What You Should Know About Forex Trading

Recently, Forex trading has become extremely popular. However, many people who are interested in Forex trading have little idea what it involves. They are often attracted to this type of trading based on its popularity and the belief that, because others are using it, it must be profitable. This is not always the case. Forex trading is most useful for larger companies rather than independent day traders. Still, if you want to get involved with Forex trading, you should understand how it works, and, more importantly, how it is different from the kind of trading most day traders do.

The first aspect of Forex trading involves interest rates. If you are trading the EUR-USD, for example, then you are buying the Euro currency and selling the US Dollar. In Forex trading, accounts are settled every day at 5:00pm ET, and at this time you earn interest rates on the currency that you bought and pay interest rates on the currency that you sold.

Here’s a useful example. Currently the European Central Bank (ECB) has set its interest rates at 4.25% while the Federal Open Market Committee (FOMC, part of the Fed) offers only 2%. If you trade EUR-USD and hold it overnight, then you receive the equivalent of 4.25% divided by 360 days for the Euros that you own and you pay the equivalent of 2% divided by 360 days for the US Dollars that you sold. So you are receiving the equivalent of 2.25% divided by 360 days every day that you hold this position. (It’s important to note that your broker will charge you the spread for "swapping" your position overnight. But if he is a reputable broker, then he will pay you the interest rate spread.)

The possibility of daily income is what effectively attracts people to Forex trading, but the actual profits you receive are relatively small. In our example, 2.25% divided by 360 is 0.00625%, which means that if you invested $10,000 in your position, then you would earn approx. $0.63 per day in interest.

Most day traders become less interested in Forex trading when they understand this. And that seems reasonable given that it is most successful when you have huge amounts to invest. Forex traders, or at least those who profit significantly from it, are usually large companies, institutions, hedge funds and banks that easily hold $100 million or more overnight and therefore earn $6,250 in interest every day. That's $187,000 per month, and they hedge their positions to minimize the risk of fluctuations in the currencies.

If you are still interested in Forex trading, there are two factors you should keep in mind:

The first factor that moves currency prices is interest rates. If you are going to invest, make sure you have a currency pair moving when the underlying interest rate markets are open. As soon as the interest markets close, the prices of the currency pair will simply be moving sideways.

The second factor that influences currency prices is foreign investment. If you are a US company that wants to invest $10 billion in Mexico, then most probably you would have to buy the Mexican Peso to pay local contractors and workers. Though some might accept payments in US Dollars it is still very common to pay local companies and workers in their local currency. This is especially true if your company is manufacturing the products in Mexico but sells them in the US; you will have to sell US Dollars and buy Mexican Pesos on a large scale, since your income is in US Dollars and you have to exchange it into Mexican Peso to pay the workers in your Mexican company.

Those two factors explain why you will see currency prices moving if a government introduces new rules and regulations for foreign investors. A change in the political landscape of a foreign country can cause sharp moves in their currency since it might affect the decision of large companies to invest in that country. These factors usually affect currency prices over days and weeks, maybe even months, and not necessarily within a single day. However, even throughout a single day you may see a sharp reaction of currency prices to geopolitical news and news that affect the interest rates of a currency.

Hopefully this helps you better understand what Forex trading is all about. If it seems attractive to you, then plan on spending some time researching which currency markets are right for you before jumping in. Obviously, there is plenty to consider when investigating these trades, and the research is very different than the kind that most day traders are used to doing since it involves knowledge of international currencies and even day-to-day politics. Still, if the possibility of regular daily profits remains attractive, Forex trading may be right for you.

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