Forex Market - Forex Trading Explained
By Gregg Abbott
Forex trading refers to the trading of currencies. Forex trading helps facilitate a wide-range of activities, including currency exchange, and helps regulate the values of various currencies around the world. These are essential functions for a global economy that now relies on international trade to fuel trillions of dollars worth of business activities. Forex trading is also a potential source for profits for the savvy investor. As currencies rise and fall, correct predictions can translate to huge profits.
In fact, the Forex market is now the largest and most liquid market in the world, valued at approximately 2 trillion dollars at any given time. The Forex market is not anchored in any single trading center, but instead managed by financial hubs around the world, including New York, London, Tokyo, and Singapore. This allows the Forex market to operate 24 hours per day during the business week.
How Does Foreign Exchange Trading Work?
Forex trading involves the exchange of one currency for another. Forex trading generally occurs through a "trading pair" in which once currency is used to buy another. This pair will consist of a "base" currency and the "quote" currency. A trader will use the base currency to buy the quote currency, hoping that the value of the base currency will fall while the value of the quote currency will rise.
Let's consider the CAD/USD trading pair. Here the United States Dollar is the quote currency while the Canadian Dollar is the base currency. This means that U.S. dollars will be used to buy Canadian dollars. Let's say at the moment the CAD/USD quote looks like tis 1.10/1.00. This means that 1 U.S. dollar will buy 1.1 Canadian dollars. For illustrative purposes imagine that you use USD10,000 to purchase 11,000 worth of Canadian dollars. Then over the course of three months the USD falls against the CAD and is now trading at 1.00/1.00. The trader can then convert his CAD back into USD and will receive USD 11,000. This results in a USD 1,000 profit.
Why Do Currencies Fluctuate?
Many currencies are allowed to float in a free market where buyers and sellers determine the value of a currency. Normally, currencies are "priced" in U.S. dollars. This means that the USD will often be found as either the base or quote currency in a currency pair. The combined actions of Forex traders create a global market place that determines how much a currency is "worth" in comparison to other currencies.
Like most buyers, Forex traders are concerned with the "quality" and "value" of the currency. The buyer is hoping that the quote currency will gain in value vs. the base currency so that they can turn a profit. Many things including inflation, national debt, the fiscal health of a country, and monetary policies of the relevant central banks can affect the overall value of a currency.
In a certain sense Forex traders are betting on the overall economic health of one country vs. another. While this is oversimplified, the notion does come into play in currency trading. For example, the European Union, as the European Union went through its "Euro Crisis" starting in 2011 and through 2012 the value of the Euro dollar would drop from 1.5 to 1.3 vs the USD. The Eurozon economy as a whole is perceived as weaker than the U.S. economy, causing the value to of the Euro to drop vs. the dollar.
Fluctuations in currencies serve important functions in the global market. Let's say the United States suffers a large trade deficit, high unemployment, inflation and other factors that cause its currency to drop in value. At the same time, let's assume that Japan's economy is roaring ahead. As the dollar drops in value and the yen increases in value it becomes more expensive for the U.S. to buy Japanese goods and cheaper for Japan to buy U.S. goods. According to the principles of the market then, the U.S. will start buying less Japanese good and the Japanese will start buying more American goods.
Forex traders try to profit off of these fluctuations by predicting which currencies will rise and which currencies will fall. They then use one currency to purchase another and hold onto their cash until market conditions are ripe to sell whether that mean producing a profit or cutting a loss. Over time this can translate to huge profits for the savvy investor.