- Foreign Exchange is an OTC market
- How Foreign Exchange Works
- Liquidity of Forex market
- Why currencies are paired one another in Forex market?
- Example of Forex trading – Buying GBP/USD
A term commonly used when referring to the foreign exchange market.
Foreign Exchange is an OTC market
Commonly referred to as FX, or Forex, is the world largest OTC market and one of the most popular trading instruments for CFD traders.
The Foreign Exchange markets are the world’s most liquid markets with global turnover in the trillions daily.
Foreign exchange markets operate 24 hours a day and only rest on weekends giving traders opportunity to trade whenever it suits them.
Online Forex brokers offer all global major currency pairs.
How Foreign Exchange Works
The concept of FX is that a trader will pick the performance of one currency and match it against another.
Hence every time you trade you will be long one currency and short another.
The first currency in the pair is referred to as the base currency and the second referred to as the quote/counter currency.
As an example let’s take a currency pair GBP/USD.
Here the base currency GBP is the Great British Pound and the quote currency would be the US Dollar.
If we thought that the Pound would strengthen against the US we would then purchase a quantity, let’s say £50,000 of GBP/USD in the hope that it goes up.
In this instance we would be long £50,000GBP and be short the equivalent in USD.
Liquidity of Forex market
The reason foreign exchange markets are so large and liquid is because of the market participants involved.
Major traders of FX include Institutional investors, Governments, Central Banks, Global Banks, Hedge Funds, Retails investors and other financial institutes.
Many online Forex brokers try to use some of the world’s largest liquidity providers to give their own clients access to these feeds with industry leading spreads.
Why currencies are paired one another in Forex market?
Often new traders struggle to grasp the concept of trading currencies in pairs.
“Why not just buy the Euro?” they might ask. Why does it have to be paired with the US Dollar?
The reason is that the currency on the right side of the pair is there to establish a comparative value.
Without it how could the base currency (currency on the left side of the pair) have any certain value?
In other words, if currencies were not paired, what would a single currency gain or lose value against?
By pairing two currencies against each other a fluctuating value can be established for the one versus the other.
Example of Forex trading – Buying GBP/USD
Here is an example of Forex trading online.
1. Opening the position
You decide to go long of the British Pound against the US dollar. Our quote is 1.5519-1.5521, and you will buy £20,000 at 1.5521.
The value of your position is £20,000 x 1.5521 = £31,042. To open the position there is a 1% margin requirement based on the full notional value.
Your margin requirement is therefore 1% x £31,042 = £310.42.
2. Interest adjustments
While the position remains open, your account is debited or credited to the current tom-next rate.
Tom-next is a market swap rate that expresses, in pips, the difference between the interest paid to borrow the currency that is being notionally sold overnight, and the interest received from holding the currency that is being notionally bought overnight.
3. Closing the position
As you predicted, GBP/USD later rises to 1.5721-1.5723, and you decide take your profits and exit the trade at 1.5721.
Opening transaction: £20,000 x 1.5521 = £31,042
Closing transaction: £20,000 x 1.5721 = £31,442
Profit on trade: $400
If the price had fallen to 1.5321 and the trade exited at this price then the trader would have lost £400.