How to make money in Forex? This is the most common question asked by all newcomers to the world of finance. If you’re serious about starting to trade on a stock exchange, but the incomprehensible words in the title confuse you, don’t panic: this article is for you.
The main source of income on stock exchanges is derived from the difference between the buying and selling price of various assets, be it currency, stocks, or precious metals. Put simply, the idea of exchange is to get the maximum profit from this difference. In practice, however, every newcomer faces a number of pitfalls. One needs to be well-versed in the specifics of exchange trading to avoid them.
Of course, there’s specialized terminology pertaining to Forex trading that requires professional translation from Financial to Human. We’ll guide you on a short journey into the theory of trading, to help you understand these complex concepts and turn your knowledge into profit. Fasten your seat belts and let’s go.
Here’s an example: someone wants to buy Apple stock at $110 per share. If this price is the highest in the market, it is called a “bid price”. The seller lists the shares on a stock exchange at $115. If this price is the lowest in the market, it is called an “ask price”. The spread in this case is the difference between the bid and ask prices, namely $5.
In fact, this is a direct loss for the trader, but, anticipating your indignation, let us note that if you’re working with an honest broker, it should be compensated by the future profits. To achieve this, the stock price must rise by at least $5. That’s why the spread is one of the most important criteria to look at when choosing a brokerage company.
In the context of the interbank foreign exchange market, there are two types of spread: fixed and floating.
A fixed spread is a constant value that doesn’t change under the influence of exchange rates or the demand and supply ratio. In Forex, this kind of spread is quite rare.
A floating spread is a volatile value that changes within certain limits depending on various market factors. This type of spread is much more common.
The size of the spread is influenced by many factors, from the liquidity (popularity) of a currency pair in the market to the general economic and political situation in the world.
The size of the spread is measured not in money, but in pip. One pip = 0.0001 / price * transaction volume (lot size). On average, in a calm market, the spread is in the range of 2–5 pips, but in emergency situations it can reach 50!
Another important concept in the world of finance is swap. A swap is a temporary exchange of any asset. The key word is temporary! Yes, you got that right, after a certain period, the transaction participants return the previously exchanged assets to each other. At first glance, this process may seem completely meaningless, but this is far from the case. Both parties in the swap process receive their own benefits: they increase the amount of assets, hedge risks or gain access to the markets in another jurisdiction with lower taxation.
A swap consists of 2 stages: the exchange of assets and, accordingly, the return of assets and the closing of the transaction. It’s important that at least one night must pass between the stages for the exchange to receive the status of a swap.
Types of swaps are very different from each other. Swaps can be:
- credit default
- swaps on precious metals, etc.
What is a Forex swap?
A swap in Forex is the difference in interest rates on loans of two currencies when the transaction is carried over to the next day. It can be either positive or negative. In the case of a positive swap, the trader profits from the difference between the exchange rates or interest rates, as well as from the resale swaps to other traders.
If a trader opens a position and doesn’t close it on the same day, a minor deduction or increase in funds will appear the next morning. This is a swap. Funds are charged or granted by the broker depending on whether the trader is holding a long or a short position.
Consider an ordinary trade in the market. The trader sells the currency to the bank, and that’s the end of the transaction. While in the case of a currency swap, the bank resells the same amount of funds back to the trader after some time. Changes in the exchange rate and the difference in rates bring profit to one of the parties, and losses to the other.
The central bank sets the discount rate for the currency of each country. The difference between the rates can be quite significant (for example, the discount rate of ЈPY is several times less than that of USD). Turns out, when you buy USD with ЈPY, you get a currency (USD) with a higher interest rate, and in return you give another currency (JPY) with a lower interest rate.
In addition to profit from the difference in quotes (we’ll get back to it in a bit), making money on the swaps themselves is also an option. This strategy is known as Carry Trade and it’s popular in the banking sector. The trader buys a currency pair where the interest rate of the base currency is higher than that of the quoted currency, which guarantees a positive swap. If the exchange rate of the currency pair is stable over a long period, the trader makes a significant profit.
According to Wikipedia, a financial quote is the current price of a financial asset, acceptable to both the seller and the buyer. An exchange rate, a stock price, an interest rate of a loan, a price of goods or raw materials can be referred to as a quote.
Quotes in the financial market are constantly changing. They are recorded by the quotation committee at the time of the opening and closing of the exchange, indicating the high and the low of each day. Quotes can be direct (price of one asset) and inverse (the amount of the asset that can be bought for a certain amount).
Quotes and their change are one of the main sources of income for traders. In Forex, traders use “currency pairs” due to the difference in the rates of different national currencies. All national currencies are priced in relation to the US dollar. The ratio of the currency of any country to the US dollar is a direct quote (EURUSD, GBPUSD, AUDUSD, etc.), and the ratio of the dollar to the currencies of other countries is an inverse quote (USDCHF, USDJPY, USDRUB, etc.). There are also so-called cross currency rates — the rates of national currencies to each other, but in such quotes, a preliminary conversion of the currency into the US dollar is carried out at the current rate. You can view the current quotes here.
What drives the currency pairs?
Forex is a decentralized unregulated system based on connections between its largest players, namely the banks, brokerage firms, various investment funds, and even central banks. They are the market makers that influence the formation of quotes in the foreign exchange market. Different Forex brokers offer different quotes, which affects the size of the spread and swap for each currency pair, as we mentioned before.