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Foreign exchange, also known as forex or FX, is the exchange of different currencies on a decentralised global market. It's one of the largest and most liquid financial markets in the world. Forex trading involves the simultaneous buying and selling of the world's currencies on this market.
Foreign exchange plays a vital role in foreign trade and business as products or services bought in a foreign country must be paid for using that country's currency. Foreign exchange rates between different currency pairs show the rates at which one currency will be exchanged for another.
Forex is one of the most widely traded markets in the world, with a total daily average turnover reported to exceed $5 trillion a day. The forex market is not based in a central location or exchange, and is open 24 hours a day from Sunday night through to Friday night. A wide range of currencies are constantly being exchanged as individuals, companies and organisations conduct global business and attempt to take advantage of rate fluctuations.
Forex is always traded in pairs – for example NZD/USD. You speculate on whether the price of one country's currency will rise or fall against the currency of another country, and take a position accordingly. Looking at the NZD/USD currency pair, the first currency (NZD) is called the 'base currency' and the second currency (USD) is known as the 'counter currency'.
When trading forex, you always speculate on whether the price of the base currency will rise or fall against the counter currency. So in NZD/USD if you think NZD will rise against USD, you go long (buy) the currency pair. Alternatively, if you think NZD will fall against USD (or that USD will rise against NZD), you go short (sell) the currency pair.
If you were right (that is if you went long NZD/USD and NZD went up in value against USD), you would make a profit. If the trade went against you, however, you would make a loss.
It's important to remember when looking at forex that a higher currency makes a country's exports more expensive for other countries, while making imports cheaper. A lower currency makes exports cheaper and imports more expensive, so foreign exchange rates play a significant part in determining the trading relationship between two countries. There are a variety of factors at play in this relationship and they all contribute in some way to whether the strength of a currency declines or improves in relation to another. Understanding the influencing factors gives traders insights they can incorporate into their forex trading strategies.
Some of these factors include political stability, interest rates, inflation, terms of trade, public debt and current account deficits. For example, in the case of interest rates, if rates are higher, lenders get a better return compared to those in a country with lower rates; therefore the higher rates attract foreign capital which causes the exchange rate to rise. This is one of the reasons forex traders may look to trade on interest rate announcements from central banks like the US Federal Reserve or the Bank of England.
The factors mentioned above can also cause a currency to decline. For example, the currency of a country with low inflation will generally rise because that country's purchasing power is higher relative to other currencies. Even natural disasters such as earthquakes or tsunamis, which put a strain on a nation’s economy, can have a negative impact on a currency.
Political instability and poor economic performance can also have a negative impact on a currency. Politically stable countries with robust economic performance will always be more appealing to foreign investors, so these countries will draw investment away from countries characterised by more economic or political risk. Furthermore, a country showing a sharp decline in economic performance will experience a loss of confidence in its currency and a movement of capital to currencies of more economically steady countries. These are just two simple examples of what can affect foreign exchange rates and the kind of things traders consider when developing forex trading strategies.
You can trade forex using leverage, which allows you to increase your potential profit, but it also increases your potential loss.
Since forex is traded on margin, you only have to deposit a percentage of the full amount you wish to trade. Our margins start from 0.20%, which could be referred to as 500:1 leverage, as the value of the full position would be 500 times the value of the deposit required to open the trade. When trading on margin it's important to remember that your profits or losses are based on the full value of the position, not just the percentage you deposited, so you can lose more than your initial deposit.
Some of the main benefits of forex trading that make this asset class a popular choice among traders are:
- The ability to trade on margin (using leverage)
- High levels of liquidity mean spreads stay tight which keeps trading costs low
- Prices react quickly to breaking news and economic announcements (this can be a disadvantage too)
- Trade 24 hours a day from Sunday to Friday
- The ability to go long and short
- Wide range of markets
Forex or currency trading is a fast-paced, exciting option and some traders will focus solely on trading this asset class. They may even choose to specialise in just a few select currency pairs, investing a lot of time in understanding the numerous economic and political factors that move those currencies.