Introduction to the Foreign Exchange Market
The foreign exchange market is the buying and selling of different national currencies. Corporations and banks that do business in different countries need to convert the money they receive into their home currency. Banks and brokers have traders that work in the currency markets to get the currencies their employers need and to generate profits from the trading. Foreign exchange trading is also popular with individuals as a way to make money from the markets. The foreign currency exchange market is commonly known as the forex market.
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Identification
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Foreign currency trading is done by identifying often-small, but profitable, differences in relative pricing between currency pairs. The different currencies are indicated with three letter identifiers like USD for U.S. dollars, CAD for Canadian dollars, EUR for euros, GBP for British pound and CHF for Swiss francs. Currency values are listed by currency pair with the base currency first. For example if the EUR/USD is at 1.2636, each euro is worth $1.2636 in U.S. dollars. Currency pairs are quoted out to four decimal places.
Function
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Currency trading does not take place on regulated exchanges. Numerous banks and brokers set up currency trading desks and allow individuals to trade different currencies. Traders can open an account with a broker, deposit some money and start trading different currency pairs. Currency trading allows up to 100-to-1 leverage. This means the trader has to put up $1,000 to trade a $100,000 currency contract.
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Features
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Forex traders can make a trade betting that a currency's price will move in either direction. With the EUR/USD, the trader can decide which direction she thinks the exchange rate will go, and place a trade to profit in the expected direction. Currency rate moves are measured to the fourth decimal place and each point move is called a pip. For example, of the EUR/USD moves from 1.2374 to 1.2378, the euro has moved four pips. Each pip on a $100,000 contract is worth $10, or 10 of whatever denomination in which the currency pair is denominated. A 20-pip move would be a $200 profit or loss for the trader.
Considerations
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The foreign exchange broker makes money by charging a spread between the buy and sell prices, typically 2 to 4 pips. So for a trader to make a 20 pip profit the currency has to move 22 to 24 pips. Forex traders need to be able to keep watch the market at all times when they have a trade open. A 100 pip move is just a penny but the leverage involved can wipe out a trader's entire trading account.
Warning
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Is is easy to start trading foreign currency, but very difficult to consistently trade profitably. The North American Securities Administrators Association commissioned a report by Ronald Johnson that determined only 11.5 percent of day traders were consistently profitable. Almost 90 percent of traders lost money or broke even. Successful currency trading requires study, practice, discipline and money management.
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References
- Photo Credit euro coins on top of euro banknotes image by Stefan Ataman from Fotolia.com
