All currency exchange rates are susceptible to political instability, internal, regional, and international political conditions and events. Particularly, political upheaval can have a severe negative impact on a country’s currency. Political events in one nation can also have a profound effect on neighboring countries and possibly even globally.
Monetary flows caused by trade deficits can also have negative impact on a nation’s currency. Sometimes, a state of global economy can influence the value of currencies of some countries whose economies are heavily dependent on exports.
Sometimes, news releases and reports published on a country’s economic growth and health, such as GDP, unemployment rates, retail sales, and so on, can also have impact on exchange rates.
During political or economic uncertainty, many investors try to secure their investments with currencies perceived as safer and more stable, and as a result, the value of those currencies rise due to the greater demand. For example, Swiss franc and US dollar have been traditionally perceived as safe havens against uncertainty.
Forex trading is another form of commodity trading; forex traders buy and sell currencies in the same way as commodity market traders buy and sell commodities like gold or oil. However, because the value of each currency is determined in relative to another currency, it is not practical to speak of an absolute value in forex trading.
When trading in the forex market, the first concept you need to understand is a currency quote or forex price quote. The quote is a record of a previous transaction where a currency pair changed hands. When two currencies are exchanged, the exchange rate at which the transaction was carried out is called a quote. The exchange rate is always fluctuating based on supply and demand at any given moment in the market.
Let’s take EUR/USD 1.3526 as an example. In this quote:
- The currency on the left is the currency you bought at the time, and it is called the “base currency”.
- The currency on the right indicates the currency you sold, and it is called “quote currency” or “counter currency”.
- 1 Euro was valued at 1.3526 US dollars at the time. So, you buy 1,000 EUR for 1,352.60 USD and you try to sell it at a higher price for a profit.
- Let’s say, the quote is now at 1.3850 and you close the position by selling it. Then, your profit would be $32.40.
- (1.3850 – 1.3526) x 1000 = 32.4.
If your leverage is 1:100 and the margin is $1,000, then you would be trading 100,000 EUR. With this scenario, your profit would have been $3,240.
- (1.385 – 1.3526) x 100,000 = 3240.
In forex trading, currencies are always traded in pairs because each currency is valued against another. The most common currencies traded in the forex trading market are called “majors”.
There are six major currencies in forex trading and they are:
- The US dollar (USD),
- The euro (EUR),
- The Japanese Yen (JPY),
- The British pound (GBP),
- The Swiss franc (CHF),
- And the Australian dollar (AUD).
When you buy a currency pair, you buy the base currency and sell the quote currency. Most forex traders concentrate on currencies of major currencies, such as EUR/USD, USD/JPY, GBP/USD and USD/CHF. As a matter of fact, the trading of these major pairs and crosses account for 95% of all speculative currency trading.
For more detailed information on Currency Pairs, see Characteristics of Currencies.
For a list of acronyms for all currencies in the world, click here .
BID, ASK and SPREAD
In forex trading, there are two prices for any given currency: the buy price and the sell price. The buy price is called the “ BID ” and the sell price is called “ ASK ”. The difference between the BID and the ASK is called the “ spread ”. The spread represents the difference between what the market maker gives to buy from a trader, and what the market maker takes to sell to a trader.
If a trader buys a currency pair and immediately sells it, and no change in the exchange rate happens, the trader will lose money because the Ask price is always higher than the Bid price.
In general, smaller spreads are better for you as a forex trader because you will be able to take advantage of a smaller movement in exchange rates to make profits more easily.
Margin and Leverage
Margin and leverage are an important concept to understand in forex trading. Margin and leverage make it possible for investors to make a large profit in a short period of time in forex. As a matter of fact, it is not very uncommon for traders to make huge profits with relatively small deposits because of the margin and leverage. Indeed, forex trading is full of excitement and thrills, and is rapidly becoming the most popular investment of all.
When you open an account with the forex broker of your choice, you will be required to make a small deposit. This deposit is known as margin . With this small deposit, or margin, you will be able to trade much larger amount of money because of the leverage.
Let’s take an example to understand this concept better.
- We will assume that:
- Your currency pair for trading is EUR/USD,
And the direction of the trade is “Buy Euro and Sell US Dollars”,
And the price is 1.3500 at the beginning of your trade,
- And also the contract value is EUR 100,000.
- Your currency pair for trading is EUR/USD,
- As the forex trader, you purchase this contract, anticipating that you would make a profit when you close the contract.
- So, say, the price has gone up by 1 cent to 1.3600 and you close the contract.
- Then, your profit would be $1,000. This is because you gain 1 cent for every single Euro in this contract (100,000 x 1 cent = $1,000).
- Because of the leverage, you don’t even need to actually own EUR 100,000. For example:
- If your leverage is 1:100, a deposit (margin) of only $1,000 is required.
- If you are trading at the leverage of 1:200, it would take only $500 to trade EUR 100,000.
Because of this possibility of making huge profits in a short period of time with very small deposits, along with much improved electronic trading platforms with robust features, the popularity of forex trading has exploded in recent years and the current daily average trading is about $4 trillion US Dollars.
EUR, GBP, AUD, NZD, as well as Gold XAU and Silver XAG, are examples of indirect quotes.
The quote is the price to a currency pair that the deal will be made with.
As mentioned in the previous section, quotes in Forex are listed in pairs, as in EUR/USD, USD/JPY, GBP/USD, USD/CHF, and so on. The first currency in a pair is called “base currency” and the second one is called “counter currency”.
So, for example, in the currency pair of EUR/USD:
- EUR is the base currency,
- USD is the counter currency,
- Therefore, if a pair of EUR/USD is trading at 1.2700, that means that it would cost $1.27 USD to buy one EUR.
When trading in the Forex market, you need to know that whenever you take a position, you are doing so in terms of the base currency. So if you buy a pair, you are buying the base currency, and if you are selling a pair, you are selling the base currency. Also keep in mind that you are doing the opposite with the counter currency at the same time. So, if you buy EUR/USD, you are buying Euros and selling US Dollars.
If this sounds a little confusing, just simply remember this: BUY if you expect the rate to GO UP, and SELL if you expect the rate to GO DOWN.
Market makers are also known as forex brokers. They provide the forex trading platform where customers can exchange currencies. They do not charge a percentage to traders, but rather they make profits on the spread of each transaction.
For instance, say the EUR/USD bid/ask rate is 1.3100/1.3200. The market maker gives $1.31 when buying from the trader, but takes $1.32 when selling to the trader. In this example, there is a spread of 1 cent. So, if the trader buys and sells without any change in exchange rate, he loses money because of the spread. This spread is how market makers make money in forex trading.