Trading currencies online through the Forex market can be fascinating and frustrating at the same time. For those who take the time to understand the currency market and learn to predict future exchange rates with reasonable accuracy, being right on the direction of prices provides mental and financial satisfaction. For those who approach it from a gambler’s perspective, constant bafflement, along with losing trades will be the probable outcome.
Forex Basics: The Currency Pair
Forex Brokers combine two currencies in what is called a currency pair. Two examples are EUR/USD for euro compared to United States dollars and AUD/USD for the Australian dollar compared to the United States dollar. One unit of the currency pair EUR/USD equals one euro (EUR) and one U.S. dollar (USD). One unit of AUD/USD equals one Australian dollar plus one U.S. dollar. Forex brokers combine many different currencies into pairs, with some brokers offering traders as many as 200 different pairs.
Understanding Forex Quotes
In the currency pair AUD/USD, the Australian dollar is known as the front currency or the lead currency. The USD in this pair is called the quote currency. For example, if a broker was showing the value of the AUD/USD currency pair as .7258, it means that the Australian dollar is worth about 72 cents in the USD. Someone with Australian currency wishing to purchase U.S. currency would pay about $1.34 AUD. Currency exchange rates fluctuate constantly during the course of a day. At times, the fluctuation can be quite dramatic and at others, rather sedate.
Mechanics of a Forex Trade
A trader thinking that the value of the Australian dollar would rise compared to the dollar would instruct the Forex broker to buy the pair, which is called going long. If the trader wanted to trade 1000 units, the broker would simultaneously buy 1000 AUD for the trader whilst simultaneously selling 1000 USD. If the Australian dollar does indeed gain value compared to the United States dollar, the trader makes a profit. The trader realises a loss if the Australian dollar drops in value. Traders can take the opposite position, called going short, by instructing the broker to sell 1000 units of the pair, resulting in the simultaneous selling of 1000 AUD and the purchase of 1000 USD. The profit/loss scenario is the exact opposite to that for going long.
Understanding the Different Types of Forex Brokers
There are two primary types of Forex broker: the market maker and the Electronic Clearing Network (ECN) broker. There are also brokers that form a hybrid of sorts, combining elements of both types. The market maker participates in all trades initiated by its clients, automatically taking the opposite position from that of the trader whilst taking a fee known as the spread for its services. Multiple clients with differing opinions on currency pair direction means that a market maker broker will carry both long and short positions simultaneously. The ECN broker, on the other hand, does not participate in trades; it simply matches traders wanting to go long with traders wanting to go short, charging a commission for its services. Retail forex traders often feel that ECN brokers, such as AlfaTrade, represent a better choice since there is no conflict of interest.
This brief discussion of four elements of Forex trading and currency rates is far from comprehensive. Those considering online currency trading need to consider many other facets, such as leverage, margin, fundamental and technical analysis and many other aspects of currency trading. Fortunately, Forex brokers offer simulated trading accounts to facilitate this process and even currency traders with years of experience often continue to use simulated trading to expand their knowledge base and test trading strategies.