We have all heard the term “Forex” mostly while travelling to different countries. So why is this term so important? Foreign Exchange abbreviated as “Forex”, has been extensively used exactly for the purpose contained in the word – Exchange, exchange of currencies.
Exchange can be used synonymously with the word ‘Conversion’ when talking about Forex. For example, if you are travelling from India to the USA, you will convert the Indian Rupees to US Dollars through the Foreign Exchange Market as the Indian Rupees will not be a valid currency in the USA.
Foreign exchange is required and used due to the fact that different countries have different currencies. But was it the always the same? Let us delve a bit into the history of Forex to find out how it came into existence.
History of Forex
We have come a long way from the previously practised barter system to the modern day system of trading currency. Following is a brief summary of the evolution of currency and how it gave rise to Forex Trading. It can be illustrated as follows:
To explain this briefly,
- The Ancient system of Trading – Trading with Gold
- Bank Notes Originated – Deposited Gold in banks in exchange for bank notes
- Role of Geography – Various banks of different regions printed different currencies
- Gold Standard – Currency pegged to gold
- Bretton Woods System – Currency pegged to USD
- Birth of Floating Currency – Currency which is not pegged to any assets or other currencies is known as a ‘floating currency‘.
You can read more about the evolution of Trading here: The Evolution Of Trading
Why is there a need for different currencies?
From the above diagram, we have seen the evolution of currencies into floating currencies.
But why do we need different currencies at all?
Why can’t there be just one currency across the globe?
Let me explain to you a few of the reasons for this diversity in terms of currency. The first problem will arise due to the necessity of a single organization to regulate, manage and print the currency, which will also mean that there will be just one single monetary policy for all the countries thus restricting the countries to make any changes to it for the economic growth of a country. Another problem would be that any adverse economic events in a country will have a global effect as it will affect the common currency of the world.
What is the Foreign Exchange Market?
The difference of currencies across the world has given rise to the Foreign Exchange Market which acts as a platform for trading currencies across the globe. Amsterdam established the first Foreign Exchange Market. Buying, selling and converting currencies can be done through the Foreign Exchange Market. It also displays the exchange rates for different currencies. Foreign Exchange Market is the most liquid market due to the huge trading volumes which reach more than a Trillion Dollars per day, and it also operates 24 hours a day except weekends thus easing the process of trading across the world.
What is Forex Trading or FX Trading?
Forex is not just limited to converting currency for travel or other purposes, but it has paved its way into the world of trading, and in such a way that, today, the Foreign Exchange Market is the most traded financial market in the world and US Dollars (USD) is the most traded currency in the Foreign Exchange Market. Forex Trading is the process of buying and selling of currency pairs in order to gain profits from the fluctuations in the currency prices occurring due to various economic and political events. Factors such as revising of interest rates, publishing of the financial reports, inflation rates in a country, etc. affect the rates of the currency. For example, a currency may appreciate or increase in value if the interest rates are increased and vice versa.
In Forex Trading, the values of currencies are quoted in pairs, also known as currency pairs, which demonstrate the value of a currency against the value of another currency, for example, EUR/USD = 1.1546 is the value of the Euro expressed in USD. Some of the most widely traded currency pairs are as follows:
These currencies can be traded in different contract sizes or lots. A lot size may vary based on the exchange you are trading in or for the currency you are trading. For example, 1 lot maybe equal to 100,000 units. Here, the units will depend on the base currency, which is the first currency in a currency pair. For example, if 1 lot equates to 100,000 unit and you wish to trade the EUR/USD pair, then EUR will be the base currency, that means if you wish to buy 100,000 Euros, you are actually buying one lot. Similarly, 500,000 Euros will be equivalent to 5 lots. 700,000 Euros will be equivalent to 7 lots and so on.
Terminologies used in Forex Trading:
Let’s understand the terminologies used in Forex Trading by using a Forex Quote from the Foreign Exchange Market. Let’s consider the EUR/USD as an example to understand the terms.
EUR/USD = 1.1532/1.1539
Base Currency = EUR
Quote Currency = USD
Bid Price = 1.1532
Ask Price = 1.1539
The Bid and Ask quotes that you come across are from the perspective of the forex broker, not yourself. You’ll find that banks and Financial Institutions (like HSBC, Citigroup, ICICI Bank, etc.) act as brokers for transacting in forex.
What is Bid Price in Forex Trading?
Bid Price is the price at which a forex broker is willing (or ‘bidding’) to buy Euros. So if you intend to sell Euros, you would be able to do so at a price of USD 1.1532 per Euro.
What is Ask Price in Forex Trading?
Ask Price is the price at which a forex broker is willing to sell ( the broker is ‘asking’ for the said price while selling) Euros. You can choose to buy Euros from the broker at a price of USD 1.1539 per Euro.
What is Bid-Ask Spread in Forex Trading?
The difference between ask and bid price is known as Bid-Ask Spread.
Bid-Ask Spread = Ask Price – Bid Price
The quotes can also be represented using a single value in the Foreign Exchange Market, for example, EUR/USD = 1.1536, in this case, ‘1.1536’ denotes the price at which the pair was last traded.
The above quote can be interpreted as, “1 Euro is equivalent to 1.1536 USD”, that means you have to pay 1.1536 USD to buy 1 Euro.
What is a Pip in Forex Trading?
Pip represents the smallest change in a value. Usually, values are quoted up to the fourth decimal place. And the fourth digit after the decimal point is known as the Pip. Let us understand the concept of a pip using the previous example:
EUR/USD = 1.1536
Here, ‘6’ represents the Pip value. Now, if the value of the EUR/USD pair rises to 1.1539, we can say that the value has changed by 3 pips.
Change in Pip = 1.1539 – 1.1536 = 0.0003
Similarly, if the price further rises to 1.1550, then we can say the price has increased by 11 pips.
Change in Pip = 1.1550 – 1.1539 = 0.0011
This is true in most of the cases in the Foreign Exchange Market; however, there is an exception to this concept while trading the Japanese Yen, in which case the second digit after the decimal point is considered as the pip because the values are quoted up to the second decimal point in the Foreign Exchange Market. For example, USD/JPY = 110.92, here 2 will be the pip value and if the price rises to 110.97, then there will be a change of 5 pips.
What is Leverage in Forex Trading?
Leverage is widely used in forex trading and in the Foreign Exchange Market, to maximize the profits even with little change in the pair value. As we know, the forex values don’t undergo drastic changes in value which in turn requires us to invest a higher amount so as to maximize profits from our trades. But, investing such a high amount in the Foreign Exchange Market isn’t always feasible and that’s where leverage comes into the picture. Leverage allows you to place large amounts of trade even with a smaller amount and they are often denoted as a ratio. For example, a 20:1 leverage ratio will let you place a trade for $20000 by only investing $1000.
How does Forex Trading work?
Now that you know about the terminologies used in Forex Trading, let us understand how Forex Trading actually works in the Foreign Exchange Market.
How to calculate profit/loss in Forex Trading?
Profit/Loss in Forex Trading = Change in Pips x No. of Lots x Value of Pip per Lot
Here, the value of pip per lot is generally 10 per Lot, but may vary according to the currency being traded.
Example of Forex Trading
Let us consider an example to understand how trading takes place in the Foreign Exchange Market.
Suppose, you are of the opinion that the Euro will appreciate against the USD and hence want to buy 1 Lot ($100,000) of the EUR/USD pair whose current value in the Foreign Exchange Market is:
EUR/USD = 1.1533
Now, you decide to use a leverage of 100:1, that is, for trading 1 Standard Lot, you will be required to invest only $1000.
Let’s assume that your prediction came true and the Euro became stronger against the USD and hence the value of the EUR/USD pair went from 1.1533 to 1.1583. Now, let’s calculate your profit in this case as per the formula discussed earlier:
Profit = Change in Pips x No. of Lots x Value of Pip per Lot
In this case,
Change in Pips = 1.1583 – 1.1533 = 0.0050 which means there was a change of 50 pips.
No. of Lots = 1 since we used 1 Standard Lot ($100,000 = 1 Standard Lot)
Value of Pip per Lot = $10 for a Standard Lot
Therefore, our formula can be used as follows:
Profit = 50 x 1 x 10 = $500
This means you have earned a profit of $500 by just investing $1000 but using a leverage of 100:1. That’s how leverage can help you gain immense profits by only investing a small amount in the Foreign Exchange Market. But, just as it can amplify the profits, it can lead to amplified losses too. Hence, the risk factor is extremely high while using a higher ratio of leverage in Forex Trading.
Imagine that value of the EUR/USD had gone in the opposite direction, that is, suppose it reduced by 50 pips. Then instead of the $500 profit, you would have incurred a $500 loss!
In this case, a leverage of lower ratio would have helped you minimise the losses in Forex Trading. Hence, choosing an appropriate and balanced leverage ratio is of utmost importance while Forex Trading in the Foreign Exchange Market.
Forex Trading is done on a huge scale across the globe due to its advantages which include the 24 hour/day market, the liquidity of the Forex market and the power of using leverage while trading thus enabling us to trade higher amounts with a lower capital. But, these advantages come with a greater risk in Forex trading which is why managing risk in Forex Trading is important.
Now that we aware of the basics of FX Trading, its time to learn it in more detail and understand how it can be implemented in Algorithmic Trading. One can learn to use Python to backtest their strategies, use momentum and fundamental factors which influence the forex markets to create new trading strategies in this course.
Disclaimer: All investments and trading in the stock market involve risk. Any decisions to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.