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Forex: Do You Understand Currency Movement ?

Posted by rantaboutit on February 26, 2007

There used to be a time when trading on the currency exchange (foreign exchange market or forex) was not for everyone. It used to be a domain for government central banks, commercial banks, investment banks, hedge funds and huge international corporation. However with the advent of the electronic trading networks, trading in forex is now more accessible than ever. The forex offers trading 24-hours a day, 5 days a week, and the daily dollar volume of currencies traded in the currency market exceeds $1.4 trillion, making it the largest and most liquid market in the world.

Forex is generally a low volatile market. Currency fluctuations are usually very small. Most high risk investors & speculators use leverage (which is possible due to high liquidity) to increase the profit margins. For example, it is possible for an investor to control a position of $100,000 by putting down as little as $1,000 up front and borrowing the remainder from his or her broker.

The movement of currency prices are based upon the demand and supply model. This cannot be manipulated easily because the size of the market does not allow even the largest players, such as central banks, to move prices at will.

What is Forex all about ?
Currencies are important to most people around the world, whether they realize it or not, because currencies need to be exchanged in order to conduct foreign trade and business. If you are living in the U.S. and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French for the cheese in euros. This means that the U.S. importer would have to exchange the equivalent value of U.S. dollars into euros. The same goes for traveling. A French tourist in Egypt can’t pay in euros to see the pyramids because it’s not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate.

The need to exchange currencies is the primary reason why the forex market is the largest, most liquid financial market in the world. One unique aspect of this international market is that there is no central marketplace. All transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The forex market can be extremely active any time of the day, with price quotes changing constantly.

Spot Market and the Forwards and Futures Markets
The 3 ways to trade forex are the spot market, the forwards market and the futures market. The spot market is the largest market because it is the underlying real asset that the forwards and futures markets are based on. When people refer to the forex market, they usually are referring to the spot market. The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.

Spot Market
The spot market is where currencies are bought and sold according to the current price. Few factors that determine the price is demand & supply, interest rates, economic indicators, political stability and future performance of one currency against another.

Forwards Market
The forward market does not trade in actual currency. Instead they deal in contracts of a certain currency type at a specific price/unit and a future date. Forward contracts are traded over the counter.

Futures Market
The futures market also does not trade in actual currency. Like forwards market they deal in contracts of a certain currency type at a specific price/unit and a future date. Futures contracts are traded upon a standard size and settled over public commodities markets such as the Chicago Mercantile Exchange.

Trading Instruments
The majority of forex traders focus their efforts on seven different currency pairs: the four majors, which include (EUR/USD, USD/JPY, GBP/USD, USD/CHF); and the three commodity pairs (USD/CAD, AUD/USD, NZD/USD). All other pairs are just different combinations of the same currencies, otherwise known as cross currencies. This makes currency trading easier to follow.

Conclusion: The forex market provides plenty of opportunity for investors. The currency market is also the only market that is truly open 24 hours a day. The amount of leverage available in the forex market also makes it attractive for many speculators. However, in order to be successful, a currency trader has to understand the basics behind currency movements otherwise the benefits of leverage can work against the trader.

Forex trading is a vast topic and will be covered in depth..
To be continued….

(Source: Investopedia)

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