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Forex basic concepts explained

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Trading on the Forex market has never been more accessible and has more profit opportunities for retail traders. Due to its high liquidity it dwarfs all the other financial markets in the world. 

Despite its size and big prominence, the concept of Forex is relatively straightforward. 

Thanks to the internet, entering the Forex market is not only in the scope of big financial institutions. Various online brokers enable ordinary people to start trading with modest amounts. 

Besides the proper knowledge about the trading process, new traders ought to make sure to opt for a reputable broker. If you want to pick the right one, a good starting point is to read a broker review

But before choosing your broker, here are some basic notions that every Forex investor should grasp.

Major currency pairs

Not all currency pairs enjoy the same popularity, with some being more traded than others. The most famous are the major currency pairs, between currencies monitored and traded around the world.

Investors and the media sometimes have different ideas about which pairs are considered major. However, most agree that the following four currency pairs belong to the group of major pairs:

  • EUR/USD
  • USD/JPY
  • GBP/USD
  • USD/CHF

In general, the lists of major currency pairs also include the three most important “commodity currencies” against the US dollar: AUD/USD, USD/CAD, and NZD/USD. Together, these seven currency pairs account for around 80% of global Forex trading.

Also, other major pairs do not include the dollar, such as EUR/GBP, EUR/CHF, and EUR/JPY. These pairs are also popular as “crossed pairs”.

Return/risk ratio

Money management is a set of factors and rules developed to have good management of the capital you will invest. The risk/return ratio is the ratio between the expected profitability of your Forex transaction (the difference between entry price and your target price) and the risk of loss. One of the keys to money management is that the risk/return ratio must be systematically greater than 2 for your Forex operations.

Carry trade

The Forex carry trade involves a trader trying to profit from the interest rate difference between the two currencies in a Forex pair. There are two main Forex carry trade strategies: positive and negative.

The positive carry trade involves borrowing a currency with a low-interest rate while buying a currency with a high-interest rate. Traders carry out a positive carry trade assuming that the currency with the higher interest rate will stay the same or appreciate.

In doing so, traders will receive interest rate payments according to the interest rate differential between the two currencies in the pair, depending on the size of their initial investment.

The negative carry trade involves borrowing a currency with a high-interest rate while buying a currency with a low-interest rate. Traders carry out a negative carry trade assuming that the currency with the lower interest rate will appreciate against the currency with the higher interest rate.

Initially, a negative carry trade will result in a net loss as the trader will have to pay interest to maintain the position. However, this could turn into a net gain that would offset losses incurred if the higher interest rate currency were to depreciate against the lower interest rate currency.

Forex interest rates

The variation in the interest rate influences that of the currency rates. In Forex, traders trade with reference to interest rates.

The investor lends capital in order to obtain, after a certain period, interest in addition to the amount loaned initially.

In Forex, the interest rate represents as a percentage and over a period of one year. The interest rate has a considerable influence on currency prices.

The level of interest rates affects the value of Forex currency pairs. Interest rate levels have significant impacts on currency rates as well as on outward and inward capital flows.

The flow of investment is stimulated by falling or rising the interest rate.

In the Forex market, the different levels of interest rates vary mainly depending on demand and supply. The interest rate is constantly adjusted according to the level of inflation.

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