Trading in the Forex market can be quite a ride for anyone who is less informed and untrained to execute trades smartly. When investing, it’s best to keep some common concepts on your fingertips while you immerse yourself in this potentially profitable but crowded market that we know as Forex!
We are going to talk about some major concepts that the Forex market runs on and in turn. It will suggest to you what measures to take in order to build an excellent forex trading portfolio!
Unlike the stock market, where investors have thousands of stocks to choose from, in the currency market you only need to follow eight major economies and then determine which will provide the best undervalued or overvalued opportunities. The following eight countries make up the majority of trade in the currency market:
- United States
- United Kingdom
- Eurozone (includes most of Europe but eyes on Germany, France, Italy, and Spain)
- New Zealand
These economies have the largest and most sophisticated financial markets in the world. By strictly focusing on these eight countries, we can take advantage of earning interest income. Economic data is released from these countries on an almost daily basis. It will allow investors to stay on top of the game when it comes to assessing the health of each country and its economy.
Yield and Return
When it comes to trading currencies, the key to remember is that yield drives return.
When you trade in the foreign exchange spot market, you are buying and selling two fundamental currencies. All currencies are quoted in pairs because each currency is valued in relation to another. For example, if the EUR/USD pair is quoted as 1.2200 that means it takes $1.22 to purchase one euro.
In every foreign exchange transaction, you are simultaneously buying one currency and selling another. In effect, you are using the proceeds from the currency you sold to purchase the currency you are buying. Furthermore, every currency in the world comes attached to an interest rate set by the central bank of that currency’s country. You are obligated to pay the interest on the currency that you have sold, but you also have the privilege of earning interest on the currency that you have bought.
More on Yield and Return
The forex market also offers tremendous leverage. It is often as high as 100:1! It means that you can control $10,000 worth of assets with as little as $100 of capital. However, leverage can be a double-edged sword; it can create massive profits when you are correct, but may also generate huge losses when you are wrong.
The use of leverage basically exacerbates any sort of market movement. As easily as it increases profits, it can just as quickly cause large losses. However, these losses can be capped through the use of stops. Furthermore, almost all forex brokers offer the protection of a margin watcher. It is a piece of software that watches your position 24 hours a day, five days per week. And automatically liquidates it once margin requirements are breached. This process ensures that your account will never post a negative balance. Moreover, your risk will be limited to the amount of money in your account.
Money values never stay fixed, and it is this power that brought forth one of the most well-known exchanging procedures ever, the carry trade. Carry traders desire to procure not just the interest cost differential between the two currencies, but additionally, search for their positions to appreciate in value. There have been a lot of chances for large benefits before. How about we investigate a few verifiable models.
When the Australian dollar also rallied from 56 cents to close at 80 cents against the U.S. dollar, between 2003 and the end of 2004, the AUD/USD currency pair offered a positive yield spread of 2.5%, which represented a 42% appreciation in the currency pair. Although this may seem very small, the return would become 25% with the use of 10:1 leverage. This means that if you were in this trade—and many hedge funds at the time were—you would have not only earned the positive yield, but you would have also seen tremendous capital gains in your underlying investment.
More on Carry Trades
The key to creating a successful carry trade strategy is not simply to pair up the currency with the highest interest rate against a currency with the lowest rate. In order for carry trades to work best, you need to belong in a currency with an interest rate that is in the process of expanding against a currency with a stationary or contracting interest rate. This dynamic can be true if the central bank of the country that you are long in is looking to raise interest rates or if the central bank of the country that you are short in is looking to lower interest rates.
The bottom line is that you want to pick carry trades that benefit not only from a positive and growing yield, but also have the potential to appreciate in value. This is important because just as currency appreciation can increase the value of your carry trade earnings, currency depreciation can erase all of your carry trade gains—and then some.
A Vigilant Eye On Interest Rates
Knowing where interest rates are headed is important in forex trading. It requires a good understanding of the underlying economics of the country in question. Generally speaking, countries that are performing very well, with strong growth rates and increasing inflation will probably raise interest rates to tame inflation and control growth. On the flip side, countries that are facing difficult economic conditions ranging from a broad slowdown in demand to a full recession will consider the possibility of reducing interest rates.
You are obligated to pay the interest on the currency that you have sold. But you also have the privilege of earning interest on the currency that you have bought. For example, let’s look at the New Zealand dollar/Japanese yen pair (NZD/JPY). Let’s assume that New Zealand has an interest rate of 8%! And that Japan has an interest rate of 0.5% In the currency market, interest rates are calculated in basis points. A basis point is simply 1/100th of 1%. So, New Zealand rates are 800 basis points and Japanese rates are 50 basis points. If you decide to go long NZD/JPY you will earn 8% in annualized interest. But have to pay 0.5% for a net return of 7.5%, or 750 basis points.
Managing Your Long-Term Investment Portfolio
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