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Forex Trading : A Beginner Guide

 Forex is a portmanteau of foreign currency and exchange. Foreign exchange

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 is the process of changing one currency into another for a variety of reasons, usually for commerce, trading, or tourism. According to a 2019 triennial report from the Bank for International Settlements (a global bank for national central banks), the daily trading volume for forex reached $6.6 trillion in April 2019.1



KEY TAKEAWAYS

  • The foreign exchange (also known as FX or forex) market is a global marketplace for exchanging national currencies.
  • Because of the worldwide reach of trade, commerce, and finance, forex markets tend to be the largest and most liquid asset markets in the world.
  • Currencies trade against each other as exchange rate pairs. For example, EUR/USD is a currency pair for trading the euro against the U.S. dollar.
  • Forex markets exist as spot (cash) markets as well as derivatives markets, offering forwards, futures, options, and currency swaps.
  • Market participants use forex to hedge against international currency and interest rate risk, to speculate on geopolitical events, and to diversify portfolios, among other reasons.

What Is the Forex Market?

The foreign exchange market is where currencies are traded. Currencies are important because they enable purchase of goods and services locally and across borders. International currencies need to be exchanged to conduct foreign trade and business.f you are living in the United States and want to buy cheese from France, then either you or the company from which you buy the cheese has to pay the French for the cheese in euros (EUR). This means that the U.S. importer would have to exchange the equivalent value of U.S. dollars (USD) into euroshe same goes for traveling. A French tourist in Egypt can’t pay in euros to see the pyramids because it’s not the locally accepted currency. The tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate.

One unique aspect of this international market is that there is no central marketplace for foreign exchange. Rather, currency trading is conducted electronically over the counter (OTC), which means that all transactions occur via computer networks among traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centers of Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich—across almost every time zone. This means that when the U.S. trading day ends, the forex market begins anew in Tokyo and Hong Kong. As such, the forex market can be extremely active any time of day, with price quotes changing constantly.

A Brief History of Forex

In its most basic sense, the forex market has been around for centuries. People have always exchanged or bartered goods and currencies to purchase goods and services. However, the forex market, as we understand it today, is a relatively modern invention.

After the Bretton Woods accord began to collapse in 1971, more currencies were allowed to float freely against one another. The values of individual currencies vary based on demand and circulation and are monitored by foreign exchange trading services.

Commercial and investment banks conduct most of the trading in forex markets on behalf of their clients, but there are also speculative opportunities for trading one currency against another for professional and individual investors.

There are two distinct features to currencies as an asset class:

An investor can profit from the difference between two interest rates in two different economies by buying the currency with the higher interest rate and shorting the currency with the lower interest rate. Prior to the 2008 financial crisis, it was very common to short the Japanese yen (JPY) and buy British pounds (GBP) because the interest rate differential was very large. This strategy is sometimes referred to as a “carry trade.”

Why we can trade currencies

Currency trading was very difficult for individual investors prior to the Internet. Most currency traders were large multinational corporationshedge funds, or high-net-worth individuals because forex trading required a lot of capital. With help from the Internet, a retail market aimed at individual traders has emerged, providing easy access to the foreign exchange markets through either the banks themselves or brokers making a secondary market. Most online brokers or dealers offer very high leverage to individual traders who can control a large trade with a small account balance


An Overview of Forex Markets

The FX market is where currencies are traded. It is the only truly continuous and nonstop trading market in the world. In the past, the forex market was dominated by institutional firms and large banks, which acted on behalf of clients. But it has become more retail-oriented in recent years, and traders and investors of many holding sizes have begun participating in it.

An interesting aspect of world forex markets is that there are no physical buildings that function as trading venues for the markets. Instead, it is a series of connections made through trading terminals and computer networks. Participants in this market are institutions, investment banks, commercial banks, and retail investors.

The foreign exchange market is considered more opaque than other financial markets. Currencies are traded in OTC markets, where disclosures are not mandatory. Large liquidity pools from institutional firms are a prevalent feature of the market. One would presume that a country’s economic parameters should be the most important criterion to determine its price. But that’s not the case. A 2019 survey found that the motives of large financial institutions played the most important role in determining currency prices.

There are three ways to trade forex. They are the spot, forwards, and futures markets, as follows:

Spot market

Forex trading in the spot market has always been the largest because it trades in the biggest “underlying” real asset for the forwards and futures markets. Previously, volumes in the forwards and futures markets surpassed those of the spot markets. However, the trading volumes for forex spot markets received a boost with the advent of electronic trading and the proliferation of forex brokers.

When people refer to the forex market, they usually are referring to the spot market. The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.

How the spot market works

The spot market is where currencies are bought and sold based on their trading price. That price is determined by supply and demand and is calculated based on several factors, including current interest rates, economic performance, sentiment toward ongoing political situations (both locally and internationally), and the perception of the future performance of one currency against another.  

A finalized deal is known as a “spot deal.” It is a bilateral transaction in which one party delivers an agreed-upon currency amount to the counterparty and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present (rather than in the future), these trades actually take two days for settlement.

Forwards and futures markets

A forward contract is a private agreement between two parties to buy a currency at a future date and at a predetermined price in the OTC markets. A futures contract is a standardized agreement between two parties to take delivery of a currency at a future date and at a predetermined price.

Unlike the spot market, the forwards and futures markets do not trade actual currencies. Instead, they deal in contracts that represent claims to a certain currency type, a specific price per unit, and a future date for settlement.

In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves. In the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange.

In the U.S., the National Futures Association regulates the futures market. Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments that cannot be customized. The exchange acts as a counterparty to the trader, providing clearance and settlement services.

Both types of contracts are binding and are typically settled for cash at the exchange in question upon expiry, although contracts can also be bought and sold before they expire. The currency forwards and futures markets can offer protection against risk when trading currencies. Usually, big international corporations use these markets to hedge against future exchange rate fluctuations, but speculators take part in these markets as well.

Note that you’ll often see the terms FX, forex, foreign exchange market, and currency market. These terms are synonymous and all refer to the forex market.

Forex for Hedging

Companies doing business in foreign countries are at risk due to fluctuations in currency values when they buy or sell goods and services outside of their domestic market. Foreign exchange markets provide a way to hedge currency risk by fixing a rate at which the transaction will be completed.

To accomplish this, a trader can buy or sell currencies in the forward or swap markets in advance, which locks in an exchange rate. For example, imagine that a company plans to sell U.S.-made blenders in Europe when the exchange rate between the euro and the dollar (EUR/USD) is €1 to $1 at parity.

The blender costs $100 to manufacture, and the U.S. firm plans to sell it for €150—which is competitive with other blenders that were made in Europe. If this plan is successful, then the company will make $50 in profit per sale because the EUR/USD exchange rate is even. Unfortunately, the U.S. dollar begins to rise in value versus the euro until the EUR/USD exchange rate is 0.80, which means it now costs $0.80 to buy €1.00.

The problem facing the company is that while it still costs $100 to make the blender, the company can only sell the product at the competitive price of €150—which, when translated back into dollars, is only $120 (€150 × 0.80 = $120). A stronger dollar resulted in a much smaller profit than expected.

The blender company could have reduced this risk by short selling the euro and buying the U.S. dollar when they were at parity. That way, if the U.S. dollar rose in value, then the profits from the trade would offset the reduced profit from the sale of blenders. If the U.S. dollar fell in value, then the more favorable exchange rate would increase the profit from the sale of blenders, which offsets the losses in the trade.

https://www.investopedia.com/articles/forex/11/why-trade-forex.asp