If you do a quick search for forex trading on Google and poke through the pages, you’ll likely be overwhelmed by the huge amount of information and jargon you’ll find. Yet, it’s one the most basic and important markets in all of investing. In fact, the forex market, or foreign exchange market, is the world’s largest investment market. I’m going to give you an extremely brief overview of what it is, why it’s important, and a little about the theory behind it.
What is forex trading?
Think of a stock market, where you’re trading shares of ownership in a company that are worth a certain amount. The forex market is similar, but instead of trading shares of ownership, you’re trading in “lots” of a particular currency. If you’ve ever traveled outside of your country, you know that in some countries your money is worth more in the local currency, and in others it’s less. The market that controls those currency fluctuations is the forex market.
For many years, this market was confined to very large banks. A standard lot is 100,000 units of a currency! But as technology progressed and more market options became available to consumers, these lots were chopped into smaller units to allow anyone to enter the forex market. Generally, you only need 1000 units of your chosen currency plus any broker fees to play in this market. Lots of currency are traded on a bid/ask system much like stocks are, but there are many variations on this.
Why is it important?
Large banks around the world have to exchange foreign currencies all the time as people and commerce occurs between different countries. Similar to how a stock market can show how much more valuable a company is compared to another one, the forex market shows which countries the market thinks have stronger economies. You may have heard that the dollar is “strong” in a financial report. This means that it is rated at a higher price on the forex market, and thus you can buy more foreign currency using dollars.
One of the most important things to know about the forex market is that it isn’t regulated by governments. In a sense, it’s like a meta-system that governments, corporations, banks, and individual investors all agree to play within. Nearly 4/5ths of all trading activity on the forex market is done by speculators who want to participate in the most liquid market available, and one in which margins of 200:1 are quite common! The reason that a broker is willing to offer this much margin is that the forex market plays with the entire money supply of every economy on Earth that chooses to exchange its currency with other countries. There’s no central forex trading floor like there is with a stock exchange. Instead, it’s a huge web of transactions, and that’s one of many reasons why it’s so difficult to understand.
How do prices fluctuate?
There are many different reasons why the price difference between two currencies can fluctuate. It can be simple supply and demand, or it can be a response to geopolitical circumstances. The price of a currency fluctuates on things like a country’s credit rating, unemployment report, GDP numbers, the cost or availability of a resource, and many other factors that a savvy forex trader will need to study deeply before investing a lot of money in this market. More than any other market, the forex trade requires you to be aware of the entire global economy. This is generally why forex traders will stick with only trading one pair of currencies until they master those fluctuations, then move to another one. Though every currency on Earth can be traded, there are generally only 18 pairs of currencies that are heavily traded for this reason.
Because the market is so large, it is possible to make huge returns and losses on the tiniest shifts, especially if you start playing with margin, without affecting the larger market. A myriad amount of systems exist to take advantage of these shifts, and only careful research will help you find the ones that work for your level of risk. Without a solid set of Forex trading strategies, deep market research, and strong discipline, your initial investment and then some can disappear in a flash. Still, if you have a strong stomach for risk and a deep urge to master some of the most arcane economic factors out there, you too might be able to make a billion dollars in one trade.