How does Forex Trading Work?

How Does Forex Trading Work?

Your handy guide to forex trading in South Africa – How forex trading works

The forex or foreign exchange market is different to global stock markets as it is open 24 hours a day, 5 days a week.  Though the local stock market is more familiar to most people, the foreign exchange market is the largest, most liquid and actively traded market in the world.

Combined with extended opening hours vs local stock markets, this means there are almost endless opportunities in the forex market.

How Forex Trading Works

How Does the Forex Market Work?

The forex market is a decentralised global market for exchanging the world’s currencies.

Historically a nation’s currencies would be pegged to and traded against gold, but the vast majority of currency is now free floating and traded against other currencies.  This means traders can place bets on whether one currency is going to outperform another.

For example, if you thought the Euro is going to outperform the US Dollar, the global forex market allows you to speculate on this.

Strength or weakness in a given nation’s economy affects the value of its currency.  Monetary policy decisions by central banks in response to such strength and weakness also affects currencies.

Forex traders watch economic data releases for clues as to what direction monetary policy is moving and what will happen to a particular currency.  Forex calendars are a handy resource for this kind of trading and something all traders should familiarise themselves with, even if you aren’t directly trading the news.

Another great thing about the forex market is you can very easily bet against a particular outcome via shorting.  In the stock market, shorting can be expensive, finding liquidity can be tough and sometimes regulators restrict the practice or outright ban it.

In the forex market, you have complete freedom to bet for or against any currency.

Currency Pairs Explained

In the forex market, currencies are always paired against each other.

If you want to bet on the Euro, for example, you have to simultaneously bet against another currency.

The most liquid currency pair in the world is EURUSD.  If EURUSD is trading at 1.20, that means 1 Euro will buy you 1.20 US Dollars.

The second most liquid currency is USDJPY, if USDJPY is trading at 110.55, that means one US Dollar will buy you 110.55 Yen.

A forex pair is made up of base and quote currencies.  The base currency is the first one and the quote is the second.  EUR is the base currency of the EURUSD pair and USD is the quote.

Conversely, when it comes to the USDJPY pair, the base is US Dollars and it is quoted in JPY.

A forex currency pair tells you how many units of the quote currency you can purchase for 1 unit of the base currency. ie how many US Dollars you can buy with 1 Euro or how many JPY you can buy with 1 US Dollar.

The majority of forex trading volume takes place on the majors – These are developed nation currencies that trade against the US Dollar.  These would be EURUSD, USDJPY, USDCHF, GBPUSD, AUDUSD, USDCAD and NZDUSD.

Though Australian and New Zealand are quite small nations when it comes to population, they both have highly advanced and large economies and punch well above their weight in international trade and the money markets.

What is Margin Trading in Forex?

Imagine you believe house prices are going to rise so you want to invest in property.

Do you pay for the house in cash or put down some collateral and borrow the rest of the value?  Of course, the vast majority of people do the latter.

Forex markets exhibit annual gains and losses similar to housing markets (+/- 10% per year), which is quite small compared to riskier assets like stocks.  As such, the overwhelming amount of currency trading for profit occurs on margin.

This means you place a deposit with your broker who then allows you to place a much larger trade in the forex market.  This is just like placing a deposit with your bank, who then allows you to make a much larger purchase in the housing market.

Just like investing in property, the leverage you use magnifies potential gains and losses.  If we look at a 5% deposit/20x leverage ratio which is common in property investment, if the value of your property goes up by 5%, you now have 10% equity in the property and have effectively doubled your money.

Conversely, if you timed the market wrong and the market fell by 5%, you have effectively lost your entire deposit and the bank will be looking to foreclose if you can’t sure things up and pay your mortgage.

Similarly, if you have a 1:20 leveraged forex account, with $1000 USD you could take a $20000 USD long position on USDZAR.  If the US Dollar appreciates against the Rand by 5%, you would double your account balance.

If on the other hand, however, the Rand appreciated against the Dollar by 5%, you’d lose your entire deposit.

This is why it’s important to select your level or leverage carefully.  You should never risk losing your entire account on a single trade, even if you stand to double your money if you’re right.

Using Margin in Forex Wisely

As the above examples illustrate, margin and leverage can be extremely effective tools for generating wealth if used responsibly.

Your number one goal as a forex trader is to learn how to do this and the only way to learn is through live trading.  Though this can be quite a challenge, the Blackstone Futures team will be here to support you every step of the way.

Ready to get started? Open a live trading account with Blackstone Futures today and kick your forex trading journey off on the right foot.

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