Every time you travel internationally and convert your local currency into a different one, you are engaging in the forex market, even if you don’t actively trade currencies. The foreign exchange market is, in fact, the world’s largest financial market, far surpassing all other capital exchanges combined with largest financial derivatives institution
This market may be enormous, but the ideas behind trading currencies are rather straightforward. Let’s look at some of the groundwork that every foreign exchange investor should have.
The Eight Most Important Foreign Exchange Factors
There are thousands of equities for investors to choose from on the stock market, but just eight main economies to keep an eye on when trading currencies. These eight economies and their currencies, collectively referred to as “The Majors,” account for 90% of all forex trades.
- United States (U.S. dollar)
- Eurozone (Euro)
- Japan (Japanese Yen)
- United Kingdom (Pound Sterling)
- Switzerland (Swiss Franc)
- Canada (Canadian dollar)
- Australia (Australian dollar)
- New Zealand (New Zealand dollar)
The foreign exchange (forex) market is dominated by the currencies of these economies, as they have the largest and most advanced financial markets in the world. To give just one example, in 88.3% of all forex trades, the U.S. dollar was used, while the euro was used in 32.3%.
Commodity block currencies, which include the New Zealand, Australian, and Canadian dollars, tend to mirror shifts in global commodity markets and are therefore used to refer to the smaller currencies that track them.
By limiting our investments to only these eight nations, we will be able to capitalize on the highest quality and highest liquidity instruments on the financial markets to generate the highest possible interest income. Nearly daily releases of economic data from these countries give investors a comprehensive picture of each economy’s state.
Forecasting Market Behavior
Forex spot market transactions involve the simultaneous purchase and sale of two different underlying currencies. Because the value of one currency is always expressed in terms of another, all currencies are always quoted in pairs. Here’s an example: if the Euro/Dollar exchange rate is quoted as 1.2200, that means that buying one Euro will set you back $1.22.
Betting on the direction of a currency’s value in the future is one of the simplest forms of Forex trading, and it can be done on the spot market or the futures market. A trader might sell dollars in expectation of a stronger euro if they expect the European Union’s economy to overtake the United Statessoon. On the other hand, a person who thinks the dollar will fare better than the other majors might sell foreign currency in exchange for dollars.
Exchange-rate futures function in the same way. Traders in a futures contract agree to make a currency swap later and a set price. One of the traders will profit if the spot rate for the currency on that day is different from the futures rate.
Foreign Exchange Profit and Loss
A crucial concept to keep in mind while trading currencies is that yield determines profit. The interest rate associated with a currency is determined by the central bank of the country issuing that currency. Interest is earned by the currency trader on the spread between the interest rates of the currencies traded and purchased.
This dynamic permits the carry trade, which is among the most often used forex trading techniques. Carry traders anticipate making a profit not just from the rise in one currency over another, but also from the spread in interest rates offered by several currencies.
If the interest rate in New Zealand is 8% and the interest rate in Japan is 0.5%, a trader who decides to go long on the NZD/JPY pair stands to gain 8% in interest over the course of a year. If they took 7.5% after fees, their net gain would be 7.5%.
Forex Trading with Leverage
With leverage in the forex market reaching as high as 100:1, a trader can manage $10,000 in assets with just $100. By comparison, stock traders are limited to 2:1 leverage. However, leverage is a double-edged sword: it can bring large profits when you are correct but may also generate huge losses when you are incorrect.
The 7.5% yield on the NZD/JPY pair would result in a 75% yearly return, even with very cautious leverage of 10:1. As a result, if you put up $5,000 in equity and held a 100,000 NZD/JPY unit bet, you would receive daily interest of $9.40.
After only 10 days, the trader would have earned $94 in interest, or $3,760 a year (barring the unlikely event that the value of the New Zealand dollar fell, resulting in the loss of all collateral). Savings accounts at banks, on the other hand, would provide no returns but zero risk.
Leverage amplifies the effects of market fluctuations. However, stops can be used to limit these losses. As an added layer of security, most forex brokers provide clients with access to a margin watcher, a piece of software that monitors your position and automatically liquidates it once margin requirements are breached. Because of this procedure, you may rest assured that your account balance will never go below zero, and your exposure will never exceed the funds now available in the account.
Strategies for Profitable Carry Trades
The key to a profitable carry trade is not just to swap high-interest currencies for low-interest ones. Much more crucial is keeping an eye on the movement of the spread; a successful carry trader would pair a currency with an increasing interest rate with one that has a decreasing interest rate.
To do so effectively, one must have a firm grasp on the economic foundations of the target countries. To rein in inflation and slow economic growth, interest rates are typically raised in countries that are doing exceptionally well.
The most lucrative carry trades are those with the potential for both a positive yield and price appreciation. Knowing this is crucial since a loss in currency value can wipe out any profits made from a carry trade and then some.
To Sum Up
Due to the sheer expansion of online trading networks, engaging in foreign currency trading, also known as forex trading, has never been simpler than it is right now. Those that invest the effort to educate themselves on the intricacies of the greatest financial market in the world and acquire the skills necessary to manage their risk exposure will be well rewarded.