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What is Forex Trading?

forex trading explainedThe Forex exchange is the biggest financial market in the world, with trillions of dollars changing hands on a daily basis. The Forex market consists of traders speculating on different currencies that represent world economies in order to gain from their rapid movement. As a trader, one looks to buy or sell currencies with the idea of making a profit if the direction of the currency is the correct one. For example, let’s assume that a trader believes that things are going to go wrong for the European Union now that the United Kingdom voted for Brexit (to exit the Union). Such a belief will lead automatically to a lower-value currency, so the Euro as a currency should weaken. Naturally, in order to speculate on this belief, the trader will turn to the Forex market and sell the European currency.

The Importance of the US Dollar

The whole global financial system is built based on one reserve currency, and that is the US dollar. It is said, therefore, that the US dollar is the word’s reserve currency, because all transactions at the are finally cleared in dollars. Let’s assume you are from Europe and want to buy a home in Canada. For that, you need to have Canadian dollars to pay for the new home. So you go to your bank and exchange the Euros for Canadian Dollars, and the bank transfers the money overseas. While you see this transaction being made between the two currencies, in reality, the bank is going to buy US dollars with your Euros, and will use those US dollars to pay for the Canadian dollars needed for the transaction. This means the transaction is cleared, and clearings happen around the clock at specific times in major financial centers such as London, New York, Shanghai, Hong Kong, Tokyo, etc.

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What Makes a Currency Pair Move?

In the foreign exchange market, currencies are paired with one another in such a way that they form currency pairs. There is a currency pair for every currency in the world, as such a pair moves based on the economic differences between the economies they represent. For example, the economic differences between New Zealand and Australia are seen through the fluctuations of the currency pair that represents those economies: AUD/NZD. If the Australian economy performs better than its New Zealand counterpart, the AUD/NZD currency pair is going to move to the upside. If on the other hand, the New Zealand economy outperforms the Australian one, the pair will move to the downside.

To speculate on the example above means taking a position, or trading the AUD/NZD pair. If  a trader believes the Australian economy is going to strengthen, they will buy the AUD/NZD with the purpose of profiting from this economic analysis, and if indeed the pair moves to the upside, the position can be closed. The difference between the opening price and the closing one being a positive one, it means a profit has been made.

The great thing about the Forex market is that a currency pair can also be sold, with the idea that if indeed it is going to move to the downside, a profit can be made as well. In order to access this huge currency market, one needs a broker. Such a Forex broker is an intermediary, or a middle man who, based on a commission, allows the trader to place trades on the foreign exchange market. The Forex brokerage business is an extremely competitive one with plenty of brokers out there, which is great from a trader’s point of view as it offers him many possibilities of finding the right broker for his needs. Some Forex brokers offer other financial products that can be traded on the same principle as well, such as stock indexes, contracts for difference (CFDs), commodities (gold, silver, oil, platinum, cotton, palladium, copper, etc.). This may also appeal to Forex traders, as again the principle is the same. In order to trade on the Forex market, one needs to open a Forex trading account with a Forex broker. In such an account all the currency pairs are listed, charts can be opened in order to make a forecast and see how prices have fluctuated in the past, and a clear list of open trades and historical transactions can be found as well.

Forex Market Participants

When trading, it is important to know what moves the currency market overall, and who is trading such a market. The biggest chunk of the market consists of central banks (yes, they do have trading desks of their own) and commercial banks (through their treasury departments they are effectively buying and selling currencies for their day to day operations), large investment houses and institutional players, and retail traders. The latest Internet developments have changed the face of Forex trading for good, in the sense that online trading has spread worldwide, so that now with a secure Internet connection anyone can trade these markets. To get an idea about the size of the retail market when it comes to Forex trading, it represents a staggering 5% of the whole market, so what moves a currency pair is definitely not the action of retail traders. Robots, or expert advisors, or trading algorithms, are part of this market as well, as they are instructed to buy or sell specific currency pairs based on economic events that are about to happen or information or about to be released, or on what a specific central bank will do. Violent moves that happen in the blink of an eye are the result of high-frequency trading (HFT) as algorithmic trading is called.

Finally, the Forex market moves based on fundamental analysis (interpreting economic news in different economies in order to speculate on the future direction of a currency) and technical analysis (forecasting future price directions based on patterns that have formed in the past, or on historical prices). Both of these are part of Forex trading, and are used by traders when speculating. To sum up, Forex trading involves speculation on the future move of a currency/currency pair with the purpose of making a profit.

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Forex Trading Explained
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