What IS Forex Trading?
Foreign exchange, also known as currency, or forex trading, is the world’s largest decentralized global market where all the world’s currencies are traded. The forex exchange market is the largest, and the need to exchange currencies of different jurisdictions is the sole reason why the forex market is the largest.
Foreign Exchange prices are influenced by a range of different factors, including inflation, interest rates, government policy, employment figures and demand for imports and exports.
Because of the sheer volume of forex market traders and the amount of cash exchanged, price movements can happen very quickly, making currency trading not only the largest financial market in the world, yet also one of the most volatile.
Forex trading instruments are comprised of what is called a Forex pair. To understand Forex trading Unlike other financial assets such as stocks, commodities or bonds, Forex trading always involves the combination of two currencies.
Lets look at a Forex Pair to better understand:
The most commonly traded Forex pair is the EUR/USD (EUR is the Euro, & USD is the US Dollar)
The EURUSD tracks the worth of €1 in Dollars. Therefore, if the EURUSD exchange rate is quoted at 1.30, that means that each €1 is worth $1.30. If the exchanged rate rises to 1.40, that will indicate that the Euro has strengthened against the Dollar, as €1 is now worth $1.40. The opposite is true if the EURUSD rate falls to 1.20.
Traders of the EURUSD are actually trading the changes in the exchange rate between the Euro and Dollar. Therefore, if you bought the EURUSD and the Euro appreciated against the Dollar (the value of €1 rises in relation to the $) you will profit on the trade. If the Euro weakens against the Dollar, your position will be with a loss.
What Causes Exchange Rates to Change
Since Forex trading involves benefiting off of changes in the currency exchange rates, it is important to know why an exchange rate changes. The answer to this question is supply and demand. When there is more demand for one currency than another, it will cause the exchange rate values to change.
For example, when the tragic earthquake and tsunami hit Japan, the value of the Japanese Yen rose against other major currencies. This was due to the fact that Japanese companies that had investments out of Japan had to quickly bring their money back into Japan to pay for repairs and insurance liabilities. These companies converted their foreign holding into Yen in the process. As a result, there was a sudden spike in demand for Japanese Yen. The demand caused Yen exchange rates to change rapidly as a result.
The main causes of changes in supply and demand are due to changes in economic trends, geo-political events, and changes to market sentiment.
- Economic Trends: When a country begins to show stronger than expected growth, it will often trigger increased investments in that country and raise currency demand. Such trends can last months or even multiple years and lead to one currency strengthening against another for a significant period of time
- Geo-Political Events : Geo Political events can also effect currency exchange rates as investors may decide to quickly exit holdings in one country if they that their funds may become less safe.
- Market Sentiment: If traders on an overall basis begin to take on additional risk, this will often create increased demand for so called "riskier currencies" which will cause exchanges rates to change.