Forex Trading: What You Need to Know About the Forex Market

The forex market: why is it so huge?

Forex is the largest and most liquid trading market in the world. Every day, international banks, corporations, governments, and individual traders trade currencies and forex products. This market enables international trade, but it also allows speculators to profit from exchange rate fluctuations.

If you have ever traveled abroad, you have already made decisions about exchange rates – even if not consciously. The exchange rate for currency conversion is derived directly from the forex market. The rates move based on a combination of economic conditions, global events, interest rates, and political factors, which makes forex an extremely dynamic and volatile market.

What options are available in trading?

In forex trading, there are fundamentally two roles you can take: either you facilitate economic transactions, such as bringing back funds for a multinational corporation, or you speculate on price fluctuations. For individual traders, the latter is much more attractive.

Arbitrage opportunities and interest rate differentials make forex full of profit-making possibilities. Traders profit from short-term fluctuations or hold currencies for a long time to earn interest income. Political events and economic news can cause significant price fluctuations over time, which the vigilant trader can capitalize on.

How does the currency pair work?

The forex market is composed of currency pairs. Each pair shows the relative exchange rate of two currencies. In the case of GBP/USD, an exchange rate of 1.3809 means that 1 pound is equivalent to 1.3809 dollars. The first currency is the base currency, and the second is the quote currency.

The most liquid and most traded pair is the EUR/USD, which is continuously traded by major banks. Additionally, USD/JPY, GBP/USD, and USD/CHF are also extremely liquid. These are referred to as major pairs.

What is the pip and the item?

When trading a currency pair, the smallest price increase is the pip (percentage in point). For EUR/USD, the pip is 0.0001. If the exchange rate increases by 0.0001, that is a movement of 1 pip. However, for pairs that include the Japanese yen, the pip is 0.01 because the yen does not have four decimal places.

Currencies are traded in lots. The standard lot contains 100,000 units of the base currency, but there are smaller options available:

• Standard: 100,000 units
• Mini: 10,000 units
• Micro: 1,000 units
• Nano: 100 units

If you trade standard lots of EUR/USD with a 100 euro pip, each pip movement represents a profit or loss of 10 dollars.

Leverage: when is it useful, when is it dangerous?

In forex trading, the profit margin is low, which is why traders use leverage. This allows you to trade with money borrowed from the broker. A 10x leverage means you can trade with ten times your own money. $10,000 with 10x leverage gives you $100,000 to trade.

A margin is required for the operation of leverage (margin). A 10% margin allows for 10x leverage, while a 5% margin allows for 20x leverage. This amount remains with the broker and is used to cover your losses.

But be careful! Leverage amplifies both profits and losses. If you want to buy one lot of EUR/USD for (100 000 euros), you will need approximately 120,000 dollars. This is a lot if you have little capital. Therefore, you can choose 50x leverage (2% margin), which only requires a 2,400 dollar deposit. But if the exchange rate drops by 240 pips – that is, you lose 2,400 dollars – your position will be closed and your account will be liquidated.

How to Reduce Risk? The Coverage Strategy

If you don't want to depend on the fluctuations of the exchange rate purely on luck, you can use hedging instruments. The most common methods are futures contracts and options.

( Futures Contracts

Assume you are selling in the eurozone and want to bring your profits home from dollars to euros after a year. The exchange rate is currently USD/EUR 0.8400. You are entering into a one-year forward contract at this exchange rate.

If you acquire 100,000 dollars, you can trade it with a guarantee of 84,000 euros in delivery. If the dollar appreciates and the exchange rate will be USD/EUR 1.0000 in a year, you would receive 100,000 euros in the spot market. But according to your futures contract, you are entitled to 84,000 euros for 100,000 dollars – meaning you save 16,000 euros in costs.

) Options Trading

Options provide similar protection but are more flexible. You pay a premium and have the right – but not the obligation – to buy or sell a currency pair at a predetermined price on or before a specified date.

A British company selling in the USA can buy a GBP/USD call option. If the pound appreciates, the option protects your exchange rate. However, if the price moves favorably for the company, you only lose the premium of the option.

Covered interest rate arbitrage: a tool for the more sophisticated trader

Interest rates vary worldwide. In the eurozone, it can be 1%, while in the USA it can be 2%. This creates an arbitrage opportunity.

Let's take the EUR/USD pair at an exchange rate of 1.400:

• You invest 100,000 euros in the Eurozone at an interest rate of 1%.
• Or you convert to dollars ###140 000 dollars### and invest in the USA at an interest rate of 2%.

An investment of 140,000 dollars in the USA will be worth 142,800 dollars in a year. If you have a one-year EUR/USD futures contract at an exchange rate of 1.4100, then the 142,800 dollars would return 101,276.60 euros. This is a profit of 1,276.60 euros – but unhedged, you would have 102,000 euros.

Why do they hedge then? Because the exchange rate rarely remains stable for a year. In exchange for a loss of €723.40, you secure a profit of €1,276.60. This risk management is much more valuable than the theoretical maximum profit.

Where and how do you trade?

Forex does not have a centralized exchange. Trading is concentrated around New York, London, Tokyo, and Sydney, but it actually involves interbank OTC ( off-exchange ) transactions.

Because of this, you need a broker. Online brokers are widely available and mostly free for basic services. Brokers earn their revenue from the bid-ask spread, which is the difference between the price they offer and the actual market price.

As a beginner, choose a broker that offers nano or micro lots. This is the easiest entry point into forex trading. Due to the leverage options, you can start with even a small amount of money, but always be mindful of the closing risk.

Why is forex special?

The EUR/USD ( and other forex pairs ) have several unique features in trading:

1. Huge geographical coverage – 180 currencies exist worldwide
2. Extraordinary liquidity – daily trading volume in the billions of dollars
3. Complex price influence – politics, economy, speculation, remittances
4. Almost open 24/5 - since there is no center to the market, trading is always taking place somewhere.
5. Low profit margin but high volume – a small price change can be profitable with large amounts moving.

Before starting forex trading, study the mechanisms. Leverage can bring great profits, but it also implies closing risks.