Brief Synopsis of Forex Trade
Forex market is a relatively new trading platform that allows you to trade in currencies and commodities. Prior to the 1970s, trading in Forex was not possible. The reason was that most countries tied their currencies to the price of gold. The amount of gold reserves held by a country determined the value of the currency.
However, this changed in 1971 when President Richard Nixon abolished currencies in the Forex market. These commodities are assigned certain symbols to make it easy to identify them in the Forex market. For example, gold is given the symbol XAU, silver XAG, platinum XPT, palladium XPD, etc.
Forex trade involves the pairing of currencies. You can pair Gold (XAU) with any currency in the world. The order of the currency pair is important and that you should understand. It basically determines the position sought by investors.
Gold can be paired with currencies in the form of XAU/USD, XAU/EUR, USD/XAU, XAU/JPY, etc. The first currency in the pair is called the “base currency”. The second pair, on the other hand, is the “quote or reference currency”. When you buy a currency pair, you are buying the base currency. When you buy a currency pair, you are selling the first or base currency in exchange for the second currency.
There are two positions in buying or selling the currency pair. These are called “long” and “short” positions. Investors with long positions will buy a currency pair when they expect the currency pair will rise in value. Investors with short positions will borrow a currency pair from the Forex broker and eventually return the currency pair by buying it back from the Forex market and gaining from the drop in price.
As an example, suppose you decide to buy a gold and dollar currency pair (XAU/USD). Buying an XAU/USD currency pair means that you expect the gold value to rise in relation to the US dollar. When the value of gold rises, you would instantly sell the currency pair and gain from the trade.
Contrarily if you expect that XAU/USD pair will fall in value, you would borrow the currency pair from the Forex broker. When the value of gold falls in relation to the US dollar, you would buy the currency pair and gain from the decrease in value.
You should note that most online platforms offer gold currency pair in the format of XAU/XXX. You cannot buy gold currency pairs in the opposite direction. However, this arbitrary trading pair does not restrict any profit-making potential. You can buy the gold currency pair any time of the day and benefit from the trade.
Online Trading Hours
Gold Forex trading is available 24 hours per day with a break during the weekends. With the trillions of dollars of transactions happening in a day, the Forex trading platform is constantly active. You just require an internet connection to connect with the online trading platform and participate in the gold trade.
Leverage and Spread
Leverage means buying currency on credit with a small initial investment. It is the ratio of the invested amount to the value of currencies bought in the Forex market. Higher leverages entail great profit potential from the Forex trade. However, this also amplifies the loss in case of a fall in the value of the base currency.
For example, if you invest $2000 to buy a currency worth $200,000, you are making an investment with a leverage ratio of 100:1. If the base currency value rises, your invested amount will also rise by 100%. If the currency value falls, you have to bear the loss of 100% of your investment amount.
Contrarily, if you invest $150,000 to buy a currency worth $200,000, you are making an investment with a leverage ratio of 50:1. If the base currency value rises, your invested amount will also rise by 50%. If the currency value falls, you have to bear the loss of 50% of your investment amount which is much more bearable.
Normally, online Forex brokers implement stop-and-limit orders to limit the risk of loss of the investment. Stop order is buying or selling a currency pair when the value surpasses a certain level. Limit order, on the other hand, means buying or selling a set number of currencies only when the specified price is reached.
In 2010 < a href=”http://www.investopedia.com/terms/c/cftc.asp”>Commodity Futures Trading Commission (CFTC) limited leverage ratios of 50:1 on major currencies pairs (EUR/USD, USD/JPY, GBP/USD, and USD/CHF) and 20:1 on other pairs. However, Forex brokers outside the US still offer leverage ratios of 400:1 and higher.
Margins
Margin refers to money that is deposited in the Forex trading account. The leverage ratio determines how much margin is required to begin a trade. For example, if the margin account has a value of $1000 and leverage of 100:1, the trader can trade up to $100,000 in foreign currencies.
You should note that the amount of margin required for a currency pair increases or decreases with the rise or fall of the currency. This term is known as “marked to market”, which will have a noticeable effect on the account balance.
Pip (Percentage in Point)
Pip (Percentage in Point) is the smallest unit of price of any currency pair. All currencies in the Forex market except the Japanese Yen are expressed to the fourth decimal point i.e. 0.0001. Japanese Yen is the only currency where a pip represents the second decimal point i.e. 0.01.
So if the value of the XAU/USD pair increases from 1.0930 to 1.0931. This means that the currency pair has risen by 1 pips. However, for XAU/JPY to increase by 1 Pips, the currency pair has to rise from 1.09 to 1.10.
Bid and Ask Price
In Forex transactions, the bid price is the price at which you can sell a currency pair, while the ask price is the price at which you can buy the currency pair. Investors consider these the bid and ask prices when trading in the Forex market. When buying the currency they would look at the ask price. On the other hand, when selling the currency they would look at the bid price of the currency pair.
The bid/ask price is normally quoted as 1.0190/1.0195. The first quote is the bid price (selling price), while the second quote is the ask price (buying price).
The difference between the bid and ask price is known as the spread. So, in the above example, the spread is 5 Pips. Forex brokers set limits on the spread of the currency pair to minimize the loss from the trade.
Spot Market, Futures, and Forward Forex Markets
Spot Forex trade is the largest segment of the Forex market. It deals with the spot or current price of the currencies. Futures Forex market deals with standard currency contracts at a future date. While the Forward Forex market deals with custom-designed contracts at a future date.