THINKING FOREX: About Forex Trading

Identification

Each nation's currency has an exchange value compared to other currencies which fluctuates in response to market forces. Currencies are traded in pairs. A good example is the US dollar/Euro pair, which is the largest volume currency pair. You'll see it quoted as EUR/USD 1.3755, meaning at the time o of the quote it cost $1.3755 to buy one Euro. The foreign exchange market exists to allow businesses, financial institutions, and governments to quickly and easily move funds from one country to another. However, traders hoping to make money off changes in exchange rates account for 80% of Forex trading volume.

The modern Forex market had its beginning in 1971 when fixed exchange rates were abandoned and currencies were allowed to float against each other, a step taken to make international trade more flexible. International trade combined with the growth of the Eurodollar market (US dollars deposited in non-US banks) created a $70 billion a day market in the 1980s. The advent of electronic funds transfers in the 1990s opened the door to speculative trading and rapid growth. By 2004 Forex trading reached nearly $2 trillion a day and passed $3 trillion daily in 2007.

Like other securities transactions, Forex is based on a "bid/ask" system. A buyer states a bid and a seller an asking price. The difference, called the spread, is small. For wholesale dealers it is often no more than $.0001 (this is the smallest possible change in price and is called a pip). Retail dealers mark the spread up to 3-20 pips and keep the difference, instead of charging commissions. In Forex trading the goal is to correctly anticipate the direction (up or down) of a currency exchange rate and hope the change is greater than the spread. If that happens the trader makes a profit.

Forex trading is done with extremely low margin requirements. This is the source of the high profit potential and high risk. The ratio of currency value to the margin requirement is usually 30, 100, and up to 400 to 1. In other words, in Forex trading you can "buy" a lot of $100,000 of a currency with as little as $250 cash. The rest is borrowed from the currency dealer. With such extreme margins, even very small changes in currency exchange rates spell the difference between a big profit and losing all of the money you put up.

Currency exchange rates change in response to economic factors such as a nation's monetary policy, balance of trade, inflation rate, and breaking news. Market trends driven by trading also influences exchange rates. Before you attempt Forex trading, you should educate yourself about these market forces. The Forex market is unregulated, so it's wise to choose a dealer who is a member of a self-regulating body like the National Futures Association.