Currency trading, is the exchange of different currencies on a decentralised global market. It's one of the largest and most liquid financial markets in the world. Currency trading involves the simultaneous buying and selling of the world's currencies on this market.
Currency trading rates between different currency pairs show the rates at which one currency will be exchanged for another. It plays a vital role in foreign trade and business as products or services bought in a foreign country must be paid for using that country's currency.
Currency trading explained
Currency is one of the most widely traded markets in the world, with a total daily average turnover reported to exceed $5 trillion a day. The currency market is not based in a central location or exchange, and is open 24 hours a day from Sunday night through to Friday night. A wide range of currencies are constantly being exchanged as individuals, companies and organisations conduct global business and attempt to take advantage of rate fluctuations.
How does currency trading work?
Currencies are always traded in currency pairs – for example, GBP/USD (sterling v US dollar). You speculate on whether the price of one country's currency will rise or fall against the currency of another country, and take a position accordingly. Looking at the GBP/USD currency pair, the first currency (GBP) is called the 'base currency' and the second currency (USD) is known as the 'counter currency'.
When trading currency, you speculate on whether the price of the base currency will rise or fall against the counter currency. So in GBP/USD if you think GBP will rise against USD, you go long (buy) the currency pair. Alternatively, if you think GBP will fall against USD (or that USD will rise against GBP), you go short (sell) the currency pair.
Currency strength indicators
It's important to remember when looking at currency that a stronger currency makes a country's exports more expensive for other countries, while making imports cheaper. A weaker currency makes exports cheaper and imports more expensive, so currency rates play a significant part in determining the trading relationship between two countries.
What causes one currency in a currency pair to strengthen?
There are a variety of factors at play in this relationship and they all contribute in some way to whether the strength of a currency declines or improves in relation to another. Understanding the influencing factors gives traders insights they can incorporate into their currency trading strategies, including day trading, swing trading and currency scalping strategies.
Some of these factors include political stability, interest rates, inflation, terms of trade, public debt and current account deficits. For example, in the case of interest rates, if rates are higher, lenders get a better return compared to those in a country with lower rates; therefore the higher rates attract foreign capital which causes the exchange rate to rise. This is one of the reasons currency traders may look to trade on interest rate announcements from central banks like the US Federal Reserve or the Bank of England.
What causes one currency in a currency pair to decline?
The factors mentioned above can also cause a currency to decline. For example, the currency of a country with low inflation will generally rise because that country's purchasing power is higher relative to other currencies. Even natural disasters such as earthquakes or tsunamis, which put a strain on a nation’s economy, can have a negative impact on a currency.
Political instability and poor economic performance can also have a negative impact on a currency. Politically stable countries with robust economic performance will always be more appealing to foreign investors, so these countries will draw investment away from countries characterised by more economic or political risk. Furthermore, a country showing a sharp decline in economic performance will experience a loss of confidence in its currency and a movement of capital to currencies of more economically steady countries. These are just two simple examples of what can affect currency rates and the kind of things traders consider when developing currency trading strategies.
What are the benefits of currency trading?
Some of the main benefits of currency trading that make this asset class a popular choice among traders are:
- The ability to trade on margin (using leverage)
- High levels of liquidity mean spreads stay tight which keeps trading costs low
- Prices react quickly to breaking news and economic announcements (this can be a disadvantage too)
- Trade 24 hours a day from Sunday to Friday
- The ability to go long and short
- Wide range of markets (trade CFDs on over 300 currency pairs with Century Financial)
What are the potential risks of currency trading?
Some of the possible risks involved in currency trading are:
- You can lose all of your capital - leveraged currency trading means that both profits and losses are based on the full value of the position
- Risk of account close out - market volatility and rapid changes in price can cause the balance of your account to change quickly, and if you do not have sufficient funds in your account to cover these situations, there is a risk that your positions will be automatically closed by the platform
- Market volatility and gapping - financial markets may fluctuate rapidly and gapping is a risk that arises as a result of market volatility, and one of the effects of this may mean that stop-loss orders are executed at unfavourable prices
Currency trading is a fast-paced, exciting option and some traders will focus solely on trading this asset class. They may even choose to specialise in just a few select currency pairs, investing a lot of time in understanding the numerous economic and political factors that move those currencies.
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