Investing in the foreign exchange or forex market can be an extremely profitable venture. It is however, not without its fair share of risks. Investing in the wrong currency at the wrong time can result in huge losses.
As was seen by the destruction of Barings Bank by rogue trader Nick Leeson, the forex market can be a dangerous place for a novice trader.
This is why it’s vital that you first understand the basics of forex trading. Let’s begin with:
What is forex trading?
Forex is a short form for foreign exchange, and it refers to the buying and selling of one currency in exchange for another. Hence the term foreign exchange.
Currencies are traded on a 24-hour foreign exchange market that is only closed from Friday to Sunday evening and public holidays. There are 3 sessions in which European, Asian and United States currencies are traded.
Traders buy and sell currencies on the foreign exchange market on a daily basis. Here, currencies are traded in pairs i.e. EUR/USD or JPY/USD. Prices are affected by a variety of factors that drive market forces.
Although some people compare it to sports betting, due to its volatility, there is a huge difference. While betting on football games involving a keen eye on the odds of NFL and lots of luck, forex trading involved sense of opportunity to notice when a currency oscillates in value.
The U.S dollar or USD is one of the most widely traded currencies on the market. Being the largest economy in the world with a relatively stable government, the USD has gained a reputation as being one of the most reliable currencies.
Geopolitics, governments and the economic climate are just some of the factors that affect currency prices. Now that you have an understanding of what forex trading actually is, let’s take a look at some transactions.
- The spot market
In the spot market, financial instruments like commodities, foreign currencies and securities are traded on the spot for immediate delivery. Thus, giving rise to the title of spot market.
Here, financial instruments can be bought at their current price. This allows traders to immediately purchase and receive their chosen assets.
For example, you anticipate a sudden appreciation in the USD over the next few days. Looking to take advantage of this situation, you exchange your EUR for USD. You purchase USD 10,000 at an exchange rate of 0.80 EUR /USD – which amounts to a cost of EUR 8000.
Over the next few days, the USD appreciates to 0.90 EUR/USD. You then exchange your USD for EUR – this allows you to receive a total of EUR 9000. Hence the foreign exchange differential has allowed you to gain a net profit of EUR 1000.
This is a simplistic model, but it clearly outlines the concept of spot market trading. In this way, traders have been able to net massive profits within a short span of time.
As a beginner, it’s wise to start off with smaller amounts of currencies while you become accustomed to trading on the spot market. This form of investment is not recommended for passive investors due to fluctuating market prices.
- The futures market
Unlike the spot market, the futures market deals in derivatives like futures contracts. Contracts derive their price from the value of an underlying asset – in this case, foreign currencies.
Essentially, contracts are an agreement between two parties to buy or sell a given asset at a given price in the future. Hence, the term futures contracts. These contracts can be bought and sold over the counter (OTC) and traded on the market.
Futures can be used to lock in the buying or selling price of a particular currency. For example, in the wake of the U.S presidential elections, you anticipate that the USD is set to appreciate next week.
You then purchase a futures contract that allows you to buy the USD at a much lower rate in 7 days. Following the results of the election, the USD appreciates by 30 percent. As you have previously purchased a contract you are able to buy USD at a more competitive price and make a hefty profit in the spot market.
Alternatively, contracts can also be traded on the futures market for a profit. In that previous scenario, you could have just as easily sold your futures to a fellow trader and made a profit on it’s higher value.
Trading on the largest market in the world does have its fair share of benefits. However, care should always be exercised when trading in foreign currencies. You should ideally keep your investments small and always be on the lookout for any sudden changes.