PortalKota – What Is Forex Trading And How Does It WorkForex, or foreign exchange, trading is an international market for buying and selling currencies.
It is similar to the stock exchange, where you trade shares of a company. Like the stock market, you don’t need to take possession of the currency to trade.
Investors use forex trading to profit from the changing values of currencies based on their exchange rates. In fact, the foreign exchange market is what sets the value of floating exchange rates.
What Is Forex Trading And How Does It Work
All currency trades are done in pairs. You sell your currency to buy another one. Every traveler who has gotten foreign currency has done forex trading.
For example, when you go on vacation to Europe, you exchange dollars for euros at the going rate. You are selling U.S. dollars and buying euros.
When you come back, you exchange your euros back into dollars.
You are selling euros and buying U.S.dollars.
The most familiar type of forex trading is spot trading. It’s a simple purchase of one currency using another currency.
You usually receive the foreign currency immediately. It’s similar to exchanging currency for a trip.
It’s a contract between the trader and the market maker, or dealer. The trader buys a particular currency at the buy price from the market maker and sells a different currency at the selling price.
The buy price is somewhat higher than the selling price. The difference between the two is called the “spread.” This is the transaction cost to the trader, which in turn is the profit earned by the market maker.
You paid this spread without realizing it when you exchanged your dollars for euros.
You would notice it if you made the transaction, canceled your trip and then tried to exchange the euros back to dollars right away. You wouldn’t get the same amount of dollars back.
The largest component of currency trades is foreign exchange swaps. Two parties agree to borrow currencies from each other at the spot rate.
They agree to swap back on a certain date at the future rate.
Central banks use these swaps to keep foreign currencies available for their member banks.
The banks use it for overnight and short-term lending only. Most swap lines are bilateral, which means they are only between two countries’ banks. Importers, exporters, and traders also engage in swaps.
Many businesses purchase forward trades. It’s like a spot trade, except the exchange occurs in the future. You pay a small fee to guarantee that you will receive an agreed-upon rate at some point in the future.
A forward trade hedges you from currency risk. It protects you from the risk that your currency’s value will rise by the time you need it.
A short sale is a type of forward trade in which you sell the foreign currency first. You do this by borrowing it from the dealer.
You promise to buy it in the future at an agreed-upon price. You do this when you think the currency’s value will fall in the future. Businesses short a currency to protect themselves from risk.
But shorting is very risky. If the currency rises in value, you have to buy it from the dealer at that price. It has the same pros and cons as short-selling stocks.
Foreign exchange options give you the right to buy a foreign currency at an agreed-upon date and price. You are not obligated to buy it, which is how an option is different from a forward contract.