What is Forex Trading?

Since the creation of the internet, investment has become more accessible. Today, practically anyone can play the markets to realize extra income or create a retirement savings. One of the most popular forms of investment in the world of digital trading is Forex, or foreign exchange, trading. Forex trading involves trading on the price fluctuations between different global currencies, making it at the same time one of the most flexible and one of the largest trading markets imaginable.

Forex Currency Pairs: The Basis of All Forex Trades

Before jumping into the specifics of Forex trading, it’s important to understand what Forex currency pairs are. All Forex trades are based on sets of paired currencies. Though there are many Forex pairs, the most commonly traded are the EUR/USD, GBP/USD, AUD/USD and USD/JPY. Other pairs, such as the AUD/JPY, are of course available. When dealing with trades, these pairs actually represent the value ratio between the two currencies. At any time, the value of the first currency in a pair is compared to one of the second currency. A ratio of 1.42 on the GBP/USD pair, for example, would mean that one British pound was worth $1.42 in American dollars.

How Forex Trades Work

Forex trades are binary positions, meaning that there are only two options in any one trade. The first option is that the overall ratio of value between the two currencies in a given pair will increase, while the second is that it will decrease. A trading position that predicts an increase in the value ratio is known as a “Call” option, while one that predicts a decrease is known as a “Put.” Once one of these two positions has been opened, the movement of the currency will determine whether or not the given prediction was correct. Calls and Puts actually represent a reserved option to buy or sell at certain prices, which is the underlying way in which currencies, and therefore the respective marginal gains made from their value fluctuations, are transferred.

The outcome of the prediction will also determine whether or not the trade was profitable. If a Call position is opened on a currency pair whose value ratio then decreases, the trader who opened that position will lose money. If, on the other hand, the value ratio increases, the trader will be able to profit. Keep in mind that the outcome can vary based on time. A currency pair’s ratio of value can decrease for a period of time before eventually going above the starting point, resulting in a profitable trade.

Leverage: The Multiplier of Forex

As you might already expect, the price fluctuations between individual currencies are rarely very large. In fact, the fluctuations are measured in units called “pips,” which are, in all currencies but the Japanese yen, representative of a decimal unit four places to the right of the zero. With such incredibly minor fluctuations being the most common in the Forex marketplace, it takes enormous amounts of raw investment capital to make good money. Needless to say, few investors can afford to invest such large amounts of money out of their own pockets. For this reason, most Forex trades are leveraged.

Leverage is effectively a multiplier of the amount of currency an investor puts into a trade. The additional capital is provided by the trading brokerage, which profits by taking a percentage of the gains on a trade. A trade leveraged at a ratio of 10:1, for example, would entitle an investor to trade with 10 times the amount of money he or she puts into the trade. Forex trades, however, have much higher leverage ratios, with 200:1 being fairly standard and 400:1 not being at all uncommon.

When making leveraged trades, it’s important to understand that increased loss is as much a possibility as increased reward. In theory, it is possible to lose more than you have invested in your trading account, thus going into debt to your broker, when making a leveraged trade. Many brokers solve this problem by automatically closing positions when your loss is equal to the amount of money in your account, but be sure that your broker employs such a system before leveraging your trades on that assumption.

Stop Loss

Another major component of modern Forex trading is the stop loss, a feature that allows traders to cut off their own positions automatically when loss occurs. Whenever a trader opens a position, he or she can set a stop loss at a certain level. If the value of the currency pair reaches that level, the position will automatically be closed. This lets traders limit the risk in individual trades by ensuring that only so much money can be lost.

Analysis in Forex Trading

Even though Forex trading involves making a trading decision in a binary environment, it is far from simple. Successful Forex traders put an incredible amount of hard work and analysis into their trading decisions. The first element of analysis in Forex trading is a basic understanding of economics. Currency values can shift substantially when economic reports come out or when marketplace events occur. Forex traders who can predict how these events will impact currency values will typically be better-equipped to accurately predict the movement of those values.

Beyond economic analysis, there is also technical analysis. Technical analysis relies on evaluation of past price trends to discover patterns. One of the most common means of technical analysis, for example, is finding a support point below which a given currency has not slipped in the recent past. If a currency tends to move gradually upward after it has slipped to a given price point, it is reasonable to assume that this pattern will continue and base future trades off of it.

Is Forex Trading Short-term or Long-term Investment?

Most people who are at all familiar with the world of investment know that some people invest for income while others invest for future financial security. Forex trading is generally used more as a short-term solution for producing income than for creating a large fund for retirement. In large part, this is because of the inherent risk that comes with Forex trading. Some traders do, however, choose to use Forex in a more long-term capacity by trading actively but not withdrawing funds from their accounts so as to let their gains add up over time. Opening long-term Forex positions and treating them as passive investments, however, is rarely a good option.

Conclusion

Forex trading is one of the largest investment opportunities out there at the moment. By giving traders the ability to profit from the vast global currency market, Forex trading offers the possibility of profits in any market condition. Be careful, however, as Forex trading is a fairly risky investment. If you’re willing to take on some risk and put in the work of learning to predict currency prices, though, you may find it to be a profitable method of investment.