Anyone who has approached Forex, out of pure curiosity, or to try to get their bearings before deciding whether or not to engage in trading, knows that the Forex market is a particular type of
OTC (over the counter) market, and it is where currencies are exchanged. Another thing that has certainly been learned, and that is part of the basics of Forex, is represented by the characteristics of the currency market, such as high liquidity and volatility, the extreme variety of participants, and the fact that it is open 24 hours a day (except for Saturday and Sunday). At this point, let's consider the implications related to these peculiar aspects and understand some fundamental aspects that you absolutely must know in order to trade.
Liquidity
The fact that it is an extremely liquid market is very positive, since the moods and statements of individual competitors cannot influence the trend (as can happen in the stock market). Obviously, there are data and decisions that do produce effects, and they are represented by macroeconomic data (not all are significant, and the useful ones are those indicated as Market Makers), and by the decisions of the Central Banks (whose institutional role is to support monetary policy). We could consider these factors as 'objective', and the distinction is important, since they are not the only factors to consider. In fact, we must not forget the psychological dimension, which undoubtedly manages to influence any type of financial market, but given the high volatility that characterizes the Forex market, only subjects that move large volumes of currencies have the strength to influence the trend. For this reason, it is advisable for small investors to follow the trend and not go against it.
Volatility
Another concept that needs to be clarified is the one related to volatility, often confused with respect to its real meaning. Volatility represents the antithesis of stability, so a very volatile market is a market that has low levels of stability, but has continuous changes that can also follow, for a period of time, the same direction, but through oscillations that are almost imperceptible. In fact, volatility should not be confused with the 'amplitude of oscillations', and the Forex market is a typical example. In fact, when considering the variation in the exchange rate between two currencies (perhaps expressed as a percentage to better understand its extent), it cannot escape that these are always limited to small magnitudes. The confusion about the size of volatility is linked to the identification that is often made between the great 'variability' of the factors considered, with the effect of Financial Leverage.
Financial Leverage
Actually, even on the latter, people usually do not have very clear ideas, and it is seen in an excessively negative way. Instead, Financial Leverage, if used well, is a fundamental tool to use in order to obtain interesting gains (but be careful, because the effects can obviously also be produced 'amplified' from the point of view of losses), precisely because of the fact that the variations generally concern a few pips, and without a tool that allows to amplify the effects, marginal gains would be obtained.
So basically, Financial Leverage allows you to trade volumes that would otherwise be unattainable, unless you deposit very high figures. This aspect becomes much easier to understand if you consider the fact that in Forex you can mainly trade 3 types of contracts:
- standard lots that have a nominal value of about $100,000
- mini lots that have a nominal value of about $10,000
- micro lots that have a nominal value of about $1,000
This implies that trading a mini lot is equivalent to opening a position with 10 micro lots, and a standard lot is equivalent to 10 mini lots and 100 micro lots. To be able to trade a standard lot I would need to have $100,000 in the deposit, for a mini lot $10,000 and for a micro lot $1,000, but thanks to Financial Leverage I can open the position with significantly lower amounts, whose entity depends on the leverage made available by the broker (for example for a micro lot and a leverage of 1:10 it is possible to open positions for a micro lot, and if the leverage were 1:100 it would take $10, and so on).
However, to better understand the effects related to the use of Financial Leverage, it must be remembered that it allows you to open and control positions with low amounts, but once these have been opened, it does not affect the gains: two positions opened and closed at the same time but with different leverages, do not lead to different gains, since the result will be the same.
Margin
Another term that creates confusion, mainly due to its link with Financial Leverage is the Margin, but this is nothing more than the minimum sum required by the broker to cover any losses. In reality, it is the law itself that requires brokers to set a specific Margin for each trader, and which must be determined by the following equation:
Required margin per trade = Current Price x Units traded x Margin %
where the margin % is in turn given by:
Margin % = 100 / leverage ratio
Financial Instruments
Finally, to complete the knowledge on the basics of Forex, you must also learn what financial instruments can be used:
- forward transactions (highly speculative): the parties define a future exchange rate and the date on which they will be compared, regardless of changes in real rates;
- futures: these are standard contracts, where pre-established amounts and maturities are exchanged at rates that can instead be freely determined;
- swap: with a single contract the parties decide the quantity of currencies, and the relative prices, which will be exchanged from A to B at maturity X, and from B to A at maturity Y;
- spot: standard contracts with the operation of futures but intended for very short maturities.
The most used instrument in Forex is the spot.
