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Forex Trading as a Derivative

Forex Trading as a Derivative

Forex trading is the process of buying a specific currency and selling it later hopefully at a profit. This is partly true, but not the whole truth.
 
If you walk into a bank or a forex bureau to exchange currency, you’ll deposit your initial currency and in exchange walk out with a different currency. Say you walk in with Kenya shillings and walk out with American dollars. In this case, you are receiving the actual delivery of your product. You buy US dollars with Kenya shillings and walk out of the deal with an actual product (USD).
 
In the online forex trading space however, currencies are bought and sold, but no actual delivery of the product is made. Instead, when you buy a currency from a broker online, what is sold to you is a virtual asset and a binding contract that the broker will take back his virtual asset once you, the forex broker is ready to sell the virtual asset back to the broker at a later date. This means you will not receive actual delivery of the bought asset.
 
As a forex trader, what you are trading online is not an actual asset. You trade a derivative of an asset. A derivative is a financial agreement between the forex broker and forex trader that shows that both parties have agreed to derive the value of a virtual product based on the value of an underlying asset.
 
If you want to buy Euros for example, you enter into a contract with the broker that states that you have bought from him virtual Euros. The value ascribed to the virtual Euros is tied to the actual value of the underlying asset. This means that the virtual assets have no value of their own. They derive their value from the value of the assets from which they are linked. 
 
In forex trading, this derivative is called “Contracts for Difference” (CFDs). With CFDs, only virtual assets are traded and there is no actual delivery of an asset. You buy or sell a particular virtual asset whose value is derived from the value of the real asset in the market. For example, if you want to buy Euros, the broker will sell virtual Euros at the present price of Euros in the market. You enter into an agreement with the broker to buy Euros, which you’ll sell at a later date. Depending on the price fluctuations of the real underlying asset, you will either make gains or losses when you sell back the Euros to the broker.

What is Forex Trading?

What is Forex Trading?

What is Forex?

 

Forex is the conversion of money from one currency to another. The word Forex is an acronym derived from the words Foreign Exchange. It’s also called fx, which is an abbreviation of the word forex.
 
Different countries worldwide use different sets of currency. America uses the US dollar while Japan uses the Japanese Yen. If an American wants to fly to Japan for business or leisure, they may visit a currency exchange bureau to have their US dollars exchanged for Japanese Yen. Similarly, if you were to import a car from Europe to your country, you’d participate in the global foreign exchange market since at one point during the transaction, an exchange of currency from your country’s currency to Euro will have to take place. This transaction of money from one currency to another is what we call forex.

Who is a Forex Trader?

 

Apart from import and travel, foreign exchange may be practiced as a profession by skilled individuals and corporates such as banks, insurance companies, and fund managers. These professionals exchange currency with the aim of making a profit from the transactions. This aspect of foreign exchange is what we call Forex Trading while someone who engages in this trade is called a Forex Trader. Forex trading therefore is the practice of exchanging currencies with the sole aim of making a profit. A forex trader is trained to time favorable market conditions to know when to enter and exit the markets at a profit. With proper training, individuals have ventured into the world of forex trading as a full time business. All that is required is a desire to learn and a laptop with stable internet connection. With that, you can start trading forex at the comfort of your home.

How are Profits made in Forex?

 

In any business, money is made by offering a product or service. There also must be a willing buyer and a willing seller for any transaction to take place. In forex trading, the product being sold is “money.” Yea, you heard it right. As a forex trader, your work is to buy a currency that you hope will go up in value, and then later sell the same currency for a profit. For example, if you found a product, say a laptop being sold in one region at $100 and the exact laptop is selling at $500 in your home town, you’d buy the laptop at that price and later sell the same for a $400 profit as long as you have a willing buyer. 
The same goes for forex. As a matter of fact, forex trading is more or less easier since you will always find a willing buyer and a willing seller online. Now all you have to do is spot an opportunity to profit from. Say you have $100, and you feel that the euro will gain value, you would quickly buy the euro worth $100 at it’s current price, wait, then later sell the euro back to your initial US dollars for a profit. That is how you make money in forex when the price of a certain currency is going up.
 
One more added advantage of trading forex is that apart from making money when prices are going up, you can also make money when prices are going down. To understand how a forex trader makes money when prices are going down, we’ll take a real world example.
Say you have a property like land worth $10,000. You predict that in one month, the value of that property will depreciate to $5,000. How would you go about shielding yourself from that loss? First, identify a buyer. The next step is to sell the property at prevailing market prices. Now, you no longer own any property, but you have $10,000 cash at hand. Wait patiently for your prediction to materialize. One month later, go back to the property you sold which is now valued at $5,000 and negotiate a deal. Buy the property back at $5,000 dollars and there you have it. You have your property and an extra $5,000 cash. You shielded  yourself from a $5,000 loss had you not taken that initiative. This is a simplified version of how money is made in forex when prices are going down.
 
To get the point home, assume you have a friend that bought a laptop at $2,000 which they are not using. Since the laptop is a new model, you predict that it will lose half of its value in three months when the new model finally floods the market. To gain from your speculation, you borrow your friend the laptop with the promise that you will give him back a new laptop, same model in three months time. Immediately, you sell the laptop at prevailing market prices and now you’ve made $2,000 out of the borrowed asset. When the value of the product depreciates, you go back to the market and buy a similar laptop for $1,000. Take back the laptop to the lender and magically, you have $1,000 left in your pocket as profit. 
 
The advantages of trading forex is that the market is open 24 hours a day, 5 days a week. This gives flexibility to a busy trader who has other commitments do plan his trading schedule accordingly. Also, unlike most other businesses, in forex, there is always someone willing to take the other side of the deal meaning there is always a willing buyer and a willing seller at any one time. Finally, a forex trader can make a profit irrespective of the direction of the market.