What is FX?
How does FX work?
Everyone interacts in some way with the Forex markets. At any given time, there are currency exchanges happening for many reasons linked to travel and the financial markets.
What is the FX market?
Whether it’s a holiday-maker exchanging Euros for USD, a day trader taking a position in the currency markets or an institution making massive currency trades, FX is traded worldwide. Institutions like central banks are especially active in the FX markets as they place trades to increase or decrease their country’s foreign reserve holdings.
Broadly speaking, currencies have a value relationship to each other in the foreign exchange markets. We could say that this relationship is based on two main components: the fundamentals of the economic performance in the currency’s home country and the investor’s perception and reaction to market news.
To break the relationship down further, let’s examine why a country’s macro-economic performance affects its currency. The value of a piece of currency, for example a US Dollar, is based on how well the economy performs. If gross domestic product (GDP) becomes weaker, the USD can lose value against its main rival, the Euro. As a result, the Euro rises against a falling USD.
The opposite happens if GDP grows stronger, in which case the USD might increase in value against the Euro, which falls accordingly.
Currency values move up and down against each other, which is why foreign exchange trades are carried out in pairs. Some examples from the major developed economies are the Eurozone’s Euro to America’s US Dollar (EURUSD) and the United Kingdom’s GBP to Switzerland’s CHF (GBPCHF).
Other examples are currencies which stem from the emerging economies like the Russian Ruble to the Chinese Renminbi (RUB to Yuan).
The base currency is used to buy the counter currency. In the example of EUR to USD, the currency on the left of the pair is the base currency and the one on the right is the counter currency.
The second component of the relationship is the extent that investors react to market-moving news like GDP performance. Reactions can range from mild to extreme and are based on what the investors were expecting. If there is little or no change in the economy’s performance and this was an expected result, the traders might just shrug it off and there will be no reaction in the value of the currency. In the same scenario that there was little or no change in the economy’s performance and the investors were expecting an improvement, they might become concerned and sell the currency.
If the economic performance is dramatically worse than expected, traders might sell off the currency as fast as they can. This is when volatility can hit the currency market and exchange values can fluctuate so much they start affecting other assets like loans, commodity prices and bond yield values.
How do I trade FX?
Currencies can be traded directly, as in a holiday-maker exchanging their Euros for USD. In this case, the currency is exchanged for another currency and the holiday-maker now holds physical USD instead of Euros in their hands.
But by far the biggest volume of daily trades are made on FX derivatives called Contracts for Difference (CFDs). In these trades, the actual currency is not physically held and instead, the CFD represents the trading pair’s relative values. In this way, traders make gains or losses on the difference between the trading pair’s rising or falling price for the duration of the trade.
CFD prices are normally linked with the movements of exchange-listed currency pairs. Futures exchanges like Eurex, ICE or CME list monthly contracts for currency pairs like the EURUSD.
This leads to the question, if a trader doesn’t physically hold the currency then how is profit or loss generated? The answer is the spread.
What is Spread in Forex?
When trading forex, spread is the difference between the bid or sell price and the ask or buy price of a currency pair. In certain situations, the upside or downside spread can be significant because of extreme market reactions. The decoupling of the Swiss Franc to the Euro on January 15, 2015 is one such example. The Euro plummeted in value after the Swiss Central Bank decided to unpeg the CHF from the Euro, sending traders into a selling frenzy.
Whether you’re a retail trader, institutional trader or holiday-maker, FX values can be affected by market-moving events so it’s a good idea to monitor the financial markets.
Political uncertainty can amplify investor fears and might result in unexpected volatility, so when trading FX be sure to use stop loss orders.
Metatrader 4 is by far the most popular platform for trading FX. The system provides technical analysis tools and different type of trading executions. You can view bar charts, candlesticks, line charts and see your trade levels and history. There is a useful demo account for beginners who want to familiarise themselves with the way the FX markets work.