Basics of the Foreign Exchange (Forex) Market

Foreign exchange market operates by trading one type of currency against another. Unlike other financial markets, the market has no physical location and no central exchange. It operates through a global network of banks, financial institutions, and individuals. The forex market is emerging as the world’s largest financial market, operating round the clock with enormous amounts of money traded on a daily basis.

Another major difference between forex market and other financial market is that in forex, investors can respond to currency fluctuations caused by economic, political and social events immediately, without waiting for the exchanges to open. Modern news services, smart online charting services, electronic forex trading platforms, signal services exploded the forex market and opened it for even small and medium traders and investors.

In the foreign exchange market 6 major currency pairs are traded the most, which accounts for almost 90% of the daily trading activity. They include:

1. EUR/USD = Euro versus U.S. Dollar

2. JPY/USD = Japanese Yen versus U.S. Dollar

3. USD/CHF = U.S. Dollar versus Swiss Franc

4. AUD/USD = Australian Dollar versus U.S. Dollar

5. GBP/USD = British Pound versus U.S. Dollar

6. USD/CAD = U.S. Dollar versus Canadian Dollar

When reading these forex quotes we have to look at the bid price which is the highest price for buying versus the ask price which is the lowest price to sell. The first currency of the pair (EUR/USD) is known as the base currency and has the value of 1. If the bid of the Euro versus U.S. Dollar is 1.2811, it means that for buying one Euro we have to pay $1.2811.

When the bid and ask prices moves in an uptrend, it suggests that the secondary currency is getting weaker and the base currency in turn is getting stronger. They go up or down by units known as pips or price interest point which is almost identical to a tick in a stock price. It is the smallest increment and a move from $1.2811 to $1.2821 is a 10 pip move upwards.

When trading the pairs, we should think in terms of the base currency for buying and selling. If we were to buy (long) the EUR/USD, it means that we bought (long) the euro, hoping it to go up, and selling (short) the dollar, hoping it will fall. If we were to sell (short) the EUR/USD, it means that we sold (short) the euro, hoping it to fall and in turn buying (long) the dollar hoping it to rise. There are different types of transactions in the forex market. They are Spot transactions, Forward transaction, Futures, Options, and Swap.

In the Foreign Exchange markets we trade in lots, which are in increments of 10,000s:

1 lot=10,000 units

2 lot=20,000 units

3 lot=30,000 units

The minimum one can purchase is 10,000 units of a certain currency pair. For example, if we were to buy 3 lots of the EUR/USD with the bid price at 1.2811, we would spend $38,433 (30,000 ´ 1.2811= 25,622). With buying 3 lots this means for every pip that it goes up you make $3. So with movements of some of these pairs, it’s possible to generate considerable profits.

It is important to remember that high risks accompany any investment like forex market has the potential for great returns. Proper knowledge, studied information and risk management measures can help the investors gain profit without the fear of losing in their trade.