Investing Basics: Forex

Investing Basics: Forex


[MUSIC PLAYING] The foreign exchange,
or forex market, is the world’s largest
financial market, and it plays a vital role
in the global economy. Every day, trillions of dollars
are exchanged from one currency to another. This kind of
currency exchange is essential for
international business. Forex market
participants include governments, businesses,
and of course, investors. Governments use the forex
market to implement policies. For example, when conducting
business with another country, whether it’s borrowing money,
lending money, or offering aid, a country needs to
convert its currency into a foreign currency. Businesses use the forex
market to facilitate international trade. For example, they may
need to convert payments for goods and services
bought overseas, or to exchange payments
from international customers into their preferred currency. And investors use the
forex market to speculate on changes in currency prices. Currency prices change almost
constantly during the week, because the forex market is
open continuously from Sunday at 4:00 PM until Friday
at 4:00 PM Central Time. A trading day starts at 4:00
PM and ends at 4:00 PM Central Time the following day. The market has to be open
around the clock because of the global nature
of the economy. Let’s go over some basics
of how trading forex works. When you trade forex, you’re
not just trading one product, you’re trading two currencies
against each other. This is known as
a currency pair. The quote for a
forex currency pair defines the value of one
currency relative to the other. The easiest way to
understand any quote is to read the pair
from left to right. Let’s look at an example of
using the euro versus the US dollar currency pair. If the EUR/USD is
trading at 1.20, that means 1 euro is
equal to 1.20 US dollars. Here’s another example
of using the US dollar versus the Canadian
dollar currency pair. If the USD/CAD is
trading at 1.25, that means 1 US dollar is
equal to 1.25 Canadian dollars. Even though there are
two currencies involved, the pair itself acts
like a single entity. It’s similar to a
stock or a commodity. And just like when
trading stock, investors profit when they buy
a currency pair and its price increases. Investors can also profit if
they sell or short a currency pair and the price decreases. Let’s look at an example. Suppose an investor who thinks
Europe’s economy is going to grow faster than the United
States, and as a result, she thinks the euro will
strengthen against the US dollar. She can buy the euro
versus US dollar pair to speculate on her assumption. If the price of the currency
pair rises, she’ll make money. Conversely, if the price falls,
she’ll experience a loss. Now that we’ve
covered the basics, let’s look at a few key
aspects of the forex market. We’ll start with margin. When you trade on
margin, you only need to put up a percentage
of the total investment to enter into a position. This amount is known as
the margin requirement. When you trade other securities
like stocks, trading on margin means you’re borrowing
funds from your broker. However, forex
trades can only be covered using funds in the
investor’s forex account. Investors can’t borrow funds
to enter a forex trade. If they don’t have funds
in their forex account, they need to transfer funds
before placing a trade. Forex margin requirements
vary depending on the currency pairs and the size of a trade. Currency pairs typically
trade in specific quantities known as lots. The most common lot sizes
are standard and mini. Standard lots represent
100,000 units, and mini lots
represent 10,000 units. Depending on your
brokerage firm, you may also be able to trade
forex in 1,000-unit increments, also known as micro lots. Margin requirements can be
as small as 2% of a trade or as large as
20%, but the margin requirement for most currency
pairs averages around 3% to 5%. To understand how
margin is calculated, let’s look at an example using
the euro versus US dollar pair. Say this pair was
trading at 1.20, and an investor wanted to buy a
standard lot or 100,000 units. The total cost of the
trade would be $120,000. That’s a lot of capital. However, the investor doesn’t
have to pay that full amount. Instead, she pays the
margin requirement. Let’s say the margin
requirement was 3%. 3% of $120,000 is $3600. That’s the amount the investor
needs in her forex account to place this trade. This brings us to another key
element of the forex market– leverage. Leverage enables investors
to control a large investment with a relatively
small amount of money. In this example, the investor
is able to control $120,000 with $3600. The leverage associated
with currency pairs is one of the biggest
benefits of the forex market, but it’s also one of
the biggest risks. Leverage gives
investors the potential to make large profits
or large losses. One more important element in
the forex market is financing. This is the calculation of
net interest owed or earned on currency pairs,
and it happens when an investor holds a
position past the close of the trading day. The US dollar is associated
with an overnight lending rate set by the
Fed, and this rate defines the cost
of borrowing money. Similarly, each foreign currency
has its own overnight lending rate. Remember, when you
trade a currency pair, you’re trading two currencies
against each other. Even though the currency pair
acts like the single entity, you’re technically long one
currency and short the other. In terms of financing,
you’re lending the currency that you’re long and borrowing
the currency you’re short. This lending and borrowing
occurs the overnight lending rate of each
respective currency. In general, an investor
receives a credit if the currency he has long
had a higher interest rate than the currency he is short. Conversely, an
investor is debited if the currency he is long
has a lower interest rate than the currency he is short. Let’s look at an example. Suppose an investor
has a position in the Australian dollar versus
the US dollar currency pair. Say the overnight lending rate
for the Australian dollar is 2% and the overnight lending
rate for the US dollar is 1%. The investor is long
the currency pair, which means he is long
the AUD and short the USD. Since the AUD has a higher
interest rate than the USD, the investor will
receive a credit. However, if the investor was
short the AUD/USD currency pair, he’d have to pay the
debit because he’s short the currency that has
a higher interest rate. Financing is performed
automatically by your brokerage firm. However, it’s
important to understand how it works and its
financial impact on the trade. We’ve reviewed just a few
elements of the forex market. As with all investment
opportunities, the forex market has a unique
set of risks and benefits, and education is the first
step to determine if this is the right opportunity for you. [MUSIC PLAYING]

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