Forex trading is the buying and selling of one foreign currency against another and taking advantage of the continually varying exchange rates in the foreign exchange markets.
When an abundance of traders buy a currency, a shortage of that currency is created in the market and consequently, the demand for that currency increases it’s value and price. When traders sell a currency, an oversupply is created, causing the demand for that currency to decrease, suppressing it’s price and value. This continually changes the exchange rates between currencies in the forex markets.
Exchange rates are displayed as graphs in currency price charts. Since exchange rates can only exist between two currencies, such price action can only be displayed as the price of one currency with reference to another. One such example is the value of the British pound compared against the U.S. dollar, referred to as the GBPUSD currency pair, or the cable.
Price Chart of GBP/USD
The price level of the chart is a representation of the fraction where, in this example, the value of the British pound is divided by the value of the U.S. dollar, hence GBPUSD. If one British pound (£1.00) equals one U.S. dollar and forty cents ($1.40), then the exchange rate is 1.40 divided by 1.00 which equals 1.40000.
If the value of the British pound increases against the U.S. dollar, the price chart will rise. Conversely, if the value of the U.S. dollar increases against the British pound, because it is on the underside of the fraction, the price chart will fall.
Imagine a holidaymaker who exchanges one thousand British pounds (£1,000.00) for U.S. dollars. At the above exchange rate, he will receive one thousand, four hundred U.S. dollars ($1,400.00), minus fees. Assume also that he still has this money when he returns to the U.K. from his holiday in the United States two weeks later. This time, the exchange rate has changed and a British pound (£1.00) is now only worth one U.S. dollar and thirty-five cents ($1.35). The U.S. dollar is now more valuable and can now buy more British pounds sterling. So he exchanges his U.S. dollars back to British pounds and receives £1,037.04, minus fees.
- He sells his dollars and buys back sterling.
- $1,4000 divided by 1.35 equals 1,037.037.
- Rounded up, this equates to £1,037.04.
- Our holidaymaker has made a profit of £37.04.
Due to the difference in the exchange rate, he has made a profit of £37.04. In a similar manner, forex traders generate profits by taking advantage of the continually changing currency exchange rates.
Before our holidaymaker went abroad, the level of the price chart was 1.40000 and when he returned, the price chart had fallen to 1.35000 – a difference of 0.05000.
The increments of the price chart are measured in pips. This unit name variously stands for: ‘Percentage In Point’, ‘Point In Percentage’ and ‘Price Interest Point’. A pip is the smallest price move that a given exchange rate makes based on market convention. In the above example, the exchange rate had fallen 0.05000, which for the GBPUSD or cable currency, is 500 pips.
Had you placed a trade based on your analysis that the GBP/USD would fall 500 pips. Risking a maximum 1% risk of your trading/investment account, it would have yielded a 5% return.
Base and Quote Currencies
All currency pairs contain a base currency and a quote currency. The base currency is the reference currency and the quote currency is quoted against it. The base currency is always displayed on the left side of the currency pair symbol and the quote currency is always displayed on the right side. Taking our example from above, the cable, the base currency is the British pound sterling (GBP) and the quote currency is the U.S. dollar (USD). Thus the currency symbol is displayed: GBPUSD.
Earlier in our example, one British pound sterling (£1.00), the base currency, was worth one U.S. dollar and forty cents ($1.40), the quote currency. So the exchange rate was 1.40000.
Majors, Minors and Cross Pairs and Exotics
Forex currency pairs are categorised as majors, minors, cross pairs or exotics.
The U.S. dollar is the world’s strongest currency, making up 64% of the global reserves. More than one-third of the world’s gross domestic product comes from countries that peg their currencies to the U.S. dollar and more than 85% of forex trading involves the U.S. dollar. For this reason, the U.S. dollar is regarded as the world’s reserve currency.
After the U.S. dollar, the seven most popularly traded currencies are the Australian Dollar, British Pound Sterling, Canadian Dollar, European Euro, Japanese Yen, Swiss Franc and New Zealand Dollar. Traded against the U.S. dollar, these form the major and minor currency pairs.
Of these seven pairs, the euro is the most popular currency, being traded in nearly 30% of all forex transactions (i.e. the most liquid), followed by the British Pound Sterling, Japanese Yen and Swiss Franc. These make up the four major currency pairs.
The remaining currencies, the Canadian Dollar, Australian Dollar and New Zealand Dollar form the minor currencies, and are less popular and less liquid.
The major and minor pairs always contain the U.S. dollar on one side of the currency symbol and they each have names.
The cross pairs do not contain the U.S. dollar and are formed by crossing the major and minor currencies. In the past, the tedious calculation of converting the value of each currency into U.S. dollars was necessary to compare them. However, this requirement no longer exists, since all brokers are able to provide direct exchange rates.
The most popular and most liquid cross pairs are achieved by crossing the major currencies together:
- EURJPY Euro, Japanese Yen
- EURGBP Euro, British Pound Sterling
- EURCHF Euro, Swiss Franc
- GBPJPY British Pound Sterling, Japanese Yen
- GBPCHF British Pound Sterling, Swiss Franc
- EURAUD Euro, Australian Dollar
- CHFJPY Swiss Franc, Japanese Yen
The remaining cross pairs are achieved by crossing major currencies with minor currencies, and by crossing minor currencies with minor currencies.
Here are some examples:
- EURAUD Euro, Australian Dollar
- CADJPY Canadian Dollar, Japanese Yen
- AUDCHF Australian Dollar, Swiss Franc
- NZDJPY New Zealand Dollar, Japanese Yen
- AUDNZD Australian Dollar, New Zealand Dollar
- AUDCAD Australian Dollar, Canadian Dollar
- NZDCAD New Zealand Dollar, Canadian Dollar
Together, the majors, minors and cross pairs provide a total of twenty-eight alternative forex trading opportunities, which should be more than enough for traders to extract money from the markets.
Failing that, the exotic currencies include the less popular and less frequently traded currencies such as the South African Rand (ZAR) and Singapore Dollar (SGD), and these currencies are traded against the U.S. dollar as well as the majors, minors and exoctic currencies
Buying and Selling
When a forex trader buys a currency within a currency pair, he is also simultaneously selling the other currency within that pair. Similarly, when he sells a currency within a currency pair, he is also simultaneously buying the other currency within that pair. This is all automated by the brokers. Thirty years ago, it was done in the hustle and bustle of the trading floors. Then the computer came along and its now done with a click of a mouse.
Most people understand how to make a profit when the price bar on a currency chart goes up. Yet many people are confused as to how it is possible to make money on a currency pair when the price bar goes down.
Think of it this way: in the anticipation that a currency will increase in value and that the price chart will rise, you buy the currency at the lower price. Once the currency value has risen, you then sell it back to the market at the higher price with a click of a mouse or by setting a target limit order. The difference between the two levels when you bought and when you sold, minus any surcharges, is your profit. This is called a long trade.
To make a profit in the anticipation that the currency value will decrease and that the price chart will go down, you do exactly the same as before: you buy low and sell high; only this time, you reverse the order in which you buy and sell. You sell when the price is high and buy when the price is low. Again, the difference between the two levels when you bought and sold, minus any surcharges, is your profit. This is called a short trade.
So how can you sell a currency which you do not own? The answer is that you borrow it from the market. You then sell the currency that you do not own (at the higher price), in the anticipation that you can buy it back at a lower price. Having bought back the currency, you then return the borrowed currency to the market. This process of borrowing money that you do not own and repaying it when you make a short trade is automated by the trading platform and done with the click of a mouse
So, for a long trade: you buy low and sell high; for a short trade: you sell high and buy low.
The names ‘long’ and ‘short’ have no relevance to distance; they are simply names of the two trading strategies. In addition to ‘long’ and ‘short’, traders also use other terms such as: bull market which is an up trending market and bear market, which is a market that is down trending.
Like a merchant who buys a discounted commodity at cost with the intention of selling it to make a profit, a currency trader buys a currency cheaply, with the intention of selling it for a profit at a later date. This could be 15 minutes later or 15 weeks later.
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