Many investors have heard of forex trading, but some may know little about what it means or how it's done. Others may simply be interested in dabbling in trading currencies. In any case, they can benefit from receiving some direction on the matter. In the following article, we've answered five of the biggest questions about forex trading, including why you would consider it, the risks of doing so, and what it all means.
What Does Trading Forex Mean?
Trading forex means making transactions that involve currencies in the foreign exchange market. This could mean buying a certain currency pair, such as EUR/USD, based on the expectation the euro will appreciate relative to the U.S. dollar. Alternatively, an investor could sell the same pair, based on the belief the common currency will depreciate against the U.S. dollar.
In addition to making basic purchase and sale transactions, traders have many ways to take positions on currency pairs, including spot contracts, forwards, derivatives and contracts for difference.
Why Should I Trade Forex?
There are several reasons investors might opt to trade currencies instead of making use of other opportunities.
Accessibility: Forex trading takes place on many different exchanges across the world, and as a result, investors can make currency trades 24 hours a day during weekdays. The forex market is also the largest capital market in the world, involving more than US$5 trillion in notional value worth of transactions per day.
Liquidity: Because there is so much activity, the global forex markets provide substantial liquidity to traders. While certain assets may be more difficult to buy and sell, traders interested in currencies will likely find substantial opportunities. Liquidity risk can occur around major news events if liquidity providers seek to limit their exposure to market volatility.
Leverage: Investors can potentially access far more leverage when trading currencies than they can when trading other assets. However, it is important to keep in mind that risk is inherent to investment. While using leverage to make larger trades can amplify returns, it can also amplify the size of losses.
Global Exposure: Forex trading provides investors with an opportunity to obtain exposure to economies across the world. By taking a more international approach, traders might diversify more successfully or potentially achieve higher returns by putting their money to work in areas that have greater potential. Once again, risk is inherent to investment, so no returns are guaranteed and investors must conduct their due diligence on regions.
Low Trading Expenses: Because there are so many buyers and sellers, spreads are low and trading costs are modest.
How Risky Is Forex Trading?
Like any form of investment, forex trading involves risk. The currency markets can experience sharp fluctuations, just like the stock, bond or commodity markets. Therefore, investors interested in forex trading are encouraged to conduct their due diligence and/or consult an independent financial advisor before making any transactions.
In terms of specific risks, the forex market can present investors with less liquidity risk because of this particular market's highly liquid nature. In other words, there is less risk that an investor will find himself unable to buy or sell a currency pair because he doesn't have another market participant to take part in a transaction. Liquidity risk can increase around major news events.
It is also worth noting that there are some unscrupulous brokers out there. As a result, investors can benefit from performing substantial due diligence on any company they might work with. For starters, they should ensure the broker is registered with regulators such as National Futures Association in the US, the Financial Conduct Authority in the UK and/or the Australian Securities and Investments Commission in Australia. Additionally, investors might want to research the financial institution's reputation and find out how long it has been in business.
How Can I Trade A Currency I Don't Already Have?
If you want to trade a currency you don't already have, there are many ways to do so. There are several different kinds of contracts you can harness to invest in currencies you don't own. For example, you could trade the euro without owning it by buying or selling options that involve the currency. Call and put options on EUR/USD would provide methods to trade the common currency's exchange rate with the U.S. dollar.
In addition, purchasing spot contracts or forward contracts involving your currency of choice would also provide exposure.
How Can I Compete With The Big Banks?
When making trades, big banks employ professionals who may have significant education and experience. As a result, you can benefit greatly by doing your best to be prepared. When evaluating currency pairs, some traders use fundamental analysis, which involves analysing economic fundamentals in different countries. When using this technique, investors might look at GDP, inflation and unemployment in the two nations involved in an exchange rate.
Another resource traders can utilise is technical analysis, which involves reading charts to get a better sense of the market sentiment surrounding a specific currency pair. For example, if you are considering taking a long position on GBP/USD, you might want to work with some technical indicators to evaluate the currency pair's market history.
Some traders might use both fundamental and technical analysis before making any transactions. By doing so, they might be able to increase their chances of competing successfully with big banks. Trading forex on margin carries a risk of losses in excess of your deposited funds and may not be suitable for all investors. As always, if you want to participate in forex trading, it can be very helpful to conduct your due diligence and/or consult an independent financial advisor.
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