This article Will Give Explanation To Most Basic Question In Forex Trading.
We will answer the following Question.
- What’s Forex
- What’s Traded in forex?
- Buying and selling currency pair?
- Different ways to trade forex.
What is forex?
Quite simply, it’s the global financial market that allows one to trade currencies. If you think one currency will be stronger versus the other, and you end up correct, then you can make a profit.
If you’ve ever traveled to another country, you usually had to find a currency exchange booth at the airport, and then exchange the money you have in your wallet into the currency of the country you are visiting.
You go up to the counter and notice a screen displaying different exchange rates for different currencies.
An exchange rate is the relative price of two currencies from two different countries.
You find “Japanese yen” and think to yourself, “WOW! My one dollar is worth 100 yen?! And I have ten dollars! I’m going to be rich!!!”
When you do this, you’ve essentially participated in the forex market!
You’ve exchanged one currency for another.
Or in forex trading terms, assuming you’re an American visiting Japan, you’ve sold dollars and bought yen.
Before you fly back home, you stop by the currency exchange booth to exchange the yen that you miraculously have remaining (Tokyo is expensive!) and notice the exchange rates have changed.
It’s these changes in the exchange rates that allow you to make money in the foreign exchange market.
In short buying and selling of currency.
What’s Traded In Forex?
What is traded in forex?
The simple answer is MONEY. Specifically, currencies.
Because you’re not buying anything physical, forex trading can be confusing so we’ll use a simple (but imperfect) analogy to help explain.
Think of buying a currency as buying a share in a particular country, kinda like buying shares in a company.
The price of the currency is usually a direct reflection of the market’s opinion on the current and future health of its respective economy.
In forex trading, when you buy, say, the Japanese yen, you are basically buying a “share” in the Japanese economy.
You are betting that the Japanese economy is doing well, and will even get better as time goes.
While there are potentially lots of currencies you can trade, as a new forex trader, you will probably start trading with the “major currencies“.
They’re called “major currencies” because they’re the most heavily traded currencies and represent some of the world’s largest economies.
Forex traders differ on what they consider as “major currencies”.
The uptight ones who probably got straight A’s and followed all the rules as children only consider USD, EUR, JPY, GBP, and CHF as major currencies.
Then they label AUD, NZD, and CAD as “commodity currencies“.
But to keep things simple, some of us just consider all eight currencies as the “majors”.
These are the list of them by their symbol, country where they’re used, currency name, and cool nicknames.
Buying And Selling Currency Pairs
Forex trading is the simultaneous buying of one currency and selling another.
Currencies are traded through a broker or dealer and are traded in pairs. Currencies are quoted in relation to another currency.
For example, the euro and the U.S. dollar (EUR/USD) or the British pound and the Japanese yen (GBP/JPY).
When you trade in the forex market, you buy or sell in currency pairs.
Imagine each currency pair constantly in a “tug of war” with each currency on its own side of the rope.
An exchange rate is the relative price of two currencies from two different countries.
Exchange rates fluctuate based on which currency is stronger at the moment.
There are three categories of currency pairs:
- The “majors“
- The “crosses“
- The “exotics“
The major currency pairs always include the U.S. dollar.
Cross-currency pairs do NOT include the U.S. dollar. Crosses that involve any of the major currencies are also known as ” minors”.
Exotic currency pairs consist of one major currency and one currency from an emerging market (EM).
Major Currency Pairs
The currency pairs listed below are considered the “majors.”
These pairs all contain the U.S. dollar (USD) on one side and are the most frequently traded.
Compared to the crosses and exotics, price moves more frequently with the majors, which provide more trading opportunities.
The majors are the most liquid in the world.
Liquidity is used to describe the level of activity in the financial market.
In forex, it’s based on the number of active traders buying and selling a specific currency pair and the volume being traded.
The more frequently traded something is, the higher its liquidity.
For example, more people trade the EUR/USD currency pair and at higher volumes than the AUD/USD currency pair.
This means that EUR/USD is more liquid than AUD/USD.
Major Cross-Currency Pairs or Minor Currency Pairs
Currency pairs that don’t contain the U.S. dollar (USD) are known as cross-currency pairs or simply as the “crosses.”
Major crosses are also known as “minors.”
While not as frequently traded as the majors, the crosses are still pretty liquid and still provide plenty of trading opportunities.
The most actively traded crosses are derived from the three major non-USD currencies: EUR, JPY, and GBP.
There are still exotic currency pairs. We will talk on that on future videos.
Different ways to trade forex.
Because forex is so awesome, traders came up with a number of different ways to invest or speculate in currencies.
Among the financial instruments, the most popular ones are retail forex, spot FX, currency futures, currency options, currency exchange-traded funds (or ETFs), forex CFDs, and forex spread betting.
Futures are contracts to buy or sell a certain asset at a specified price on a future date (That’s why they’re called futures!).
A currency future is a contract that details the price at which a currency could be bought or sold and sets a specific date for the exchange.
Currency futures were created by the Chicago Mercantile Exchange (CME) way back in 1972 when bell-bottoms and platform boots were still in style.
Since futures contracts are standardized and traded on a centralized exchange, the market is very transparent and well-regulated.
An “option” is a financial instrument that gives the buyer the right or the option, but not the obligation, to buy or sell an asset at a specified price on the option’s expiration date.
If a trader “sold” an option, then he or she would be obliged to buy or sell an asset at a specific price at the expiration date.
However, the disadvantage in trading FX options is that market hours are limited for certain options and the liquidity is not nearly as great as the futures or spot market.
A currency ETF offers exposure to a single currency or basket of currencies.
Currency ETFs allow ordinary individuals to gain exposure to the forex market through a managed fund without the burdens of placing individual trades.
Currency ETFs can be used to speculate on forex, diversify a portfolio, or hedge against currency risks.
The spot FX market is an “off-exchange” market, also known as an over-the-counter (“OTC”) market.
The off-exchange forex market is a large, growing, and liquid financial market that operates 24 hours a day.
It is not a market in the traditional sense because there is no central trading location or “exchange”.
In an OTC market, a customer trades directly with a counterparty.
There is a secondary OTC market that provides a way for retail (“poorer”) traders to participate in the forex market.
Access is granted by so-called “forex trading providers“.
Forex trading providers trade in the primary OTC market on your behalf. They find the best available prices and then add a “markup” before displaying the prices on their trading platforms.
This is similar to how a retail store buys inventory from a wholesale market, adds a markup, and shows a “retail” price to their customers.
Forex trading providers are also known as “forex brokers”. Technically, they are not brokers because a broker is supposed to simply act as a middleman between a buyer and a seller (“between two parties”). But this is not the case, because a forex trading provider acts as your counterparty. This means if you are the buyer, it acts as the seller. And if you are the seller, it acts as the buyer. To keep things simple for now, we will still use the term “forex broker” since that’s what most people are familiar with but it’s important to know the difference.
Forex Spread Bet
Spread betting is a derivative product, which means you don’t take ownership of the underlying asset but speculate on whichever direction you think its price will move up or down
A forex spread bet enables you to speculate on the future price direction of a currency pair.
A currency pair’s price being used on the spread bet is “derived” from the currency pair’s price on the spot FX market.
Your profit or loss is dictated by how far the market moves in your favor before you close your position and how much money you have bet per “point” of price movement.
Spread betting on forex is provided by “spread betting providers“.
Unfortunately, if you live in the U.S., spread betting is considered illegal. Despite being regulated by the FSA in the U.K., the U.S. considers spread betting to be internet gambling which is currently forbidden.
A contract for difference (“CFD”) is a financial derivative. Derivative products track the market price of an underlying asset so that traders can speculate on whether the price will rise or fall.
The price of a CFD is “derived” from the underlying asset’s price.
A CFD is a contract, typically between a CFD provider and a trader, where one party agrees to pay the other the difference in the value of a security, between the opening and closing of the trade.
In other words, a CFD is basically a bet on a particular asset going up or down in value, with the CFD provider and you agree that whoever wins the bet will pay the other the difference between the asset’s price when you enter the trade and its price when you exit the trade.
A forex CFD is an agreement (“contract”) to exchange the difference in the price of a currency pair from when you open your position versus when you close it.
A currency pair’s CFD price is “derived” from the currency pair’s price on the spot FX market. (Or at least it should be. If not, what is the CFD provider basing its price on? 🤔)
If the price moves in your chosen direction, you would make a profit, and if it moves against you, you would make a loss.
In the EU and UK, regulators decided that “rolling spot FX contracts” are different from the traditional spot FX contract.
The main reason being is that with rolling spot FX contracts, there is no intention to ever take actual physical delivery (“take ownership”) of a currency, its purpose is to simply speculate on the price movement in the underlying currency.
The objective of trading a rolling spot FX contract is to gain exposure to price fluctuations related to the underlying currency pair without actually owning it.
So to make this differentiation clear, a rolling spot FX contract is ruled as a CFD. (In the U.S., CFDs are illegal so it’s known as a “retail forex transaction”)
Forex CFD trading is provided by “CFD providers“.
Outside the U.S., retail forex trading is usually done with CFDs or spread bets.