How Does Forex Work ?
The foreign exchange market (forex, FX, or currency market) is a global, worldwide-decentralized financial market for trading currencies.
Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies
The currency exchange rate is the rate at which one currency can be exchanged for another. It is always quoted in pairs like the EUR/USD (the Euro and the US Dollar). Exchange rates fluctuate based on economic factors like inflation, industrial production and geopolitical events. These factors will influence whether you buy or sell a currency pair.
Example of a Forex Trade
The EUR/USD rate represents the number of US Dollars one Euro can purchase.
If you believe that the Euro will increase in value against the US Dollar, you will buy Euros with US Dollars.
If the exchange rate rises, you will sell the Euros back, making a profit.
Trader A has an account of USD 50.000.He buys EUR/USD 500.000 at 1.1500 at the market and places a stop loss order at 1.1460. At this point his maximum risk is USD 2.000 and his margin utilization is 10%, above the minimum.
Throughout the day, the forex market fluctuates and initially moves down to 1.1480. Trader A has an unrealized loss of USD 1.000 and his margin utilization has fallen to 9.60% reflecting the effect of the downward move on his margin capacity.
The price moves back up to 1.1550 and Trader A decides to take profit. He sells at 1.1550 making a USD 2.500, representing a 5% return on his account value.
Trader A took a risk of 2000 USD and made a return of 2.500 USD, which equates to a risk/reward ratio of 1.25. A high risk reward ratio is what every trader aims for.
The previous example is a random case scenario and in by no means meant to allude that the potential for profit is greater than the potential for loss in foreign exchange trading.
Why Trade Currencies?
Forex is the world's largest market, with about 3.2 trillion US dollars in daily volume and 24-hour market action.
- Many firms don't charge commissions - you pay only the bid/ask spreads.
- There's 24 hour trading - you dictate when to trade and how to trade.
- You can trade on leverage, but this can magnify potential gains and losses.
- You can focus on picking from a few currencies rather than from 5000 stocks.
- Forex is accessible - you do not need a lot of money to get started.
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