will benefit from some strategy when exchanging money to and from the required currencies is needed.

Individuals also trade on the Forex markets – although they represent a tiny fraction of the £4.5 trillion that’s traded each day – that said, even a tiny fraction of such a huge sum of money can represent enormous gains – or losses – on a daily basis.

What’s involved in Forex trading?

You’ll virtually always hear currencies quoted in ‘pairs’ – and, like in our example, it’s the fluctuation between these two currencies where a trader will look to make a profit. The currency that’s quoted first -and referred to as the ‘base’ – is the one that you think will change in value against the second currency – generally referred to as the ‘quote’.

The key Forex trading is the future direction of the market – if you think the value will go up then you would buy currency – if you think it’s going to go down then you’d sell to minimise losses.

A pair price is generally illustrated like this:

GBP/EUR – 1.13346meaning that 1 of the base currency (£1.00) is worth 1.13346 of the quote currency (€1.13346) – if the number goes up the Pound is becoming stronger when compared to the Euro. If the number goes down, the Euro is getting stronger compared to the Pound.

The number is usually illustrated to 5 decimal points – and one of these units is referred to as a ‘pip’ or point. Hence, in financial news you’ll hear reports about a currency “closing 3 points up against the Dollar” – or similar.

When to buy – when to sell

Generally, people will buy a currency pair if they think that either the base currency will strengthen against the quote – or the quote currency will weaken against the base – either way opening up a gap across which profit can be made.

Buying is referred to as ‘going long’ – conversely, selling is referred to as ‘going short’ – with a pip increase representing a profit – and a pip decrease representing a loss.

Simple, right?

Although the fundamentals of how currency trading works look simple, it’s really an extremely complex marketplace with a virtually unlimited set of variables – although that’s not to say people can’t make a handsome profit trading.

Forex trading is generally done over shorter periods of time when compared to the trade of stocks and shares – usually over a few days or weeks, rather than months or years – and trading is normally done through an online execution service that helps to facilitate your trades.

Is Forex right for me?

There’s no simple yes or no answer as to whether FX trading would be right for you – there is a word of warning though. All trading involves some risk – and – particularly when ‘margin trading’ is involved, there’s a possibility that your losses can outweigh your deposits significantly.

Is Forex trading easy? The answer is a distinct no – and you should not trade with any money that you cannot afford to lose. That said, there are numerous execution services that will allow you to trade virtually – allowing you to simulate what would happen were you to real invest money.

Such a service can give you a good indication of how the market works – while protecting you from real losses. If you feel like Forex trading could be a positive step for you, begin with a trial account, understand the basics and study how the markets have previously performed – and what’s caused that performance. Only when you have a detailed understanding of the processes and risks involved should you consider real monetary trading.

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Sidney Deserres

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