20 May 2012
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Learn Forex
Understanding a Forex Trade
Learning to make money trading forex involves first understanding the fundamentals of a currency transaction.
What follows may seem somewhat basic to you by now, but these important concepts require mastery by anyone interested in profiting from trading forex.
Basically, understanding how a foreign exchange trade works represents the first step to trading currencies, and it will help eliminate any confusion when you are trading.
What is involved in a Forex Transaction
Despite this level introducing more advanced trading concepts, this section will be reviewing some of the more basic mechanics of forex trading in order to clarify the topics.
Foreign exchange trades involve a bit more than just buying a security which can later be sold. Forex transactions involve the simultaneous purchase of one currency and the sale of another, instead of just a straight purchase or sale of a specific financial instrument.
The exchange rate for a particular currency pair consists of the price of one currency expressed in terms of the other. The first currency named in the pair is referred to as the base currency. This represents the dominant currency, the value of which is rising and falling in terms of the value of the secondary or counter currency.
Currency Quote Examples
For example, when EUR/USD is trading at 1.2500 this indicates that the Euro is the base currency with the 1.2500 number indicating that one and one quarter units of the U.S. Dollar counter currency is needed for the purchase of one unit of the base currency. Therefore, it takes $1.25 USD to purchase one EUR.
Alternatively, when the U.S. Dollar is the base currency in a pair, then the exchange rate is expressed in terms of the counter currency. For example, when the USD/JPY exchange rate is quoted at 90.00, this indicates that it takes 90 Japanese Yen to purchase one U.S. Dollar.
Spot, Forward and Futures Deliveries
When a forex transaction takes place each party receives one currency and pays another on the agreed-upon delivery date. Also, the parties can agree to deliver the currencies involved in several different ways that might include:
- Cash: The simplest and fasted is cash on cash delivery. This is how you would exchange money at a bank or a currency exchange house when dealing in person, but transaction amounts are usually limited in size to what cash is on hand or to an amount that has been ordered in advance.
- Spot: Transactions in the spot market have a two business day settlement period except for USD/CAD which is one business day. Spot trades make up the largest percentage of currency trades, and the high liquidity of the spot market makes huge transaction amounts possible.
- Forward: Currency deals done for forward delivery dates are also known as forward outrights. They involve two parties contracting for the delivery of a currency at a specified price and future date that is usually further out than the spot value date.
- Futures: The last type of currency delivery is that which occurs in the futures market. Futures on currencies consist of standardized contracts that trade on a centralized exchange like the Chicago IMM and have set monthly or quarterly delivery dates.