Forex, which stands for Foreign Exchange, is the market for trading currencies. Currencies are not traded in an exchange. They are traded Over The Counter (OTC). So, they are traded 24 hours a day, 5 days a week.
How does Forex trading work?
Let's say you are in Germany. You want to trade Euro against US dollars. The exchange rate is 1.5, i.e., €1 = $1.5. You exchange €1000 and get $1500. Now you hold the money in US dollars till the exchange rate goes down.
After a few days, the exchange rate goes down to 1.3. Now you exchange the US dollars back into Euros. So, you would get $1500/1.3 = $1154. Thus, you have made a profit of $154. This is how forex works.
Even though this sounds simple, choosing the right currency pair and the right time to trade is not easy. Depending on the economic and political conditions in each country, the value of its currency can rise or fall. The demand and supply for a currency can also affect its price in the forex.
Terms used in forex:
Currency Pair
The two currencies which are coupled for trading in forex form a Currency Pair. In the above example, we used the currency pair of Euro and Dollar. Similarly, other currency pairs can also be used. The six most commonly traded currencies in the forex are:
- The US Dollar
- The Euro
- The Yen
- The British Pound
- The Canadian Dollar
- The Swiss Franc
Lots
In forex, currencies are traded in lots.
1 micro lot = 1,000 units of the base currency (E.g., $1,000 or €1,000)
1 mini lot = 10,000 units of the base currency
1 standard lot = 100,000 units of the base currency
Pip
The smallest unit of movement of an exchange rate is called a Percentage in point (Pip). Generally, 1 Pip = 1/100th of a percentage = 0.0001. In Currency pairs, where the Japanese Yen is involved, 1 Pip = 1 percentage = 0.01.
Let's understand what Pips are, with an example. Consider an investor who wants to trade 100,000 Euros.
Case 1:
Euro - US Dollar
Let's say the Euro is trading against the Dollar at a rate of 1.5. When the trader exchanges €100,000, he will get $150,000. After a few days, it is trading at 1.499. If he exchanges it back, he will get, 150,000/1.49 = €100,671. So, a profit of (1.5 - 1.49)/0.0001 = 100 Pips generates a profit of €671. If you were trading the other way round, i.e., US Dollar - Euro, you would have made a loss of 100 pips.
Euro - Japanese Yen (¥)
Let's say the Euro is trading against the Yen at a rate of 100. When the trader exchanges €100,000, he will get ¥10,000,000. After a few days, it is trading at 99. If he exchanges it back, he will get, 10,000,000/99 = €101,010. So, a profit of (100 - 99)/0.01 = 100 Pips generates a profit of €1,010.
Simply put, your returns depend on the change in the number of pips and the amount you are trading.
Leverage
In finance, leverage refers to the concept of buying assets using borrowed money. Many forex trading companies can offer their traders leverages. It enables you to reap higher returns when you make profits.
Leverages are normally expressed in ratios. If a forex trading company offers you a leverage of 10:1, and you use $1,000 for a trade, it is similar to using 1000 x 10 = $10,000. If you made a profit of 5% without leverage, it translates to 5% of $1,000 = $50. But, if you use a leverage of 10:1, your profit will be 10 x (5% of $1,000) = $500. However, the opposite is also true. A loss of 5% will mean that you lose $500, i.e., half of your investment.
What should you know before investing in forex:
Even though investing in forex to get rich quick can be tempting, it comes with great risks.
Lack of information
Unlike stocks which are traded publicly, currencies are traded over the counter. This leads to a lack of transparency. Therefore, big institutions that participate in the forex trade could have access to information that you lack. This could hurt your chances of success.
Time
Unlike experts, who know when to buy and when to sell the currencies, as a beginner, you may not know those tricks. For example, You may hold on to a losing currency, hoping that it will bounce back. If it doesn't bounce back, you will end up losing more of your money.
Too much leverage
Too much leverage can amplify your losses. As a result, you may end up losing more money than your initial investment.
What should you look for in a forex broker?
Authenticity
Is the brokerage firm a legit one? How long has it been in existence? Do they enable you to transfer funds without any problem?
Costs
What are the transmission costs? Is there any minimum deposit requirement?
Currency pairs
How many currency pairs do they offer for trading, and what are they?
Leverage
If you really want to make huge profits, and want to use the leverage option, how high is the leverage offered?
Educational materials
What educational materials do they offer to help you learn forex trading? Is there a mock account to help you practice?
Software
Forex trading can be very volatile. Any delay, between the moment you click on 'Buy' and the moment the actual purchase is made, can cost you money. So, make sure that the software functions without any glitches, lags, and bugs.
