Components of a Forex deal

A Forex deal is a contract agreed upon between the trader and the market-maker (i.e. the Currency Trading Platform). The contract is comprised of the following components:

  • The currency pairs (which currency to buy; which currency to sell)
  • The principal amount (or "face", or "nominal": the amount of currency involved in the deal)
  • The rate (the agreed exchange rate between the two currencies).

Time frame is also a factor in some deals, but this chapter focuses on Day-Trading (similar to 'Spot' or 'Current Time' trading), in which deals have a lifespan of no more than a single full day. Thus, time frame does not play into the equation. Note, however, that deals can be renewed ('rolled-over') to the next day for a limited period of time.

The Forex deal, in this context, is therefore an obligation to buy and sell a specified amount of a particular pair of currencies at a pre-determined exchange rate.

FX trading is always done in currency pairs. For example, imagine that the exchange rate of EUR/USD (euros to US dollars) on a certain day is 1.1999 (this number is also referred to as a 'spot rate', or just 'rate', for short). If an investor had bought 1,000 euros on that date, he would have paid 1,199.00 US dollars. If one year later, the Forex rate was 1.2222, the value of the euro has increased in relation to the US dollar. The investor could now sell the 1,000 euros in order to receive 1222.00 US dollars. The investor would then have USD 23.00 more than when he started a year earlier.

 

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However, to know if the investor made a good investment, one needs to compare this investment option to alternative investments. At the very minimum, the return on investment (ROI) should be compared to the return on a 'risk-free' investment. Long-term US government bonds are considered to be a risk-free investment since there is virtually no chance of default - i.e. the US government is not likely to go bankrupt, or be unable or unwilling to pay its debts.

Trade only when you expect the currency you are buying to increase in value relative to the currency you are selling. If the currency you are buying does increase in value, you must sell back that currency in order to lock in the profit. An open trade (also called an 'open position') is one in which a trader has bought or sold a particular currency pair, and has not yet sold or bought back the equivalent amount to complete the deal.

It is estimated that around 95% of the FX market is speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency.

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