Guest Writer: Emma Foreman
Forex sounds like a complex financial term, but in fact s is a simple concept and one which many people will have experienced when they swap their everyday money for their holiday cash; the fluctuations between currencies with some rising in value and others dropping.
Forex, or foreign exchange trading as it is also known, involves picking a pair of currencies and betting which way each one will move compared to the other. This is one of the factors which makes forex very different to trading stocks and shares, it is possible to make money even if the value of the currency decreases – as long as that is the way you predicted the market would move.
There are a huge number of currency pairs available, but the majority of trades – nearly 85% – involve the US dollar as well as one of the other most frequently traded currencies – the euro, yen, sterling, Australian dollar, New Zealand dollar, Canadian dollar and the swiss franc. These are known as the majors.
There are other pairs available which do not incorporate any of the above denominations – these are known as the exotics – and often include currencies from emerging economies such as Brazil.
To make money on a forex trade, it is not sufficient to correctly predict the direction in which the currency will move, the swing must also be large enough to pass the broker`s spread. The spread is the range which each individual broker offers between the selling price and the buying price and is how they make their money.
It is not possible to trade directly on the exchange which is why every trader must have a broker. Unlike stocks and shares, dealers do not charge fees or commission for a standard trade but will instead make their money from the spread. It is preferable for the broker to offer a wide spread but far more attractive to the trader to have a narrow spread.
All forex prices come with two prices, the bid price – which is usually the lower – and the ask price, which is higher. The bid price relates to the point at which the broker is willing to buy the currency from the trader – and the ask price relates to how much the broker will sell the trader the currency for.
As mentioned above, all trades are executed in pairs, with each currency abbreviated to a three letter code, such as `USD` for the US dollar. The first currency named in each pair is known as the base currency whilst the second named currency is the quote currency. As an example, a trader may refer to a pairing of USD/GBP – the US dollar is the base currency and UK sterling is the quote currency.
The trader must decide how he believes the two currencies will move against each other and the prediction up or down is referred to according to what the base currency will do.
In the above example, if the US dollar is expected to climb in value, a trader would buy the US dollar – also known as going long – hoping that when he closes the trade, the dollar would have risen in value. If he thinks that sterling will rise compared to the dollar, he will sell the US dollar – also known as going short – in the expectation that when the trade closes the dollar will be worth less than he sold it for.
Whichever option -short or long – is chosen, then the appropriate selling or asking price is used, then when the position is closed, the opposite price is used to calculate any profit or loss.
As an example, the EUR/USD may have a bid price of 1.54568 and an ask price of 1.54588 and the difference between the two prices is known as the spread. Going long on the euro means that the bid price of 1.54568 is used to open the trade. When the position is ready to be closed, the opposite price – the ask price – is used as the trader is effectively buying back the currency. This means that before any profit is earned, the bid price must have risen beyond the ask price of 1.54588. If the price has risen but is lower than the ask price, a loss will still be incurred. This is why the spread is so important to profits.
Spreads are only one of the features which make a good broker, so for anyone considering starting currency trading it is essential to research the market thoroughly first.