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Forex is a common abbreviation for foreign exchange, and forex trading refers to trades that take place in the foreign exchange market. For individual traders, the primary objective of forex trading is to make a profit by exchanging one currency for another at an agreed price, for example exchanging Australian Dollars for US Dollars. Forex is the world’s most traded market but it does carry some risk. With this in mind, forex trading tends to suit experienced traders, rather than beginners.
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Forex traders have one main aim: profiting from the change in value of one currency against another. They do this by basing their trading decisions on which way they think forex prices will fluctuate in the future.
A common way to trade forex is through contracts, such as futures contracts or CFDs (contracts for difference). Rather than buying and holding foreign currency, the trader enters into an arrangement with a broker to profit off any change in the exchange rate between two currencies. Of course, if the exchange rate between the two currencies doesn't move in their favour, the trader stands to lose money as well.
On the global forex market, all currencies are quoted in pairs - that is, in terms of their value versus another currency. For example, AUD/USD, GBP/EUR and USD/GBP are just a few common currency pairs. When a trader initiates a forex trade (or 'opens a position'), it's as though they are buying one currency and selling another at the same time. If the value of one of the currencies moves against the other, the trader 'closes out' their position, selling the other currency and buying back the original currency they sold.
Say you opened a position with a broker that saw you simultaneously buy Australian dollars and sell US dollars. If the Aussie dollar strengthens against the US dollar over the coming days or weeks, you would then seek to close out your position by trading your US dollars for Aussie dollars - getting more Aussie dollars back than you originally sold. That's how a profit is realised on forex trades.
Of course, it's important to remember that at no stage during the above transaction do you actually own or take delivery of the currencies involved in the trade. That's why forex traded in this way is considered a derivative instrument, because its value is based on an underlying asset, without that asset ever being physically exchanged between the trading parties.
Forex trades of this type are typically leveraged, meaning you only contribute a small stake towards the total value of the trade. Most currency contracts are large - the minimum amount you can trade is typically 1,000 units (for example, $1,000). That's because currencies' exchange rates only fluctuate by small amounts - usually by tenths or hundredths of a cent. So to realise any significant profit or loss, you need to trade at high volumes. Leveraged trading (or trading on margin) allows you take out a small stake in a much larger trade, with your broker typically making up the shortfall.
If the exchange rate moves in your favour, you stand to profit off the full amount that was traded, not just your small stake. Of course, it works in the opposite direction as well, so if the exchange rate moves against you, you are liable for the losses incurred off the full value of the trade.
That's why forex trading is typically considered to suit more experienced and less risk-averse traders. These days, the trading platforms offered by forex brokers are relatively sophisticated and come with a range of features and tools designed to help traders get the most out of their trades.
Forex trading has many advantages for the right trader, starting with the fact that forex markets are highly accessible with many open 24 hours a day. Unlike the Australian Stock Exchange, for example, which only offers normal trading between 10am and 4pm on business days, the global forex market runs around the clock (but not on weekends). This means foreign exchange prices are constantly going up and down and there are plenty of opportunities for traders.
In addition, because forex is a leveraged product, individuals can trade on the market for a smaller initial outlay. In order to place a trade, you only need to spend a small percentage of the full value of your position, which means there is a much higher potential for profit from a small initial outlay than in some other forms of trading. Unfortunately, this also means there is a greater risk of suffering a loss.
Graham Trades USD/EUR
Graham is a veteran investor and chooses to trade in forex as a CFD. Believing that the US Dollar will likely increase in value against the Euro, Graham enters a contract with his broker to trade $100,000 worth of US Dollars at €0.90 per USD$1. His forex contract at the time of purchase is worth €90,000. Because his forex trading platform allows him to place trades at a margin of 1%, this investment costs Graham $1,000 to place.
Graham’s prediction is correct and the US Dollar rises to €0.925, resulting in a profit of around AUD$3,500 for Graham, less any transaction fees.
There are several forex trading services that available to Australian traders. These include:
Before deciding on the right trading platform for you, make sure to compare the fees and benefits of several providers.
Just like trading regular shares through an online broker or broking platform, you need to make yourself fully aware of the fees and charges that apply before you begin trading forex. To start with, compare the margin you will be required to meet in order to make a trade with a range of providers. This could be 0.5%, 1% or some other figure, and this will affect the amount of money you will have to spend to open a forex position. For example, if your account has a margin of 1%, a trade worth $100,000 will require you to spend $1,000.
In addition, most providers will charge a commission for every trade you make. These fees are generally be quite low, such as a few cents per thousand dollars. However, some providers will not charge any commissions on your trades. Other fees may apply to credit and debit card payments.
Finally, you will also need to consider the spread, which is the difference between the buy and sell prices for each currency pair and is effectively what a broking platform will charge you to make a trade. Look for a trading platform that offers tight spreads to minimise the cost involved.
Most forex trading platforms will typically allow you to apply for an account within minutes online. While the application process varies between providers, you will usually have to fill out an online application and then await a response from the provider to learn whether or not your application has been approved.
You will usually have to supply:
- Your name
- Your date of birth
- Your contact details
- Your address
- Your country of residence
- Proof of ID, for example a driver’s licence or passport
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Just like with any other form of investment, there are several strategies you can consider when trading forex ranging from the basic right through to quite complex approaches. One strategy traders can use is to perform technical analysis or fundamental analysis to try and accurately predict the future performance of currency pairs.
Another common strategy is known as the day trading strategy, and it is based on the simple premise that you do not hold any forex positions overnight. Because the longer you hold open a position the greater risk of you suffering a loss, traders can close all the positions they hold before the end of the trading day and therefore minimise risk.
A third common strategy is support and resistance levels. This involves researching the past fluctuations of a currency and using them to predict future price movements. The previous upper limit of a price is its resistance limit and the previous lower limit is its support limit. This can help traders make an educated guess as to when a currency’s value may rise or fall.
Before you start trading forex you should make sure that you are well aware of all the risks involved with this sort of trading. These include:
- Even though you only have to pay a small percentage of the value of your trade upfront, you are still responsible for the entire amount.
- Foreign exchange rates are volatile and can quickly move against you, causing you to lose a significant amount of money.
- As markets are open 24 hours a day, you may need to devote plenty of time to tracking any open positions.
- Predicting currency markets is quite difficult as they can be affected by a wide range of factors.
- Even stop loss orders which are designed to minimise your losses can only offer limited protection against the risks involved.
- Ask price. This is the lowest price at which a trader can buy a currency.
- At best. This is an instruction given to a broker to purchase or sell a currency at the best rate currently available in the market.
- Base currency. This is the first currency listed in a currency pair. It shows the value of one currency when measured against another, for example AUD/USD.
- Bear market. A bear market situation is when prices sharply decline.
- Bid price. This is the price at which an investor can sell a currency.
- Bull market. This is a market where prices are rising.
- Forex. An abbreviation of foreign exchange.
- Hedging. This involves opening a new position in opposition to an already open position in order to protect against exchange rate fluctuations.
- Leverage. Leverage refers to a trader’s ability to control a large amount of money in the foreign exchange markets after only having to invest a small percentage of the overall value of a trade.
- Margin. The amount you are required to spend to open a trade.
- Margin call. This is a warning message when your trading account does not hold sufficient funds to maintain all the positions you have open.
- Spread. The difference between the bid price and the ask price.