Investing Basics: Forex

[MUSIC PLAYING] The foreign exchange,or forex market, is the world's largestfinancial market, and it plays a vital rolein the global economy.

Every day, trillions of dollarsare exchanged from one currency to another.

This kind ofcurrency exchange is essential forinternational business.

Forex marketparticipants include governments, businesses,and of course, investors.

Governments use the forexmarket to implement policies.

For example, when conductingbusiness with another country, whether it's borrowing money,lending money, or offering aid, a country needs toconvert its currency into a foreign currency.

Businesses use the forexmarket to facilitate international trade.

For example, they mayneed to convert payments for goods and servicesbought overseas, or to exchange paymentsfrom international customers into their preferred currency.

And investors use theforex market to speculate on changes in currency prices.

Currency prices change almostconstantly during the week, because the forex market isopen continuously from Sunday at 4:00 PM until Fridayat 4:00 PM Central Time.

A trading day starts at 4:00PM and ends at 4:00 PM Central Time the following day.

The market has to be openaround the clock because of the global natureof the economy.

Let's go over some basicsof how trading forex works.

When you trade forex, you'renot just trading one product, you're trading two currenciesagainst each other.

This is known asa currency pair.

The quote for aforex currency pair defines the value of onecurrency relative to the other.

The easiest way tounderstand any quote is to read the pairfrom left to right.

Let's look at an example ofusing the euro versus the US dollar currency pair.

If the EUR/USD istrading at 1.

20, that means 1 euro isequal to 1.

20 US dollars.

Here's another exampleof using the US dollar versus the Canadiandollar currency pair.

If the USD/CAD istrading at 1.

25, that means 1 US dollar isequal to 1.

25 Canadian dollars.

Even though there aretwo currencies involved, the pair itself actslike a single entity.

It's similar to astock or a commodity.

And just like whentrading stock, investors profit when they buya currency pair and its price increases.

Investors can also profit ifthey sell or short a currency pair and the price decreases.

Let's look at an example.

Suppose an investor who thinksEurope's economy is going to grow faster than the UnitedStates, and as a result, she thinks the euro willstrengthen against the US dollar.

She can buy the euroversus US dollar pair to speculate on her assumption.

If the price of the currencypair rises, she'll make money.

Conversely, if the price falls,she'll experience a loss.

Now that we'vecovered the basics, let's look at a few keyaspects of the forex market.

We'll start with margin.

When you trade onmargin, you only need to put up a percentageof the total investment to enter into a position.

This amount is known asthe margin requirement.

When you trade other securitieslike stocks, trading on margin means you're borrowingfunds from your broker.

However, forextrades can only be covered using funds in theinvestor's forex account.

Investors can't borrow fundsto enter a forex trade.

If they don't have fundsin their forex account, they need to transfer fundsbefore placing a trade.

Forex margin requirementsvary depending on the currency pairs and the size of a trade.

Currency pairs typicallytrade in specific quantities known as lots.

The most common lot sizesare standard and mini.

Standard lots represent100,000 units, and mini lotsrepresent 10,000 units.

Depending on yourbrokerage firm, you may also be able to tradeforex in 1,000-unit increments, also known as micro lots.

Margin requirements can beas small as 2% of a trade or as large as20%, but the margin requirement for most currencypairs averages around 3% to 5%.

To understand howmargin is calculated, let's look at an example usingthe euro versus US dollar pair.

Say this pair wastrading at 1.

20, and an investor wanted to buy astandard lot or 100,000 units.

The total cost of thetrade would be $120,000.

That's a lot of capital.

However, the investor doesn'thave to pay that full amount.

Instead, she pays themargin requirement.

Let's say the marginrequirement was 3%.

3% of $120,000 is $3600.

That's the amount the investorneeds in her forex account to place this trade.

This brings us to another keyelement of the forex market– leverage.

Leverage enables investorsto control a large investment with a relativelysmall amount of money.

In this example, the investoris able to control $120,000 with $3600.

The leverage associatedwith currency pairs is one of the biggestbenefits of the forex market, but it's also one ofthe biggest risks.

Leverage givesinvestors the potential to make large profitsor large losses.

One more important element inthe forex market is financing.

This is the calculation ofnet interest owed or earned on currency pairs,and it happens when an investor holds aposition past the close of the trading day.

The US dollar is associatedwith an overnight lending rate set by theFed, and this rate defines the costof borrowing money.

Similarly, each foreign currencyhas its own overnight lending rate.

Remember, when youtrade a currency pair, you're trading two currenciesagainst each other.

Even though the currency pairacts like the single entity, you're technically long onecurrency and short the other.

In terms of financing,you're lending the currency that you're long and borrowingthe currency you're short.

This lending and borrowingoccurs the overnight lending rate of eachrespective currency.

In general, an investorreceives a credit if the currency he has longhad a higher interest rate than the currency he is short.

Conversely, aninvestor is debited if the currency he is longhas a lower interest rate than the currency he is short.

Let's look at an example.

Suppose an investorhas a position in the Australian dollar versusthe US dollar currency pair.

Say the overnight lending ratefor the Australian dollar is 2% and the overnight lendingrate for the US dollar is 1%.

The investor is longthe currency pair, which means he is longthe AUD and short the USD.

Since the AUD has a higherinterest rate than the USD, the investor willreceive a credit.

However, if the investor wasshort the AUD/USD currency pair, he'd have to pay thedebit because he's short the currency that hasa higher interest rate.

Financing is performedautomatically by your brokerage firm.

However, it'simportant to understand how it works and itsfinancial impact on the trade.

We've reviewed just a fewelements of the forex market.

As with all investmentopportunities, the forex market has a uniqueset of risks and benefits, and education is the firststep to determine if this is the right opportunity for you.

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Source: Youtube

Investing Basics: Forex

Every day, trillions of dollars are traded on the forex market, which influences other asset classes. To get a big picture of the global economy, learn more about how currencies are bought and sold on the largest financial market in the world.