What Is Online Forex Trading?
The foreign exchange, or Forex, market is a global network that facilitates the exchange of world currencies. This market operates on two tiers. There is an interbank market, which is used by banks and other large institutions to directly exchange currencies with one another, and a secondary market, which permits smaller, retail traders and investors to participate in currency exchange. Online Forex trading is the act of using an online broker to buy currency, speculating its price will increase in relation to a second currency.
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Currency Pairs
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In the Forex market, currencies are priced based on their relation to other currencies. For example, the price of the dollar is meaningless unless you know what it is worth in euros, yen or other world currencies. Thus, currencies in Forex are quoted in pairs. One of the most popular pairs is EUR/USD. This pair quotes the value of the euro as it relates to dollars. If you wish to trade the euro for dollars, you would purchase USD/EUR. If the price of the dollar rises in relation to the euro, you can sell your position for a profit.
Bid and Ask Spread
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Like the stock market, the Forex market works as an auction, where currency pairs sell to the highest bidder. Those who wish to buy put in a bid price, while those who wish to sell put in an ask price. The difference between the bid and ask price is called a spread. Popular currency pairs typically have a very small spread between the bid and ask. Less popular pairs may have a wider spread. Wide spreads can be a problem for Forex traders. For example, if you wish to sell, you may have to sell at a bid price that is several points lower than the next available asking price.
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Lots
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Each Forex transaction represents the exchange of one currency for another. If you buy EUR/USD, you are selling dollars in exchange for euros. The basic unit of currency pair trading is called a lot. A lot represents 100,000 units of currency. Thus, if you buy one lot of EUR/USD, you exchange 100,000 dollars for 100,000 euros. Today, many brokers cater to smaller traders, offering mini lots of various sizes.
Margin
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Forex traders do not have to pay the full value of their trade if they have a margin-approved trading account. The typical margin requirement is between 1 and 5 percent. For example, if the GBP/USD, or the British pound versus the dollar, is selling at 1.5852, it would cost $158,520 to buy one lot. With a margin requirement of 2.5 percent, you could control $200,000 worth of British pounds with only $5,000. While using margin can vastly increase your profit potential, keep in mind it also increases risk, putting you into a position where you can lose more money than you have in your trading account.
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References
- Photo Credit Twenty dollars among dollars image by Borodaev from Fotolia.com
