What makes the world go round? Well, it’s certainly not “love” as you might have thought, but trillions of currencies.
All that transactional volume ($5 trillion to be exact) has created a market that you’re probably eager to learn about -- that’s why you’re here.
And you made the right choice because this article will explain all the basic stuff you need to know to get an idea about how currency trading works.
What is the currency market?
History can tell you that the exchange of goods in the past had taken different forms and with astounding creativity.
In grade school, your teacher had probably taught you about barter, which doesn’t resemble the embodiment of money represented by today’s fiat currency.
Because with barter, people exchanged things for other things, apples for oranges, or livestock for poultry — whichever the case may be.
Then there were gold coins, seashells, and eventually paper money.
These earlier versions of currencies provided a systematic way of trading as opposed to bartering: it assigns a widely accepted monetary equivalent to goods.
The fiat currency is a combination of the earlier forms of money, but with the addition of a digitized version — think of transferring money through the internet or purchasing online.
Also, each country has its own currency except for those that adopt the currency of another country, like Ecuador, Zimbabwe, British Virgin Islands, and some others that use the US dollar.
And since the value of currencies fluctuates relative to others thanks to the abolition of the Bretton Woods Agreement, traders have a global playing field for haggling over price differences, thereby creating a market.
Who participates in the currency market?
Now, a market can't exist without participants who partake in the exchange of something. For example, the fish market’s participants are fishermen, vendors, and fish buyers.
In the currency market, the primary participants are the central banks of the world. The ones that follow are commercial banks, multinational corporations, fund managers, and retail traders.
How do the participants affect the currency market?
Central banks can curtail or increase the production of their country's currencies by raising or lowering interest rates -- they can also just create money out of thin air by making an accounting entry to their balance sheet.
Central banks like the Federal Reserve can also load up on currencies other than the US dollar for different purposes.
But the most common rationale for the Fed to stock up on foreign currencies is to be able to meet obligations if something undesirable happens to the dollar.
Commercial banks take part in the foreign-exchange market by speculating on the price movements of currencies to make a profit.
There are assigned Forex traders in banks who take on significant positions in the global platform for currency trading.
MNCs or companies that have global operations affect the flow of currencies through repatriation and international trade.
When MNC’s send the profits made overseas back to their home country, there is a conversion risk.
The bottom line of a corporation could report a lower figure due to fluctuations in currency rates.
As a countermeasure, companies may use a hedging tool by purchasing a currency forward, which is essentially a contract that guarantees a specific exchange rate for a future transaction.
International trade affects currencies through imports and exports. Tesla, for example, imports auto parts from a company in China. What Tesla pays the Chinese company is not the dollar but the yuan.
Fund managers, specifically those who work for hedge funds, are also one of the players in the Forex market.
They play their part by also speculating on the currency price movements for a profit.
Lastly, the retail traders (or aspiring traders like you) make up for the smallest volume of trades from the group.
When you start trading currencies, you somehow impact prices even for a minuscule capacity.
How it ties in to the value of currencies?
Now, all those participants affect the daily ups and downs in price movement by influencing supply and demand.
For instance, if the Fed raises its rates, the US dollar can become more attractive, especially against the currency of a country with a lower interest rate.
You see when traders can get a better yield from the dollar, they can borrow in another currency, say the Euro, to purchase the dollar and reap its returns (also known as the carry trade).
Raising rates would also make people want to borrow less, which decreases the money supply. Conversely, money supply goes up if rates are lowered since people would be more encouraged to borrow.
Stocking up and Trading
And as mentioned earlier, when central banks pile up foreign exchange reserves, the effect is an increase in demand for a particular currency.
On the commercial banks and hedge fund side of things, prices can swing aimlessly in a minute if these big players execute large orders in reaction to news or economic data.
While retail traders can react similarly, the likely impact may not be as pronounced as the banks and fund managers.
A more subtle influence on the demand and supply of currencies and without any particular attention to the underlying fundamentals of a country is through the mere act of exchanging currencies for international travel.
Trading currencies to make money
Now, you understand who participates in Forex trading and how each of them affects the value of currencies.
But what's in it for you?
You came here because you wanted to learn how to make money in Forex.
So, how does that work?
As mentioned earlier, you are classified as a retail trader, and in a general sense, you are part of the market that trades on a lower scale.
And trading currencies is afforded to you by a Forex broker.
Forex brokers give you the platform so you can participate in trading currencies.
By opening an account with a broker, you get access to multiple financial products that you can trade.
You are also given access to a trading platform wherein you can place your trades.
How to do currency trading?
Once you have an account in place, what you aim to do is take a position in particular currencies.
Since you're now aware that the value of one currency doesn't remain the same, especially when contrasted with another currency, your goal is to profit from by taking a side: BUY or SELL.
Now, as you gain more experience, you will become more in tune with BUYING and SELLING mechanics.
But for the purpose of simplification, you BUY a currency when you expect it to appreciate in value over another, and you SELL it when you think it's poised to go down.
You then place these orders on your trading account that you opened with your broker.
And, your job after that is to monitor how your trade goes.
If you predicted right, you gain a profit, and if you predicted wrong, you lose some of your account balance.
Everything may still be confusing to you at this point, so the best thing to do is to continue learning and become well-versed in the subject before you engage yourself in the activity.
When you feel that you have adequate knowledge, don’t expose real money right away.
Most experienced traders advise newbies to trade as much as they can with a demo account until profitability is consistent.
A good three to four months of simulated trading would do a trader well in the long run.