Forex trading has become very popular in the last couple of years – pretty sure most of you have seen a Forex ad at some point while you were surfing the internet. But what exactly is Forex and how does it work? Forex is short for Foreign Exchange, or in other words, currency trading. It has been around on an inter-bank level for a long time but recent developments in technology and online trading platforms made it possible for every individual to give it a shot. It is the world’s largest financial market with a daily turnover in excess of 3 trillion USD and a very high level of liquidity. It is also open 24/5. This would make it a very attractive market to trade in right? While this might be true, it is important to know how Forex trading works in order to determine if it matches your investor personality. This article will explain some of the main principles that you need to consider.
Long and Short Positions
Having a long position is a commonality in all the financial markets. It means you have bought a stock, for example, and you are waiting for its price to appreciate. This is exactly the same in the Forex market. Having a short position, on the other hand, is a feature much more common in Forex trading than in other financial markets. It means that you have sold a currency pair you do not own and are anticipating the price to depreciate. At a certain point you then buy the currency pair back (this is called “covering”) at a lower price (making a profit) or at a higher price (making a loss). This might seem a bit confusing but it is a really simple principle. When you go short the broker basically lends the currency pair to you and when you buy it back, you return it. That’s all there is to it.
Leverage
One of the most important characteristics of Forex trading is leverage. Leverage simply means that you are not required to put up a full amount in order to control a position – you only need a margin amount. To give an example, if leverage is 1:100 (this is the leverage most commonly used in FX trading) you would only need $1000 to control a position worth $100,000. That means you get all the risks and benefits of holding a $100,000 position – if the price rises to $101,000 (1%), you have effectively made a 100% profit on your $1000 trade, assuming your position was long.
The important thing to remember here is that leverage is a two sided blade. It amplifies your gains and it also amplifies your losses. If the price dropped to $99,000 (1%) you would lose that $1000 you initiated your trade with. Additionally, if you didn’t have any funds in excess to that $1000 on your trading account, your position would automatically be closed by your broker. You always need to maintain a certain margin of the position value on your trading account (determined by the broker) in order to avoid automatic closing.
High Frequency of Trading
Another important aspect of Forex trading is the frequency and duration of trades. When someone says they are a long term trader in the stock market, they usually mean they are holding shares for years. When someone is a long term trader in Forex, they hold their position for a couple of weeks at most. The shortest trades in the Forex market can only last milliseconds. Those trades are programmed to have automatic execution and are done tens (or even hundreds) of times per day. This higher frequency of trading makes it more exciting, but it also requires you to invest more time in developing your strategy. If you are the kind of investor who prefers to keep his position open for long periods of time, Forex might not be the optimal choice.
Liquidity
Earlier I mentioned that the Forex market was open 24/5. This means you can trade Monday-Friday all day and all night. However, you need to realize that different currency pairs have different liquidity levels at different times. For example, the most liquid currency pair, EUR/USD, will have the most liquidity when US and European markets are open, so it makes sense to trade in that time slot. On the other hand, USD/SGD will see most of the trades executed when Singapore and US markets are open.
