What is Forex Trading and How Does it Work?
Forex trading is an efficient way to speculate on the future direction of currencies by purchasing and selling pairs on an exchange. Most traders specialize in spot market forex trading, in which traders buy and sell currencies based on supply and demand prices at current or predetermined prices. Spot forex trading is an attractive form of derivatives trading that enables traders to make profits without purchasing or owning the underlying currency pair. Leverage makes this possible, enabling traders to leverage larger amounts than they could afford with just their own money. However, using leverage involves certain risks which should be understood before beginning any forex trades.
On the spot market, each forex pair is defined by its base and quote currencies. A base currency represents the first listed in a pair and can be represented by three-letter codes similar to stock ticker symbols – for instance EUR represents EUR as the base in EUR/USD pair and so forth. A quote currency comes second with its three letter code attached – in order to be profitable trading must occur between two relative prices of both base and quote currencies rising relative to each other.
Forex trading’s primary speculative goal is to capitalize on price differences between base and quote currencies in any given pair, typically by going long on one currency pair or short on another (hoping one currency will increase relative to another) or shorting (thinking its value will decrease against its respective base currency) respectively. You could also enter into forward contracts which allow traders to buy or sell specified amounts of currency on future dates.
Most forex traders utilize both fundamental and technical analysis when making decisions regarding forex markets, given all the various influences such as economic news, political events and central bank policy that affect currency prices. When starting out with forex trading it’s crucial to have a robust risk management plan in place that includes stop losses, take profit levels and other risk-reducing tools – stop losses may even help. Furthermore, diversifying portfolio with other assets classes such as stocks and bonds may reduce overall exposure risk.