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The foreign exchange, or forex market,
is the world's largest financial market,
and it plays a vital role in the global economy.
Every day, trillions of dollars are exchanged from one currency
to another.
This kind of currency exchange is
essential for international business.
Forex market participants include
governments, businesses, and of course, investors.
Governments use the forex market to implement policies.
For example, when conducting business with another country,
whether it's borrowing money, lending money, or offering aid,
a country needs to convert its currency
into a foreign currency.
Businesses use the forex market to facilitate
international trade.
For example, they may need to convert payments
for goods and services bought overseas,
or to exchange payments from international customers
into their preferred currency.
And investors use the forex market to speculate
on changes in currency prices.
Currency prices change almost constantly during the week,
because the forex market is open continuously from Sunday
at 4:00 PM until Friday at 4:00 PM Central Time.
A trading day starts at 4:00 PM and ends at 4:00 PM Central
Time the following day.
The market has to be open around the clock because
of the global nature of the economy.
Let's go over some basics of how trading forex works.
When you trade forex, you're not just trading one product,
you're trading two currencies against each other.
This is known as a currency pair.
The quote for a forex currency pair
defines the value of one currency relative to the other.
The easiest way to understand any quote
is to read the pair from left to right.
Let's look at an example of using the euro versus the US
dollar currency pair.
If the EUR/USD is trading at 1.20,
that means 1 euro is equal to 1.20 US dollars.
Here's another example of using the US
dollar versus the Canadian dollar currency pair.
If the USD/CAD is trading at 1.25,
that means 1 US dollar is equal to 1.25 Canadian dollars.
Even though there are two currencies involved,
the pair itself acts like a single entity.
It's similar to a stock or a commodity.
And just like when trading stock,
investors profit when they buy a currency pair and its price
increases.
Investors can also profit if they sell or short a currency
pair and the price decreases.
Let's look at an example.
Suppose an investor who thinks Europe's economy is going
to grow faster than the United States, and as a result,
she thinks the euro will strengthen against the US
dollar.
She can buy the euro versus US dollar pair
to speculate on her assumption.
If the price of the currency pair rises, she'll make money.
Conversely, if the price falls, she'll experience a loss.
Now that we've covered the basics,
let's look at a few key aspects of the forex market.
We'll start with margin.
When you trade on margin, you only
need to put up a percentage of the total investment
to enter into a position.
This amount is known as the margin requirement.
When you trade other securities like stocks, trading on margin
means you're borrowing funds from your broker.
However, forex trades can only be
covered using funds in the investor's forex account.
Investors can't borrow funds to enter a forex trade.
If they don't have funds in their forex account,
they need to transfer funds before placing a trade.
Forex margin requirements vary depending on the currency
pairs and the size of a trade.
Currency pairs typically trade in specific quantities
known as lots.
The most common lot sizes are standard and mini.
Standard lots represent 100,000 units,
and mini lots represent 10,000 units.
Depending on your brokerage firm,
you may also be able to trade forex in 1,000-unit increments,
also known as micro lots.
Margin requirements can be as small as 2% of a trade
or as large as 20%, but the margin
requirement for most currency pairs averages around 3% to 5%.
To understand how margin is calculated,
let's look at an example using the euro versus US dollar pair.
Say this pair was trading at 1.20,
and an investor wanted to buy a standard lot or 100,000 units.
The total cost of the trade would be $120,000.
That's a lot of capital.
However, the investor doesn't have to pay that full amount.
Instead, she pays the margin requirement.
Let's say the margin requirement was 3%.
3% of $120,000 is $3600.
That's the amount the investor needs in her forex account
to place this trade.
This brings us to another key element of the forex market--
leverage.
Leverage enables investors to control a large investment
with a relatively small amount of money.
In this example, the investor is able to control $120,000
with $3600.
The leverage associated with currency pairs
is one of the biggest benefits of the forex market,
but it's also one of the biggest risks.
Leverage gives investors the potential
to make large profits or large losses.
One more important element in the forex market is financing.
This is the calculation of net interest owed or earned
on currency pairs, and it happens
when an investor holds a position past the close
of the trading day.
The US dollar is associated with an overnight lending
rate set by the Fed, and this rate
defines the cost of borrowing money.
Similarly, each foreign currency has its own overnight lending
rate.
Remember, when you trade a currency pair,
you're trading two currencies against each other.
Even though the currency pair acts like the single entity,
you're technically long one currency and short the other.
In terms of financing, you're lending the currency
that you're long and borrowing the currency you're short.
This lending and borrowing occurs the overnight lending
rate of each respective currency.
In general, an investor receives a credit
if the currency he has long had a higher interest rate
than the currency he is short.
Conversely, an investor is debited
if the currency he is long has a lower interest rate
than the currency he is short.
Let's look at an example.
Suppose an investor has a position
in the Australian dollar versus the US dollar currency pair.
Say the overnight lending rate for the Australian dollar is 2%
and the overnight lending rate for the US dollar is 1%.
The investor is long the currency pair,
which means he is long the AUD and short the USD.
Since the AUD has a higher interest rate than the USD,
the investor will receive a credit.
However, if the investor was short the AUD/USD currency
pair, he'd have to pay the debit because he's short
the currency that has a higher interest rate.
Financing is performed automatically
by your brokerage firm.
However, it's important to understand
how it works and its financial impact on the trade.
We've reviewed just a few elements of the forex market.
As with all investment opportunities,
the forex market has a unique set of risks and benefits,
and education is the first step to determine if this is
the right opportunity for you.
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