Beginners Guide to FOREX Trading
Forex stands for "foreign exchange." The forex market is the worldwide virtual marketplace for the exchange of currencies. Countries and institutional investors buy and sell each other's currencies all the time for a variety of reasons: To hedge against declines in their own currencies, to lock in pricing on expected international transactions and even to profit from identifying overvalued or undervalued currencies.
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Mechanics of Pricing
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In the forex market, every currency has a listing price, or exchange rate, against every other currency on the market. Each currency has a unique three-letter code and prices are expressed in terms of the exchange rate of one currency for another . For example, USD is the code for U.S. dollar, while EUR is the code for euros. If the two currencies are trading evenly, you would see the price for the exchange of dollars for euros to read "1."
Bid-Offer Spreads
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There are no commissions for forex transactions in the traditional sense. But it is important to understand how pricing works, since forex transactions are not free. Instead, the broker, or market maker, charges a higher price to bidders than he collects from sellers. The difference is called the "bid-offer spread." These spreads are generally quite small and often equate to just a few hundredths of one percentage point. The bid-offer spread is measured in "pips," or one one-hundredth of one percentage point.
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Basic Trades
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There are just a few basic trade structures on the forex market. The simplest is the direct exchange of one currency for another. A "swap" is an exchange, plus an agreement to reverse the transaction at a later date. A "forward" transaction is an agreement to trade currencies at some future date. The forex market also enables investors to buy and sell options to buy or sell currency at set prices in the future. These options work much like stock options.
Leverage
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Because currency swings can be very small, forex brokers often allow investors to borrow large amounts of money on margin, using their deposits as collateral. The use of margin, or leverage ("gearing," in Australia and the UK) can magnify any gains. For example, if you leverage your investment 10-to-1 by borrowing $10,000 against a $1,000 deposit, and you buy a currency, or an option to buy a currency that appreciates by 10 percent against the dollar, your actual gain is 100 percent. But leverage works the other way, too: Losses are magnified as well. You could potentially lose more than you invested by using leverage.
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