Forex Trading Basics

Forex Trading is a market that exceeds $5 trillion a day in volume, making it the largest market in the world. Forex is short for ‘foreign exchange’ – this market is open 24/7 – with multiple participants at various locations throughout the world. Currencies play a huge role in the local and international economy.

Currency exchange plays a huge role in every economy, from local businesses, to multinational corporations (i.e. Apple exchanging currency for their international operations). Small movements in currencies may not be significant, however, with large amounts of cash – forex traders speculate these movements, in order to make a profit.

How Does Forex Trading Work?

The basic concept of forex trading is the continuous buying and selling of currency. The value of the currency is impacted by the exchange rate – which represents the relative value of different currencies. Similar to stock markets, forex markets are open, with several market participants, at several locations throughout the world. These market participants determine the price of the currency – which is impacted by supply and demand.

Forex traders speculate on the currency movements. Let’s use the USD/CAD (US Dollar and Canadian Dollar) currency pair as an example. In this pair, the USD would be known as the base currency, whereas CAD is known as the counter currency. In this case, if you’re expecting USD to rise against CAD, you would do a long position – selling CAD, and buying USD. If you’re expecting the USD to depreciate against CAD, you would do a short position – buying CAD and selling USD.

US Dollar ($) ⇨ Canadian Dollar (CA$)
24-month chart
Google Finance

Let’s say you’re expecting USD to depreciate against CAD. As mentioned above, a short position would be executed. With this position, you would purchase CAD and sell USD. When the USD currency depreciates, you would sell CAD, and purchase more USD than the initial amount that was sold, since USD is worth relatively less, against CAD. The difference between USD bought and the USD sold is equal to the profit of the position.

Speculation

Currency movement is dependent on many macroeconomic factors. These include, but are not limited to, the country’s trade relationship, overnight interest rates, and debt levels. Interest rate announcements by central banks are always watch very closely by investors in general.

Typically, lower interest rates depreciate the country’s currency and lead to higher asset prices. This is seen in Canada, where low interest rates are contributing to the hot housing market (mostly in Toronto and Vancouver), and weaker Canadian dollar. Demand for goods also play a role in the valuation of a currency. This is one of the concepts that explains the decline the Canadian Dollar as oil prices tumbled in 2015. Approximately 40% of US oil is imported from Canada (US Energy Information Administration). This is one example of how prices of goods can affect the demand for the currency.




Volatility

Huge amounts of money is typically traded within forex markets. The smallest movement in a currency pair can lead to a huge gain/loss. Volatility varies for each currency pair, since it is dependent on many external factors. Huge political moves, such as the Brexit have significant impacts on the foreign exchange markets. In the case of Brexit, the Great British Pound (GBP) dropped around 10% against the USD.

Bottom Line

Forex is an extremely fast pace market. It’s a market that never sleeps, allowing you to trade at anytime. Typically, there is higher risk. It’s common knowledge that higher risk leads to higher (potential) returns. The forex markets are known to have very high liquidity – which can be used to your advantage (i.e. quicker closing/opening of positions).

Forex can be complicating, however, just like any other investment vehicle, it is a learning process. Some strategies can reap huge gains, whereas others can lead to huge losses. There are many sources available on the internet – to help you learn more about forex. CMC Markets has great resources on their website, from learning more about forex, to fundamental analysis.

Just like any other investment; do not put all of your eggs in one basket. Aim to have a good mix of stocks, bonds, cash, and more complicating investments, such as forex and options.

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Writer: Jelani Smith

Disclaimer: All investing can potentially be risky. Investing or borrowing can lead into financial losses. All content on Bay Street Blog are solely for educational purposes. All other information are obtained from credible and authoritative references. Bay Street Blog is not responsible for any financial losses from the information provided. When investing or borrowing, always consult with an industry professional.