What is Forex ?
Forex is an abbreviation of the first three letters of the word “foreign” and the first two letters of the word “exchange”. The term “foreign exchange” is self-explanatory: the exchange of foreign currencies. However, it is more apt to define foreign exchange as the business of exchanging one currency for another, and re-exchanging the two currencies in order to profit from the exchange rate differential. For us to speak of an exchange rate differential, it means that the following variables must be present:
- There must always be at least two currencies involved in the transaction.
- The rate at which one currency is exchanged for another cannot be static. Therefore, the rate of exchange must be dynamic and not fixed. Currencies that exhibit this behavior are said to float.
- There must be a buyer and a seller. In the online forex market, these roles are fulfilled by brokers and traders.
There are different ways by which the rate of exchange of one currency to another are determined. Some of these methods are as follows:
- It is possible for the rate of exchange of a currency to be determined by a central authority such as an agency of government. Usually, the agency of government charged with this function is the central bank. In situations where the government fixes the exchange rate, we refer to this exchange rate as a fixed exchange rate regime.
- On the other hand, exchange rates of currencies can be determined solely by market forces or the forces of demand and supply. In this manner, market participants will by their attitude and bias (or lack of it) towards a currency, determine its rate of exchange to other currencies and consequently its value. In turn, there are various factors that determine the demand that market participants will have on a currency as well as the supply of a currency in the market with respect to other currencies. In situations where exchange rates are determined by forces of demand and supply, we say that a floating exchange rate regime is in place. The word “floating” is used, because an object which floats on water is not in a static position, but bobs about according to the movement of the water body on which it rests. It is the floating of currencies which produces the exchange rate differentials and this forms the basis of the online forex market.
How Does Forex Trading Work?
Now that the basis of forex trading has been established, a description of how money is made in forex can be provided.
A trader can make money in forex in both directions. In other words, a trader can benefit from a rising exchange rate, or a falling exchange rate.
- Rising Exchange Rate
Trader A buys 10,000 British Pounds with $12,500 (exchange rate of 1.2500). In three hours, 1 GBP exchanges for $1.2580. Trader A uses his 10,000 GBP to purchase $12, 580. He has gained $80 in the trade, which is the difference between the new exchange rate and the old one.
- Falling Exchange Rate
Trader B sells $US10,000 for Japanese Yen. The exchange rate for 1 USD is 112 JPY, therefore the trader gets 1,120,000. In one week, the value of the USD falls, and 112 JPY now exchanges for $1.05. The trader sells the JPY he had for USD, and gets USD10,500. He has gained $500 in the trade.
That is how online foreign exchange trading works, in theory. In practice, it is not as easy as it sounds. There are many factors that come into play. A trader must be able to determine the direction that the exchange rate will assume in order to make a correct trade decision, and the statistics show that only 5% of retail traders are able to do this. Institutional traders are much more successful at this.
Should this discourage you? No it should not. Rather, it should awaken your consciousness to what you need to do in order to succeed in forex trading.
How to Start Trading Forex
In order to start participating in online forex trading, the trader must undergo some processes and perform certain requirements. These are listed below:
- The trader has to open an account with a forex broker, so as to be able to get access to the market using the broker’s trading platform. Online account opening with the broker of choice can be carried out by simply filling an online form. This takes about 5 to 10 minutes.
- The trader can only perform trading by investing money into a transaction on the forex market. Therefore, the trader needs an acceptable means of transaction with which to perform the transactions. This is done by obtaining a credit/debit card, a digital wallet or a domiciliary bank account. Once this has been obtained, a deposit to the broker can be made, from where the trading account can be funded.
- Trading forex is performed using a decentralized exchange. Access to this exchange is via the broker’s trading platform. There are desktop, web-based and mobile trading platforms that are used for this purpose. The trader will be provided one by the broker.
- The trader’s identity and address will need to be verified. This will be done using an international passport (or where allowed, a drivers’ license and national ID card). Also, a bank statement of utility bill is required as proof of address.
- Once all these are in place, the trader is ready to start trading forex.
It is then up to the trader to use the money in the trading account to participate in online forex trading by buying and selling currencies. In order to do this successfully, the trader must pass through a learning and training process, followed by practice on the broker’s demo account before going live to trade real money. This is what forex is all about.