Over the last few years, the foreign exchange market (Forex Trading market) has been dominating the financial headlines. We often see in the news stories about currencies breaking new high and lows. In fact, currency trading or Forex trading has become one of the most prolific activities carried by investors in the financial markets. That’s why it is hardly surprising to find that the daily turnover of the Forex market is close $5 trillion. So what does all this mean for you as an investor?
What is Forex?
So what actually is Forex? Well Forex is short for foreign exchange. If you take a look at the financial pages of a newspaper, you will notice that the exchange rate for the U.S dollar, Euro, British Pound and many other currencies are fluctuating every day. Most of the time, these changes are very small. Nevertheless even though these price movements are small, there is actually a good opportunity for you to make a tidy sum from these price movements. A good real life example is from the man who “broke’ the Bank of England on September 16, 1992. George Soros. By trading against the British Pound and forcing the British government to withdraw from the European Exchange Rate Mechanism (ERM), George Soros made a billion dollars on that “Black Wednesday”.
It should be noted that Forex trading only became widespread during the last 15 years, coinciding with the vast improvements in computing technology and faster internet speeds. This is why today you can trade Forex online from the comfort of your home. However, you should also bear in mind that Forex trading carries a significant risk and there is a real possibility of you losing a substantial part of your trading capital. That’s why is it important that you never trade Forex with money that you can ill afford to lose.
The Mechanism of Forex Trading
Earlier we mentioned briefly that Forex is about the exchange rate. To be more precise, Forex is essentially about exchanging one country’s currency for another country’s currency. This is why currency quotes are always quoted as a pair. For example, the quote EUR/USD is for the Euro and U.S dollar currency pair. The Euro in this instance is referred to as the “Base” currency while the U.S dollar is referred to as the “Quote” currency. In short, it shows how much one unit of the Base currency can be exchanged for the Quote currency.
Why Trade Forex
So why should you trade Forex? First of all, the Forex market is the largest market in the world with a daily turnover that runs into trillions of dollars. It is immensely active. And with all the trading activities going on around the clock across the globe, an astute Forex trader can easily spot numerous opportunities to make a nice profit every day. In addition with so many players in the Forex market, brokers can afford to keep trading costs low, making it extremely competitive to trade in this arena. As most of the trading activities are centered around a handful of major currency pairs, this makes it easier to focus and specialize on a select few currency pairs. But the most important reason why you should trade Forex is because of the fact that you can trade on leverage.
Leveraging your Forex Trades
As you are already aware, the price movements in the Forex market are incrementally very small. In fact most of the time the movements are less than 1%. So in order to achieve a respectable return, you need to trade in volume. The problem is, in order for you to trade in volume, you need to expend a substantial amount of investment capital, something which most people will find extremely difficult to do given their limited resources.
Fortunately, you are able to leverage your trades with the use of the margin trading facility provided by most Forex brokers. So if your broker extends to you a margin trading facility with a leverage ratio of 1:200, this mean that for every $1, you are allowed to transact with $200 worth of currency value. So if you have $1000 in your trading account and are given a leverage ratio of 1:200, the maximum value of your trade will be $200,000. In short, even a small fluctuation in the exchange rate can potentially help you realize a return reaching thousands of dollars. Of course with higher leverage, you also risk magnifying your trading losses by the same factor. This is why leverage if utilized recklessly can also be a double edged sword.
Forex Trading with Binary Options
But with the introduction of binary options in 2008, Forex traders now have an alternative way to trade Forex. What is unique about binary options is the fact that the returns offered are fixed and predetermined. In addition, there is no leveraged trading meaning you can never lose more than what you invested.
Factors Affecting the Exchange Rate
The exchange rate of a currency pair is dictated by the same rules affecting other goods and services that is by demand and supply. This means the more there is a demand for a currency, the higher the exchange value that currency will have.
Primarily, currency values are affected by the following factors:
- The Interest Rate
When the central bank raises the primary interest rate, this will have the effect of making the currency more attractive and hence fueling a higher demand for it. This why whenever the market expects the Federal Reserve to raise the interest rates, the U.S dollar will go up in value relative to other currencies.
- The Gross Domestic Product GDP
If the GDP of a country is growing healthily, this means the economy is expanding, making it more tempting to invest in. Consequently this will help to fuel a higher demand for the currency used in that economy leading to a higher exchange rate.
- Inflation Rate
This factor is closely related to the interest rate imposed by the central bank. Normally an extremely high inflation rate will impact the exchange rate negatively.
To learn more about Forex trading start working your way through a selection of articles in this section of the site.