How forex investment works

How Does Foreign Exchange Trading Work?

Foreign exchange trading was once just something that people had to do when traveling to other countries. They would exchange some of their home country's currency for another and endure the current currency exchange rate.

These days, when you hear someone refer to foreign exchange trading, they are usually referring to a type of investment trading that has now become common. Traders can now speculate on the fluctuating values of currencies between two countries.

It's done for sport and profit.

Beginner Trading.

It seems like something that most people would find easy, except, in this particular industry, there is a high rate of failure among new traders. Even traders that are aware of that tend to start out with the attitude of "It happened to them, but it won't happen to me." In the end, 96 percent of these traders walk away empty handed, not quite sure what happened to them, or maybe even feeling a bit scammed.

Forex trading is not a scam; it's just an industry that is primarily set up for insiders that understand it. The goal for new traders should be to survive long enough to understand the inner working of foreign exchange trading and become one of those insiders.

The number one thing that hangs most traders out to dry is the ability to use forex trading leverage. Using Leverage allows traders to trade on the market with more money than what they have in their account.

For example, if you were trading 2:1, you could use a $1,000 deposit, to control $2,000 of currency on the market. Many forex brokers offer as much as 50:1 leverage. New traders tend to jump in and start trading with that 50:1 leverage immediately without being prepared for the consequences.

Trading with leverage sounds like a really good time, and it's true that it can increase how easily you can make money, but the thing that is less talked about is it also increases your risk for losses.

If a trader with $1,000 in their account is trading with 50:1 and trading $50,000 on the market, each pip is worth around $5. If the average daily move is 70 to 100 pips, in a day your average loss could be around $350. If you made a really bad trade, you could lose your entire account in 3 days, and of course, that is assuming that conditions are normal.

Most new traders being optimistic might say "but I could also double my account in just a matter of days." While that is indeed true, watching your account fluctuate that seriously is very difficult to do. Many people start out assuming that they can handle it, but when it comes down to it, they don't, and forex trading mistakes are made.

Avoiding Mistakes.

Assuming that you can manage not to fall into the leverage trap, you'll need to have a handle on your emotions. The biggest thing that you'll tackle is your emotion when trading forex. The availability of leverage will tempt you to use it, and if it works against you, your emotions will have your vision upside down, and you will probably lose money. The best way to avoid all of this is to have a trading plan that you can stick to. Not only should you have a trading plan, but you should keep a forex trading journal to keep track of your progress.

You might feel when looking around online, that other people can trade forex and you can't. It's not true; it's just your self-perception that makes it seem that way. A lot of people that are trading foreign exchange are struggling, but their pride keeps them from admitting their problems, and you'll find them posting in online forums or on Facebook about how wonderful they are doing when they are struggling just like you.

Winning at trading forex online is an achievable goal if you get educated and keep your head together while you're learning. Practice on a forex trading demo first, and start small when you start using real money. Always allow yourself to be wrong and learn how to move on from it when it happens. People fail at forex trading every day for lack of ability, to be honest with themselves.

If you learn to do that, you've solved half of the equation for success in forex trading.

Currency Trading.

The term "currency trading" can mean different things. If you want to learn about how to save time and money on foreign payments and currency transfers, visit XE Money Transfer.

How Forex Works.

The currency exchange rate is the rate at which one currency can be exchanged for another. It is always quoted in pairs like the EUR/USD (the Euro and the US Dollar). Exchange rates fluctuate based on economic factors like inflation, industrial production and geopolitical events. These factors will influence whether you buy or sell a currency pair.

Example of a Forex Trade:

Why Trade Currencies?

Forex is the world's largest market, with about 3.2 trillion US dollars in daily volume and 24-hour market action. Some key differences between Forex and Equities markets are:

Many firms don't charge commissions – you pay only the bid/ask spreads. There's 24 hour trading – you dictate when to trade and how to trade. You can trade on leverage, but this can magnify potential gains and losses. You can focus on picking from a few currencies rather than from 5000 stocks. Forex is accessible – you don’t need a lot of money to get started.

Why Currency Trading Is Not For Everyone.

Trading foreign exchange on margin carries a high level of risk, and may not be suitable for everyone. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. Remember, you could sustain a loss of some or all of your initial investment, which means that you should not invest money that you cannot afford to lose. If you have any doubts, it is advisable to seek advice from an independent financial advisor.

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What Is Forex Trading? How It Determines the Dollar's Value.

What Market Trades $5.3 Trillion PER DAY?

Definition: Forex, or foreign exchange, trading is an international market for buying and selling currencies. It is similar to the stock exchange, where you trade shares of a company. Like the stock market, you don't take possession of the money. It is a way to profit from the changing values of these currencies based on their exchange rates. In fact, the foreign exchange market is what sets the value of floating exchange rates.

How Much Money Trades Each Day?

According to the Bank for International Settlements, average daily forex trading in April 2016 (most recent data available) was $5.1 trillion. Of this, spot trading made up $2.6 trillion. The rest was trading in foreign exchange derivatives.

April’s trading is down slightly from the record $5.4 trillion traded in April 2013. That’s a result of a slowdown in the spot trading market.

In 2010, forex trading was $4.4 trillion traded per day. In 2007, the pre-recession high hit $3.2 trillion traded per day. But forex trading kept growing right through the 2008 financial crisis. This was up 30 percent In 20014, only $2 trillion was traded per day traded.

How Does Forex Trading Work?

All currency trades are done in pairs. Every traveler who has gotten foreign currency has done forex trading. For example, when you go on vacation to Europe, you exchange dollars for euros at the going rate.

When you come back, you exchange your euros back into dollars.

About one-third of all exchanges are spot trades. It's similar to exchanging currency for a trip. It's a contract between the trader and the market maker, or dealer. The trader buys a particular currency at the buy price from the market maker and sells a different currency at the sell price.

The buy price is somewhat higher than the sell price. The difference is the spread. It’s the transaction cost to the trader, which in turn, is the profit earned by the market maker.

You paid this spread without realizing it when you exchanged your dollars for euros. You would notice it if you made the transaction, canceled your trip and then tried to exchange the euros back to dollars right away. You wouldn't get the same amount of dollars back.

The remaining two-thirds of exchanges are forward trades, short trades or other complex trades. A forward trade is like a spot trade, except the exchange occurs in the future. The trader pays a small fee to guarantee that he will receive an agreed upon rate at some point in the future. This protects him from the risk of his preferred currency’s value rising by the time he wants to claim it. (Source: "Forward Contract," U. S. Forex)

A short-sale is like a forward trade, except the trader sells the foreign currency first. He will buy them later. He hopes that the currency's value falls in the future. (Source: Intro to Currency Trading, OANDA. "Profit in Falling Markets (Short-Sale Selling Basics)," DailyFX, February 8, 2012)

What Are the Most Traded Currencies?

As of April 2016, most trading (88 percent) happened between the U. S. dollar and some other currency.

The euro is next at 31 percent. That’s down from 39 percent in April 2010. The yen carry trade returned with force. Its trading rose from 17 percent in 2007 to 22 percent in 2016. Trading in the Chinese yuan more than doubled from 2 percent in 2013 to 4 percent in 2016. Find out the Dollar's Value in Five Other Currencies.

The chart below shows the top 10 currencies and the percent of global currency trades in 2016. It also shows and percent traded among their primary currency pairs, where available.

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Who Are the Biggest Traders?

Banks are the biggest traders, accounting for 24 percent of the daily turnover. It is a source of revenue for these banks that saw their profits decline after the subprime mortgage crisis. Investment companies always look for new and profitable ways to invest. Currency trading is a perfect outlet for financial experts who have the quantitative skills to invest in complicated areas.

Hedge funds and proprietary trading firms come second and contribute 11 percent. Although they represent smaller proportion, their trading is increasing for the same reason as the banks.

Pension funds and insurance companies are responsible for another 11 percent of the total turnover.

Corporations contribute just 9 percent. Multinationals must trade foreign currencies to protect the value of their sales to other countries. Otherwise, if a particular country's currency’s value declines, the multinational's sales will too. This can happen even if the volume of products sold grows.

Why Is Forex Trading So Massive?

Forex volatility is declining, reducing the risk for investors. In the late 1990s, volatility was often in the teens. It sometimes rose to as high as 20 percent with U. S. dollar versus yen trades. Today, volatility is below 10 percent. It includes historical volatility, or how much prices went up and down in the past. It also includes implied volatility. That's how much future prices are expected to vary, as measured by futures options.

Why is volatility lower? One, inflation has been low and stable in most economies.

Central banks have learned how to measure, anticipate and adjust for inflation. Two, central bank policies are more transparent. They clearly signal what they intend to do. As a result, markets have a lower chance of overreacting. Three, many countries have also built up large foreign exchange reserves. They hold them either in their central banks or sovereign wealth funds. These funds discourage the currency speculation which creates volatility.

Four, better technology allows for faster response on the part of forex traders. It leads to smoother currency adjustments. The more traders there are, the more trades occur. This contributes to additional smoothing in the market.

Five, more countries are adopting flexible exchange rates, which allow for natural and gradual movements. Fixed exchange rates are more likely to let the pressure build up. When market forces overwhelm them in the end, it causes huge swings in exchange rates. This is true in particular for emerging market currencies, making them more important global economic players. The "BRIC" countries, Brazil, Russia, India and China, seemed impervious to the recession until recent times. Forex traders became more involved in their currencies. In 2013 though, these countries started to falter, leading to an exodus and fast depreciation of their currencies.

Why Didn't the Recession Reduce Forex Trading?

The BIS was surprised that the recession didn't affect the growth of forex trading as it did for so many other forms of financial investments.

A BIS survey found that 85 percent of the increase was due to increased trading activity from "other financial institutions."

Just a few high-frequency traders do most of the trades. Many of them work for banks, who are now increasing this area of their business on behalf of the biggest dealers. Last but not least, is an increase in online trading by retail (or ordinary) investors. It has become much easier for all of these groups to trade electronically.

This shift is compounded by algorithmic trading (also called program trading). It means computer experts, or "quant jocks," set up programs that automatically conduct trades when certain parameters are met. These parameters can be central bank interest rate changes, an increase or decrease in a country's gross domestic product or a change in the value of the dollar itself. Once one of these parameters is met, the trade is automatically executed.

How It Affects the U. S. Economy.

Overall, lower volatility in forex trading means less risk in the global economy than in past decades. Why? Central banks have become smarter. Also, the forex markets are now more sophisticated. It means that they are less likely to be manipulated. As a result, dramatic losses based on currency fluctuations alone (like we saw in Asia in 1998) are less likely to happen.

Traders still speculate in the forex market though. In May 2015, four banks (Citigroup, JPMorgan Chase, Barclays and Royal Bank of Scotland) admitted to rigging foreign exchange rates. They join UBS, Bank of America and HSBC, who have already admitted to price fixing and colluding with each other to manipulate foreign exchange rates. The investigation is related to the Libor investigation. (Source: "Banks Near Settlement in FX Probe," Wall Street Journal, May 7, 2015)

Forex leverage: How it works, why it's dangerous.

Currency traders around the world are still reeling from the effects of the Swiss National Bank's surprise move to ditch its efforts at pegging the value of Swiss francs to euros.

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For three years, the SNB had used its own war chest to make sure that a euro was worth 1.20 Swiss francs. After giving up on trying to artificially keep the euro strong and franc weak, the value of euros plummeted, thus wreaking havoc on global currency markets.

And it wasn't just large banks, hedge funds and corporations that felt the pain but also smaller traders and investors, as well.

Over the past decade or so, the world of foreign exchange trading has seen the emergence of brokerages that cater to retail, or smaller traders. While the accessibility to global currency markets had been reserved for just professionals, or larger institutions, retail forex brokerages allowed up-and-coming traders with limited financial resources to participate in the market.

However, the risks that kept the market "off limits" for the smaller folks came roaring back with a vengeance over the last couple of days.

The SNB's action to remove its currency peg pushed the value of euros relative to Swiss francs off a cliff, and allowed no real time for anyone to react, or manage trading risks in a traditional manner.

The economic impact, in terms of losses, is much greater from a corporate or institutional standpoint. However, many retail traders found their trading accounts completely wiped out, being on the wrong side of a trade that couldn't be liquidated fast enough to preserve their capital. Trading in currency markets at the retail level, with these types of brokerages, centers on the use of one of the biggest double-edged swords in financial markets: leverage.

In other words, borrowed funds that are used to amplify potential returns but can also exacerbate the potential losses of trading positions. In the world of retail foreign exchange trading, use of leverage is key.

Here's how it works:

Let's say you want to take a $10,000 position in terms of Swiss francs. Under current regulatory guidelines in the U. S., you are mandated to keep at least $200 in your account in order to support that position. That's because there's a mandated minimum margin requirement of 2 percent for retail forex markets.

In other words, you can only have a position that's 50 times greater than the equity in your margin account.

If the value of your position grows because of market movements, there is no issue. But if your position loses value to a point where you no longer meet minimum margin requirements, your broker will liquidate assets to help assure that you don't lose more money than you put into the account.

The reason why some retail foreign exchange brokerages have gone bankrupt, and others are in severe distress, has to do with how those margin accounts were maintained during the SNB's shock move. Certain accounts with losing positions weren't able to be liquidated quickly enough before they went into deficit. That left some brokers responsible for the debit balances in client margin accounts. If those debit balances were high enough, that could cripple the capital position of these retail brokerages.

At that point, a handful of things can happen.

For one, the broker can request the client to add enough funds to bring their account back into good standing. Or, the broker is left holding the bag on client losses, perhaps with only legal recourse to try to recover those losses.

According to Forex, which is a retail foreign exchange broker and is owned by publicly traded Gain Capital, the company does "reserve the right to hold clients responsible for large debit balances and in special circumstances." Its website also encourages clients to manage use of leverage carefully, since use of more leverage increases risk.

Bottom line, the pain of the SNB's removal of its currency peg hit numerous parts of the market, and will lead to outsized financial losses for the big guys and the little guys. On a relative basis, retail traders may feel more pain than their bigger counterparts.

The recent market action serves as a potent reminder of just how dangerous leverage can be when price action moves swiftly, and without warning.