April 14, 2021 | by sandeep
What is a Forex Trade?
Let’s imagine a Forex trade in everyday life.
While on holiday, we visit the foreign exchange booth and carry out a foreign exchange transaction.
For example, if we were to come from Europe and we are traveling to, say, Florida to take the kids to Disney World, we would need to find a currency exchange booth perhaps at the airport or hotel to exchange our euros or pounds to US dollars so we can spend freely at the resort. This process of exchanging our local currency is known as a foreign exchange transaction.
For some reason, people find the concept of selling euros and buying US dollars (or the idea of buying money) a little difficult to grasp. Obviously, we are used to buying goods. We sell our money for goods; we sell euros and we buy a toaster oven.
In foreign exchange, we sell our money and we buy a different type of money. The concept is the same if we use our bank, credit card or phone to pay.
An Example of How the Forex Market Works
Let’s say we’re at the exchange booth and the exchange rate is 1:10. So that’s Eurodollar. That means one euro gets us one dollar and ten cents or $1.10. So, we trade and exchange 100 euros. We’ve now got 110 dollars.
We know it is not real but, let’s just say, we didn’t spend any money on that holiday. It’s unlikely we went to Florida with only $110 in the first place. But, just for this example, after the holidays, we come back to the airport with our $110 and we want to convert it back to 100 euros.
However, we notice now that the exchange rate has changed. It’s gone to one to one or 1:1 instead of 1:10. We had exchanged 100 euros and received $110. So when we change the $110, it is now worth 110 euros. We’ve made 10 euros. It’s this change in the exchange rates that make us lose or make money in the Forex market.
US Dollar vs. Yen (or Any Other Currency)
Notice that we are talking about the euro and the dollar. We’re always talking about two currencies, never just one. Currencies are traded in pairs. So, if we just bought a dollar, how are we going to pay for it? In euros, in yens, in Mexican pesos?
If we are selling the euro to buy the dollar, we have to sell one currency to buy another currency. It’s a little bit like when we buy that bottle of water; we also sell our currency in exchange for water. So, in trading Forex, we are selling one currency to buy a different kind of currency.
Immediately, we realize that we not only need to pay attention to which currency we wish to buy but we also want to find one to sell. It’s essentially a strong versus weak scenario.
So, if we want to buy the US dollar because we think the dollar is going to strengthen, we now have to decide which will be the weak currency to sell against that dollar.
With the dollar-yen example, buying dollar-yen means we are buying dollars because we believe the dollar will go up and we are selling yen because we feel the yen will be the weaker currency.
So, in Forex, we do this sort of matching where we match currency pairs, strong versus weak.
What Makes a Currency Strong or Weak?
What gives a currency strength? What makes it weak?
There are a number of things that influence these strong versus weak outcomes in currencies.
When there’s trade between two different countries, that can be a huge factor.
So, let’s say a lot of people want to start buying goods and services from the United States, they’re going to need to pay for them in dollars. Therefore, the demand for dollars will go up and they can expect the US dollar to strengthen. And that’s why as currency traders, we need to have a very good understanding of the economy that we are looking to trade. It’s important to measure that economy so that we can anticipate benefits before they happen and plan for this.
Another big influence on currencies is interest rates.
If we own currency, then we receive interest on that currency. Let’s say we have a lot of money in Japan and we decide we are not benefiting from the interest rate in Japan. So we transfer our money to the US where they’ve got a better interest rate.
In the US, they use dollars as a currency denominator. Hence, we have to exchange our yen to dollars to earn that higher interest rate. That would mean an increase in the demand for dollars and a decrease in the demand for yen. So, the interest rate of a country may be a reason why money is attracted to that country.
Inflation also has a huge effect on the strength and weakness of a currency.
Inflation measures price rises in an economy. If inflation is high, we see rapid increases in prices at the supermarket or for services. This is something a country’s Central Bank will be monitoring closely. Anything the Central Bank is looking at or is interested in, then we, as currency traders, have to be interested in as well. Central Banks monitor inflation. If they think it’s too high, they usually raise interest rates. This is one of the ways Central Banks combat inflation.
Lastly, we’ve got politics.
Unfortunately, we will also have to pay some attention to politicians, which for many of us is a bit of a negative side to being a currency trader. We’ve got to listen to politicians. We have got to pay attention to elections because this is where government policy, war and the overall outcome for a particular economy is defined.
These are all risks that we need to take into account when forming our trading strategies and they’re all factors that make the currency of any particular country move one way or another.
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