trade

Investing Basics: Forex

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The foreign exchange, or forex market,

is the world's largest financial market,

and it plays a vital role in the global economy.

Every day, trillions of dollars are exchanged from one currency

to another.

This kind of currency exchange is

essential for international business.

Forex market participants include

governments, businesses, and of course, investors.

Governments use the forex market to implement policies.

For example, when conducting business with another country,

whether it's borrowing money, lending money, or offering aid,

a country needs to convert its currency

into a foreign currency.

Businesses use the forex market to facilitate

international trade.

For example, they may need to convert payments

for goods and services bought overseas,

or to exchange payments from international customers

into their preferred currency.

And investors use the forex market to speculate

on changes in currency prices.

Currency prices change almost constantly during the week,

because the forex market is open continuously from Sunday

at 4:00 PM until Friday at 4:00 PM Central Time.

A trading day starts at 4:00 PM and ends at 4:00 PM Central

Time the following day.

The market has to be open around the clock because

of the global nature of the economy.

Let's go over some basics of how trading forex works.

When you trade forex, you're not just trading one product,

you're trading two currencies against each other.

This is known as a currency pair.

The quote for a forex currency pair

defines the value of one currency relative to the other.

The easiest way to understand any quote

is to read the pair from left to right.

Let's look at an example of using the euro versus the US

dollar currency pair.

If the EUR/USD is trading at 1.20,

that means 1 euro is equal to 1.20 US dollars.

Here's another example of using the US

dollar versus the Canadian dollar currency pair.

If the USD/CAD is trading at 1.25,

that means 1 US dollar is equal to 1.25 Canadian dollars.

Even though there are two currencies involved,

the pair itself acts like a single entity.

It's similar to a stock or a commodity.

And just like when trading stock,

investors profit when they buy a currency pair and its price

increases.

Investors can also profit if they sell or short a currency

pair and the price decreases.

Let's look at an example.

Suppose an investor who thinks Europe's economy is going

to grow faster than the United States, and as a result,

she thinks the euro will strengthen against the US

dollar.

She can buy the euro versus US dollar pair

to speculate on her assumption.

If the price of the currency pair rises, she'll make money.

Conversely, if the price falls, she'll experience a loss.

Now that we've covered the basics,

let's look at a few key aspects of the forex market.

We'll start with margin.

When you trade on margin, you only

need to put up a percentage of the total investment

to enter into a position.

This amount is known as the margin requirement.

When you trade other securities like stocks, trading on margin

means you're borrowing funds from your broker.

However, forex trades can only be

covered using funds in the investor's forex account.

Investors can't borrow funds to enter a forex trade.

If they don't have funds in their forex account,

they need to transfer funds before placing a trade.

Forex margin requirements vary depending on the currency

pairs and the size of a trade.

Currency pairs typically trade in specific quantities

known as lots.

The most common lot sizes are standard and mini.

Standard lots represent 100,000 units,

and mini lots represent 10,000 units.

Depending on your brokerage firm,

you may also be able to trade forex in 1,000-unit increments,

also known as micro lots.

Margin requirements can be as small as 2% of a trade

or as large as 20%, but the margin

requirement for most currency pairs averages around 3% to 5%.

To understand how margin is calculated,

let's look at an example using the euro versus US dollar pair.

Say this pair was trading at 1.20,

and an investor wanted to buy a standard lot or 100,000 units.

The total cost of the trade would be $120,000.

That's a lot of capital.

However, the investor doesn't have to pay that full amount.

Instead, she pays the margin requirement.

Let's say the margin requirement was 3%.

3% of $120,000 is $3600.

That's the amount the investor needs in her forex account

to place this trade.

This brings us to another key element of the forex market--

leverage.

Leverage enables investors to control a large investment

with a relatively small amount of money.

In this example, the investor is able to control $120,000

with $3600.

The leverage associated with currency pairs

is one of the biggest benefits of the forex market,

but it's also one of the biggest risks.

Leverage gives investors the potential

to make large profits or large losses.

One more important element in the forex market is financing.

This is the calculation of net interest owed or earned

on currency pairs, and it happens

when an investor holds a position past the close

of the trading day.

The US dollar is associated with an overnight lending

rate set by the Fed, and this rate

defines the cost of borrowing money.

Similarly, each foreign currency has its own overnight lending

rate.

Remember, when you trade a currency pair,

you're trading two currencies against each other.

Even though the currency pair acts like the single entity,

you're technically long one currency and short the other.

In terms of financing, you're lending the currency

that you're long and borrowing the currency you're short.

This lending and borrowing occurs the overnight lending

rate of each respective currency.

In general, an investor receives a credit

if the currency he has long had a higher interest rate

than the currency he is short.

Conversely, an investor is debited

if the currency he is long has a lower interest rate

than the currency he is short.

Let's look at an example.

Suppose an investor has a position

in the Australian dollar versus the US dollar currency pair.

Say the overnight lending rate for the Australian dollar is 2%

and the overnight lending rate for the US dollar is 1%.

The investor is long the currency pair,

which means he is long the AUD and short the USD.

Since the AUD has a higher interest rate than the USD,

the investor will receive a credit.

However, if the investor was short the AUD/USD currency

pair, he'd have to pay the debit because he's short

the currency that has a higher interest rate.

Financing is performed automatically

by your brokerage firm.

However, it's important to understand

how it works and its financial impact on the trade.

We've reviewed just a few elements of the forex market.

As with all investment opportunities,

the forex market has a unique set of risks and benefits,

and education is the first step to determine if this is

the right opportunity for you.

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