A little guide to what’s going on when you trade forex
Let’s get back to basics.
We’ve written countless articles on forex strategies, planning, execution, etc. All of these articles assumed one basic thing though, that you, the reader knew what forex was.
Well, if you didn’t, we’re sorry but that’s what today’s article is for.
We’re going to count some of the features that identify the forex market. What are the advantages and/or disadvantages in the market when you compare it to other markets that are available out there.
Forex is a nickname for foreign currency exchange market.
The main characteristic of the forex or fx market in comparison to other financial markets, is that it is decentralized. There is no one exchange that is responsible for trading currencies.
Currencies in forex are considered just like every other commodity. Potatoes, tomatoes, bread, butter, currency.
As such, the price of each currency is determined by a different currency. Let’s say you want to buy euros but you live in the US, so you would pay for them in US dollars. Or maybe you live in Japan and hold yen. You want to buy canadian dollars. So you buy the commodity canadian dollars with japanese yen.
These commodities are being traded all over the world, with no one central place arranging the facilitation of trading. Price is therefore determined by what different organizations or participants agree on.
For example, you want to buy 100 million euros paying with usd. So you walk into a local Deutsche Bank and they say we’ll give xx rate. That rate determines the price of the commodity.
Same Market, Different Prices
Because the entire market is decentralized, sometimes you can find the same commodity at a different price. If, for example, you do arbitrage triangles, you can find differences in the exchange rates. Each bank you visit will offer slightly different prices.
Contracts for the Commodity
Boiled down, the forex market is a market of buying contracts on the commodity. This means you’re not actually going to hold the asset of the currency. For example, if you’re doing a trade of buying 100,000 euro paid with dollars, you won’t actually own 100,000 euros. You will own the contract of that sum.
When you sell back the purchased contracts, you get the difference of the price of that contract. Let’s say the contract cost you x and now it costs x+1 your delta will be earning 1 on that whole trade.
This is totally different from buying stocks or company shares where one exchange manages this trading facility. When you buy apple shares for example, you buy ownership into apple as a shareholder.
So, when you trade forex, you’re actually trading this market in order to make profit off of expected price moves based on the relationship between two currencies. But at any given time, you’re not entitled to contact the exchange and ask for a truck full of currency because you’re not actually holding assets, just a contract with a broker.
Finding a Reliable Broker
Having a contract with a broker means your broker should be reliable enough to give you the right price and to respect your holding of the contract. In the past few years, new regulations on trading have been put in place to make sure brokers honor their commitment to you in a fair and decent way.
Leverage, Leverage, Leverage
Because you’re trading for differences in the contract price, it means you can also get a ton of leverage. Most brokers will give you more value to the assets than you actually have. This means you only have to deposit a fraction of the money to the broker with the agreement that once your investment is worth less than the security you deposited, they will automatically return the contract back to you
This means you have almost unlimited leverage to buy any contract. For instance, with a 100 to 1 leveraged account, you can deposit $1000 in securities and be able to buy $100000 worth of contracts. The agreement will be that as long as the difference is not bigger than the $1000, you can have the trade running. If the difference goes higher, the broker will automatically return the contract to you and take the deposit.
This massive leverage is a big advantage when you’re trading for contracts, not assets like in the stock market. As we mentioned earlier, with stocks if you want to buy something, you have to bring the same amount to deposited.