You may have heard the word Forex mentioned in a discussion or while reading about finance related topics. If you wondered about what Forex is, here’s a brief explanation. Forex is basically just an abbreviation for foreign exchange, most commonly used when one describes foreign exchange markets with investors and speculators being involved. That being said, it’s called Forex when one trades in foreign currencies – very much like the stock market but dealing with the direct trading of currency instead of the investing or selling of stocks.
How Does Forex Work?
Trading Forex works in a way similar to that of the stock market. In a stock market scenario, an investor would look to buy undervalued stock at a low price, hoping that the company the stock is tied to will be successful and show profits. That would make the stock prices raise, allowing the investor to sell the stock back at a higher price – thus earning a profit. In the Forex market, an investor would try to buy a currency that is currently undervalued in comparison to its paired foreign currency in the hopes that the currency would later rise in value so that it could be sold back to the Forex market at a higher price.
In Forex markets, all currencies are grouped in pairs. This can be a bit confusing at first, but over time you’ll begin to understand why. The US dollar, or USD, is usually paired up with the euro, or EUR. Let’s say that you want to buy euros because you feel that they will rise in value due to your knowledge of global economies or any other factors you are adding into the mix. In this situation, you would want the value of the euro to rise relative to the value of the USD. Since you bought your euros with USD, and your euros end up becoming more valuable than the original USD you spent to get them, you could turn around and buy back more USD than you had to start with.
To help understand it even more, here is a brief fictional scenario.
You have $500 USD and you want to buy EUR. You know that at this moment, the USD is worth more than the EUR, but you feel that the EUR will rise in value, either soon or over time. So you buy up as many EUR as you can buy with $500 USD, let’s say around $400 EUR. If your prediction comes true, the EUR you bought will eventually be worth more than the USD you used to buy it. When you feel like the time is right, you can sell the EUR to get back more USD than you originally had. Depending on how soon you turn your investment around, you could have profited by a healthy margin, or perhaps barely at all.
The foreign exchange, or Forex, is a decentralized global market. It’s used to put a value on the different currencies of the world. It’s also an open market with constantly fluctuating values – very much like the stock market. Unlike the stock market, however, there is no one central hub where all the trading takes place. Instead, Forex is traded around the world by many different markets. One of the better aspects of Forex trading is that unlike the stock market, profits can be made even when market trends are down.
Constantly Changing Values
The value of Forex market currencies change – just like the value of a stock for any given business can change. How does a currencies value change? Well, any currency could become undervalued if there is too much of it and not enough demand for it, while it could become overvalued if there is not enough of it and too much demand for it. While some currencies are simply made with papers, others still use gold – these too can be traded in the Forex market. For example, you could buy another currency in the form of gold using the American dollar. If the value of gold rises in comparison to the value of the USD, you could sell the gold back for more USD – thus earning a profit.
Understanding Forex Terms
When trading Forex, you will definitely want to become familiar with some of the more common terms used. For example, when measuring the value of one currency to another, increases or decreases in value are referred to as pips. If the value of the USD is currently 1.2052, and it rises to 1.2059 – that would be measured as 7 pips of movement.
Another commonly used term is the lot. A lot is simply the smallest trade size available. Some markets might have lot sizes of 500 units, while others may allow you to trade in sizes of up to 100,000 units or more. In FXCM environments, lot sizes are locked in increments of 1,000, and can be raised higher so long as they remain in increments of 1,000.
As mentioned earlier, Forex market currency values are quoted in pairs, and while this may seem confusing at first, it’s actually very sensible. For example, if you are looking at the current EUR/USD market, and it reads 1.4035 – that explains how much one euro is worth in US dollars. If you flip it around and the market is USD/EUR with 1.4035 – that explains how much one USD is worth in euros.
While leverage may not be wise for all investors, it is a very useful way to profit from borrowed money. Let’s say that you are offered an account in the Forex market with leverage of 200:1. This would allow you to trade in currencies using $1,000 after putting in a $5 security deposit. Sounds simple enough, but how does that help? Currencies change, but the change is very nominal. Unlike the change that might occur in the price of a stock on the stock market, which could involve a drastic change in value, Forex currency value changes are almost always small movements. This means you need to trade more quantities of currencies in order to show a small profit.
On the other hand, leverage could also lead to a decrease in profits and even a loss of profits altogether. It’s very important to understand the small changes in currencies to use leverage with success.