What is foreign exchange trading?

The Forex market is the largest in the world in terms of volume and liquidity. Brokers, companies, and governments exchange coins to facilitate international trade, while many traders use it for speculative purposes. Personally, I have found it fascinating how arbitrage opportunities with exchange rates and interest rates make this market so attractive for trading in large volumes or leverage.

The market consists of fiat currency pairs and their relative prices, which are usually bought in lots. A standard lot contains 100,000 units of the base coin, although there are smaller options available down to 100 units for those of us starting with less capital.

Traders often use leverage to increase their investment power. We can also manage risks through forwards and swaps to trade at specific prices in the future. This combination of instruments creates various investment opportunities.

Introduction

Although you do not trade in Forex, this market affects your daily life. While the effects of a stock market crash are not always evident, a change in the value of your moneda directly impacts the prices of goods and services. If you have traveled abroad, you have probably exchanged currencies paying fees based on current quotes.

Forex is a unique asset that differs from stocks, commodities, and bonds. By delving into its particularities, we understand why there is such a large market and the need for a truly global system.

What is Forex?

Foreign exchange trading or FX involves buying and selling sovereign coins. The exchange rates we find at banks or exchange houses are determined by what happens in this market.

Exchange rate movements are based on economic conditions, global events, interest rates, and political factors. This makes Forex extremely liquid and has the highest volume of trades among all financial markets.

The market comprises two main activities: economic transactions and speculative trading. For companies operating internationally, buying and selling currencies is essential to repatriate funds or acquire goods abroad.

Speculators represent the other side of the market. High volume short-term trading is common, taking advantage of small price fluctuations. Forex is full of arbitrage opportunities, which explains its enormous trading volume.

We also seek long-term gains through fluctuations in interest rates or geopolitical events. By holding a coin over time, we can achieve substantial benefits, or agree on exchange rates years in advance through futures contracts.

For small users, trading can be challenging without leverage or significant initial capital, which explains why banks and financial institutions generate most of the volume.

What is a currency pair?

At its most basic level, the market contains pairs that describe the relative price between two coins. The first is the base coin and the second is the quoted or counter coin. The value is expressed in relation to one unit of the base coin.

GBP/USD shows the price of £1 in dollars. A quote of 1.3809 indicates that 1 pound is worth 1.3809 dollars. This pair, known as “cable” ( nickname that comes from a 19th-century transatlantic cable ), is one of the most traded.

Among the most liquid pairs, we find USD/JPY, GBP/USD, USD/CHF, and EUR/USD, known as major pairs, formed by the United States dollar, Japanese yen, British pound, Swiss franc, and euro.

Why do we trade in Forex?

The market is not limited to speculation. Banks, companies, and other entities participate to facilitate international transactions. Companies also agree on forward exchange rates to lock in future costs (hedging). Governments accumulate reserves and pursue economic objectives through monetary linkage or control of imports/exports.

For individual traders, Forex offers attractive advantages:

• Leverage that allows you to invest more capital than available
• Low entry costs compared to stocks
• Nearly continuous operation, adaptable to any schedule
• High liquidity and reduced spreads
• Availability of options and futures for short selling strategies

Where to trade in Forex

Unlike stocks traded on centralized exchanges, foreign exchange trading occurs in global centers. Participants trade directly through OTC operations or via the interbank network.

Supervision is complex due to the different regulations for each coin. Although many jurisdictions have agencies that oversee domestic trading, their international reach is limited.

The main trading areas are New York, London, Tokyo, and Sydney. Without a central point, you can find brokerages that facilitate operations worldwide.

There are numerous free online brokerage services that profit from the difference between the offered price and the actual market price. For beginners, I would recommend choosing an agency that allows trading in microlots.

Unique Aspects of Currency Trading

Forex has distinctive features:

1. Huge geographical coverage with 180 recognized coins
2. Extreme liquidity and volume of operations
3. Prices influenced by multiple global factors
4. Almost continuous operation, five days a week
5. Profit margins that require large volume to be significant

How to trade in Forex

We can approach the market in several ways. The simplest is to buy a pair and hold it expecting appreciation. We can also leverage funds to increase our available capital, use options that allow buying or selling at a fixed price on a specific date, or take advantage of interest rate differentials between countries.

An interesting aspect is to earn profits through interest rate differentials between central banks. However, we must consider additional costs such as remittance fees, bank charges, and different tax regimes.

Pips and lots in trading

A pip (percentage in points) is the minimum increment in the price of a pair. In GBP/USD, it represents 0.0001, while in pairs with Japanese yen it equals 0.01. Some brokers offer pipettes, an additional decimal.

In Forex, currencies are traded in lots. A standard lot contains 100,000 units of the base coin, but there are smaller options:

• Standard lot: 100,000 units
• Mini: 10,000 units
• Micro: 1,000 units
• Nano: 100 units

With lots, it's easy to calculate gains and losses. For example, buying a standard lot of EUR/USD, an increase of one pip equals $10 in profit.

Leverage and Hedging

Leverage allows borrowing with a small margin, multiplying the available capital. Brokers express this as 10x, 20x, etc. A 10x leverage with $10,000 provides $100,000 to trade.

To do this, we maintain a margin that covers potential losses. Leverage amplifies both gains and losses, allowing access to markets that require large capital.

Hedging allows fixing exchange rates for financial stability through futures or options. A futures contract obligates trading at a specific rate on a future date, while options give the right but not the obligation to do so.

Covered interest arbitrage takes advantage of differences between global rates while offsetting the risk of fluctuations. Although it generates less profit than unhedged operations, it guarantees minimum returns in volatile environments.

Forex offers a unique alternative to stocks for those of us interested in the global economy. Although it may seem less accessible than cryptocurrencies or stocks, online brokers have democratized access. However, leveraged strategies carry high risk, so it is essential to understand the mechanisms well before trading.