Forex Trading, Brokerage and Key Aspects for Success

Forex in a Nutshell

The Foreign Exchange Market (hereon Forex Market) operates on the basis of speculating whether a certain currency will gain or lose value. People who buy or sell a certain currency is said to access the Forex market. It is decentralized unlike the regular stock market, meaning it does not operate through a specific location. The operation is usually undertaken by a forex broker and the forex brokers make money through commissions and fees which will be explained further below, allowing you to choose the most suitable broker for you.

Forex Brokers and How to Choose Them

A Forex broker takes orders from investors to buy or sell a chosen currency on the over-the counter (OTC) market; a market that is not subject to the same rules and regulations of regular financial exchanges or markets. There is no central control mechanism for this market so one must be careful that the counterparty does not default. In such dealings with a counterparty, the risk is that one party will not honor their obligation. Choosing a reliable broker would be essential for this.

So how does a Forex broker make money? A broker can make money by charging commission per trade or per spread or both. A spread is the difference between the price you will receive for selling a currency (bid price) and the price you will have to pay for buying a currency (ask price). If a broker is offering ‘commission free’ trade, it is likely that their profit stems from a wider spread on trade. The spread can be fixed or variable; a variable spread is heavily dependent on the market movement such as changes in interest rates. The broker can also have a different spread for buying and selling the same currency as they can set their own pricing. It is advised for investors to closely examine a brokers pricing strategy.

If you intend to use Forex in a way to provide a stable income, for instance if you are paid in a different currency than the one used in your home country, you can benefit from commercial Forex companies to make sure you receive the same amount every month. Forex companies, for a pre-set minimum contract amount, may offer you a customized forward contract. A forward contract allows parties to fix an exchange rate between two designated currencies at a specific point for a set amount of time. For what is called ‘major pairs’, investors can seek up to 10 years for a forward contract. This means that you do not need to worry about rates going against your favor however you also won’t be able to benefit from the rates shifting in your favor.

Strategies and Risks

It is the nature of international trade to have billions in foreign currencies spent on a daily basis. Along with banks who trade vast amounts of currency, Forex market is involved in trading billions every day. And how do traders strategize?

Forex traders aim to use changing exchange rates to their advantage based on what they predict will change. The trader buys a currency he/she thinks will gain more value and if correct, sells the currency once it becomes more valuable. In order to make accurate predictions, the trader must be able to predict the influence of economic events over the currency rates.

There are simple ways to make good predictions on whether a currency will rise or fall. Currencies are, as they have always been, priced based on the concept of supply and demand. An economic event occurs (we will get into this with more detail later on), makes a certain currency more attractive, everyone wants to buy that so demand rises. Simultaneously, there would be a limited amount of that attractive currency available for purchase so it would attract a higher price. For instance, at a time where the UK economy is regarded strong, US investors will seek to invest in Pounds. Pound Sterling becomes the go-to currency, the price rises and the US investors will have to pay more dollars to get Pounds. At the same time, another currency will become less attractive due to another economical factor and the holders of that currency will want to get rid of it quickly to minimize loss. But there would be limited buyers for a currency on the fall and the holders will not be able to sell it for the high price they bought it for. Thus, the currency on the fall will be worth less in the financial market. The two events discussed above are likely to happen dependent to each other rather than being two independent events.

Based on what we discussed above, it is also important to get a hold of which economic factors can affect the demand in currencies. Ordinary person tends to think that economic strength automatically makes the currency strong and conversely economic crisis makes it weak. Thus, most investors invest in countries with ongoing political stability for instances the US and the US-dollar. USD, over the years, has proven to be steadier than other currencies mostly because even in the most globally eventful times US economy stayed more stable in comparison to other countries. While at some instances solely investing in famously stable countries and their currencies might be good strategy, this would be too simple and all of us would be forex dealers by now. It is possible that certain economic crises can strengthen the standing of a currency depending on the management of the respective crisis.

Inflation inevitably plays a major role in the currency value and this also connects to interest rates; when the rates are lower people can borrow more and thus spend more. Conversely when the rates are higher borrowing becomes harder and spending decreases. In setting interest rates, the balance of supply and demand once again play a significant role as the demand for credit causes interest rates to rise and where there is less demand, lenders will have to lower the interest rates to attract customers.

Considering the Forex market is a major rival to traditional markets and banks, there are instances when banks took the matters in their own hands and affected the investment strategies of investors. Forex is a 24-hour market so taking an accurate reading of its current worth is almost impossible. Financial institutions solved this issue by taking readings of trade at a particular time each day. In London, this is daily, 30 seconds before and 4PM, called the 4PM Fix. The issue is that now that everyone knows when the estimated value is being read, banks can give large orders at that particular time making the actual market situation different than it actually is as the Fix would show an unreal rise in demand. Therefore, investors get a very different picture of the market events than what is normally happening and this would reflect on pricing. This activity was deemed unethical and certain precautions were taken, for instance the Fix has been extended from 30 seconds to 5 minutes before and after 4PM so that any mass demand would not reflect significantly. However, it is worth noting that if you are trading large sums of money, even small fluctuations may mean big differences on your part.

Concluding Remarks

At first, it may be tricky to understand the gist of Forex trading. However, starting from the supply-demand relationship you can slowly get the hang of it. You must always remember that there is no certain way to determine how the exchange rates will fluctuate; you may gain and you may lose within the same week. For beginners, easiest way to guarantee minimal loss would be to bargain for a forward contract which can be customized according to your needs. In terms of pricing, the Forex market is not transparent it is mostly up to the brokers are loosely regulated globally and not at all regulated in TRNC. You can find more about the legal status of Forex trading and brokers in the ‘Legal Status of FOREX Brokerage in the TRNC and the Republic of Cyprus’ article available on our website.