Currency Trading Explained
When you go on holiday to an exotic country one of the things you need to do is change your home currency for the currency of where you are going. When you make that exchange, usually through a bank, you’ve conducted a foreign exchange (forex for short) transaction.
How does forex trading work?
Let’s look at how that works with an example where you live in the USA and plan to go to Europe on holiday for a month in July. You will need to buy euros with your US dollars and the amount of euros you can get in exchange will depend on the exchange rate at the time of your transaction.
- To buy €1,000
- With exchange rate of EUR/USD 1.20
- You will need US$1,200
Now, when you come back from your trip, any euro you have left you may want to exchange back for dollars. For simplicity, let’s assume you didn’t need to use your cash and are looking to exchange the exact amount back. The exchange rate may have shifted even by a few cents so the amount of dollars you get back will be different to what you had sold it the previous month.
- To sell €1,000
- With exchange rate of EUR/USD 1.10
- You will get back US$1,100
The exchange rate of 1.20 means that for every 1 euro you buy it will cost you 1.20 US dollars. So in this example, since the exchange rate dropped from 1.20 to 1.10 (down 10 cents), you will lose 10 cents in every dollar.
*Note, all figures are fictional for illustrative purposes. This example does not take into account the spread (fee) you would pay the bank for the transaction
Trading the Forex Markets
Forex trading is when people buy and sell currencies with the aim to make money on the difference between the two currencies. They will buy currency ‘A’ against currency ‘B’ in the belief that the price of A will increase against B after some time. If the currency does indeed increase in value, they will close their trade with a gain. However, if the currency decreases in value, then the trader will incure a loss.
When you trade forex on a platform you are trading it as an Over the Counter (OTC) transactions. This means that you speculate on the movement of currencies against each other but don’t actually take physical ownership of the actual asset (in this case, money). You only take the resulting profit (or in some cases loss).
Why Currencies Matter
The foreign exchange market or forex market is the largest financial market in the world, comprising more than $5 trillion per day in transactions as it spans currency trading activity in various exchanges, institutions, and banks all over the world. At this rate, it dwarfs even the major stock markets such as the NYSE, London Stock Exchange, and Tokyo Stock Exchange combined!
The exchange rate is one of the most important indicators of a countries economic well-being. A high rate means they can import or buy goods and services easily, whereas a low rate means they can sell or export easily. This is why central banks’ monetary policies are often working to get a good balance on their rates.
What Makes Currency Rates Fluctuate?
A number of factors affect the value of a country’s currency in relation to other currencies. The importance and weight of any one of the below factors may shift and should be considered in combination.
Inflation – generally, the lower a country’s inflation, the higher its currency’s exchange rate.
Interest rates – Central banks may manipulate interest rates to manipulate their currency’s value. A higher rate of interest brings in foreign investment raising the exchange rate and vice versa.
Trade – The ratio of export vs import prices leads to the balance of payments. Higher exports (than imports) means the country’s goods are in demand leading to an increase in their currency which is needed to pay for their good.
Political stability – foreign investors look for stable countries to invest in. This leads to greater demand for their currency.