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How does forex trading work?

August 14, 2009 12:39 IST
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Forex trading is the act of trading currencies from different countries against each other. Forex is acronym for foreign exchange.

For example, in Europe the currency in circulation is called the Euro (EUR) and in the United States, the currency in circulation is called the US Dollar (USD).

An example of a forex trade is to buy the Euro while simultaneously selling the US Dollar. This is called going long on the EUR/USD.

Forex trading is typically done through a broker or market maker. As a forex trader you can choose a currency pair that you feel is going to change in value and place a trade accordingly.

Orders can be placed with just a few clicks and the broker then passes the order along to a partner in the Interbank Market to fill your position.

When you close your trade, the broker closes the position on the Interbank Market and credits your account with the loss or gain. This can all happen in seconds.

The main enticements of currency dealing for private investors and attraction for short-term forex trading are:

  • 24-hour trading, 5 days a week with non-stop access to global forex dealers.
  • An enormous liquid market making it easy to trade most currencies.
  • Volatile markets offering profit opportunities.
  • Standard instruments for controlling risk exposure.
  • The ability to profit in rising or falling markets.
  • Leveraged trading with low margin requirements.
  • Many options for zero commission trading.

To know if you made a good investment in forex trading, one needs to compare this investment option to alternative investments.

At the very minimum, the return on investment (ROI) should be compared to the return on a 'risk-free' investment. One example of a risk-free investment is long-term US government bonds since there is practically no chance for a default, i.e. the US government going bankrupt or being unable or unwilling to pay its debt obligation.

When trading currencies, trade only when you expect the currency you are buying to increase in value relative to the currency you are selling.

If the currency you are buying does increase in value, you must sell back the other currency in order to lock in a profit.

An open trade (also called an open position) is a trade in which a trader has bought or sold a particular currency pair and has not yet sold or bought back the equivalent amount to close the position.

However, it is estimated that anywhere from 70%-90% of the forex market is speculative.

In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency.

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