Forex trading happens for two reasons. The first and the simplest reason is, a Mr. X from the United States wants to go for a holiday in Australia. But he fears that the US dollar might not be as easily accepted there. So he decides that he'd better convert his United States dollars (USD) to Australian dollars (AUD) in order to avoid any problems.
But another Mr. Y decides to buy Australian dollars not because he's looking for a sojourn on the Gold Coast, but because they are available at rate which he believes will increase. Confused? Let me explain with the help of an example. Suppose today Mr Y can buy ASD3 in exchange for USD1, and just for a moment, assume that he can sell them tomorrow for USD2, he's going to make a tidy little profit of USD1 on what is widely known as the Foreign Exchange (Forex) Market. But why will the price of ASD3 jump from USD1 to USD2? Because of the fluctuations in the demand and supply of various currencies in the Forex market.
Firstly, let me explain why the price of the ASD is going up. The Forex market works on the old demand and supply model. This means that if the supply of one currency is less (in this case the ASD) and the demand for it is high, then the currency is going to command a higher price in the market. Now Mr. Y must have done some research of the expected demand for ASD before he came to the conclusion to buy. Roughly speaking, the Forex market too works like the stock market.
Now let us look at some basic terms that are used in forex trading and their meanings.
Bid/Ask: In the Forex market, there are two prices. One is called the 'bid' while the other is called 'ask'. For example, as of writing this article, the price of a EUR/USD (one Euro to US dollars) is 1/1.4161. Out of these two the 'bid' price is the lower one(1), and is the dollar price that the person who wants to buy the Euro is quoting i.e., he is offering to buy 1 Euro in exchange for $1.4161. The second number (1.4165) is the price that the holder of the Euro is 'asking' for a single Euro.
Pip: A pip (price interest point) is the incremental move which one currency makes over the other. In the previous example, we took the EUR/USD to be 1.4161, if the bidder ups his bid to 1.4165 to match the asker's rate, then it is said that there was a move of 4 pips. Pips are calculated on the last two digits on the right of the decimal point.
Why Does the Demand for a Currency Increase/Decrease?
Since the value of the currency is largely dependent on the demand for it, we need to understand what causes the shifts in the demand while learning forex trading. The number of factors which influence the demand are GDP, inflation, interest rates, trade agreements, budget plans, budget deficits, etc. For example, suppose the capital market of an emerging market like Brazil is doing rather well. And the nation is earning a substantial GDP. In such a case, Brazil will be viewed as a potential target for multinationals to invest in. The Brazilian stock market will also come under the radar of foreign institutional investors. Hence, in order to invest in Brazil, there will be an increase in demand for the Brazilian currency. Hence, this high demand will increase the value of the currency.
Forex market is a highly speculative market and one needs to research very carefully before buying a currency, if one wants to make a profit.