You have been introduced to the Forex market in our last blog post. Now, you know how huge it is and what is traded. I expect that you are already excited about the prospect it holds. Indeed, the Forex market is full of opportunities for virtually everyone, irrespective of background. However, the fact is this: most lose in it. Why is this so?
To succeed in any trade, there is a need for discipline and an understanding of its basics. Forex Trading is not an exception. In fact, the reason many Forex traders lose money can be largely attributed to their denial of that fact. Most retail traders of Forex just lack a basic knowledge of it.
Therefore, it is important that Forex traders, both the aspiring and existing ones, take the time to learn about the trade while developing the much-needed discipline along the way. To that end, here are some of the basics of Forex Trading that you need to know.
What is Forex Trading about? Currencies. As explained in the previous post, it is the buying and selling of currency pairs to profit from the fluctuations in their exchange rates. Thus, when you buy one currency, you have to sell another at the same time.
Those currency pairs have been grouped into major, minor, and exotic pairs. The classification is based on the USD and the frequency of trading of the pairs. Thus, the major currency pairs, known as the majors for short, are those that contain the USD and are the most widely traded of all.
As a result, they are the most liquid of their peers. They are:
Minor pairs, also known as cross-currency pairs, are the currency pairs that do not have the USD. Even though they also enjoy substantial trading volumes, they are far less frequently traded than the majors. However, the most widely traded of them are those derived from the three popular currencies, the EUR, GBP, and JPY.
Exotic pairs are made up of the major, popular currencies and the currencies of any of the relatively unpopular and emerging economies of the world. USD/BRL (the United States Dollar/Brazilian Real) and USD/MXN (the United States Dollar/Mexican Peso) are two notable examples of them.
The less frequently a currency pair is traded, the more the associated trading costs will be. Hence, exotic pairs attract the highest costs to trade. Also, the risk that comes with trading them is high. But their huge day-to-day price fluctuations present substantial opportunities for gains. In terms of trading costs, exotic pairs are followed by the minor pairs. The majors, being the most extensively traded, have the lowest transaction costs of all.
You should have noticed that there is a conventional way by which currency symbols are written. The first two letters of each identify the country or zone, while the last letter represents the currency itself. For example, in AUD, the AU is the country (Australia) while the D is the Dollar.
Nowadays almost any individual can freely access the foreign exchange market. This is due to Margin Trading which is a allows Forex traders to deposit only very small amounts of capital to be able to open and maintain positions.
That “small amount of capital” is known as Margin. Imagine you want to buy a house of $100,000 and the realtor requires you to make a deposit of just $10,000 first. Margin is like that, too. It is the deposit held in good faith by your broker that enables you to open positions and keep them open.
Two terms have to be defined as far as Margin Trading is concerned. They are Margin Requirement and Required Margin. Margin Requirement is the portion, expressed as a percentage, of the position size you want to open. Required Margin is simply the monetary equivalent of that.
Margin Requirement, however, varies with different brokers and currency pairs. As a result, you may see it ranging from as little as 0.25% to as high as 12% or more. For example, EUR/USD and GBP/USD have margin requirements of 2% and 5% respectively. On USD/JPY it is 4%.
Assuming you want to buy 10,000 units of the USD/JPY pair on your USD-denominated trading account. Without margin, you will have to put up $10,000, which is the full value of the position you want to open. However, with a margin account, you will need just (4% of $10,000 = $400) to open your desired position.
The use of leverage is all around us. Companies, for example, use it to optimise their operations and generate more value for their investors. It occurs in Forex too, as a provision by brokers that make it possible for traders to control large amounts of money by depositing only a little of their funds.
Summarily, leverage is the ratio between your deposited amount, the required margin, and the larger position you wish to trade.
This is how it works. Imagine you want to open a $50,000 trade but you cannot come up with the entire $50,000 capital yourself. You can deposit as little as $500 and then opt for a leverage of 1:100. With this, you will not only be able to control the desired position, but you will also have the potential to increase your gains.
Hence, with a decent strategy, you could make as much as 100% in return by entering that position with leverage. However, you should be careful. The cliché “leverage is a double-edged sword” is a truth. That is, as leverage can result in substantial returns so can it result in tremendous losses for you.
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Besides currency pairs, margin, and leverage, there are more Forex basics you should grasp and incorporate into your trading arsenal. You should watch out for our next post for them!