Foreign Exchange, FX or forex for short, is the buying and selling of currencies. The forex market is traded 24 hours a day, 5 days a week with an extraordinarily large liquidity traded daily at over 4 trillion dollars exchanging hands every day. Forex offers high leverage, liquidity, and is the largest OTC exchange-free trading market. Forex CFDs are exciting and offer traders excellent opportunities. There is some terminology and basics to learn about forex itself first.
In forex, currencies are quotes as pairs. AUD/USD is the amount of American dollars required to buy Australian dollars. The first listed currency, AUD, is referred to as the base currency. Suppose AUD/USD is quoted as 0.9500. This means 95 American cents are needed to purchase 1 Australian dollar.
Currency movements are measured with pips. A pip is 4 decimal places to the right (the exception is USD/JPY, where 1 pip is two decimal places, or 0.01). For example, if a currency moves from 0.9500 to 0.9501, it has increased by 1 pip. Currency movements are small. Therefore, the forex industry offers traders very high leverage (limited by local regulations) to realize higher gains. At the same time, higher leverage may also mean higher losses.
EUR/USD (Forex) Trading Example
This example illustrates how to trade CFDs based on currencies. Market downturns are not necessarily a bad thing since it is possible to make a profit during falling markets. This is referred to as a short trade and is the opposite of a long trade (where you buy low and sell high). For example, you expect Euro to weaken (euro depreciates) against the Dollar and you decide to sell (go short) 2 CFDs at 1.5020. Assume the euro weakens against the Dollar and when it reaches 1.4860 you decide to cash in on your profits. The new bid-ask price is 1.4857/1.4860 and you buy back 2 CFDs at 1.4860.
You sold at 1.5020 and bought back at 1.4860, a fall of 160 points (or pips), which at 2 CFDs net a profit of £320 (1.5020 – 1.4860 x 2 CFDs). If however, the Euro appreciated and rose to 1.5180, you would have posted a £320 loss.
Forex traders should be aware of the most commonly traded currency pairs, called the majors. These are the most liquid and popular currencies that are traded daily. Most of these pairs involve the US dollar. EUR/USD is the most traded currency pair worldwide. Other common pairs include GBP/USD, AUD/USD, NZD/USD, USD/CAD, and USD/CHF.