Having a good understanding of the change in exchange rates is a basic aspect of Forex. After all, that’s how traders make money!
There are a lot of factors that go into determining exchange rate changes. And it’s always good to review why the graphs on your trading platform move.
Most people have a simple understanding of exchange rates when, for example, they go overseas and have to buy things in another currency.
However, because Forex uses a derivative financial product to engage in trading, there is an extra level of sophistication, and all currencies have to be paired. This is why even though we are interested in factors that can affect a currency in particular, what matters as an FX trader are the pairs that currency is in.
In retail forex trading, you don’t get a bunch of coins and bills delivered to your house each time you make a trade. That would be impractical.
What happens is that in order for you to buy a currency, you have to sell another currency at the same time. Also, in order to sell a currency, you have to buy another. This is how the pairs are constructed.
If you, for example, think the pound will get stronger, then you want to have pounds. But, stronger is relative!
Against what will it be stronger?
Let’s say, the dollar. That means you want to buy pounds and sell dollars. In other words, buy GBPUSD. Therefore, there are two parts to each trade: the buy part, and the sell part.
Supply and Demand
When you put your order into the Forex market that you want to buy a certain amount of pounds, let’s say one lot, your broker then looks for people who want to sell pounds at that price.
If there is someone who wants to sell one lot, your trades are matched, and it’s executed. But, what if there is no one who wants to sell at that price?
The law of supply and demand means that if there isn’t enough supply, then the price goes up. If the price of pounds goes up, but the price of dollars stays the same, then the exchange rate has changed.
Thousands of Forex brokers all over the world are constantly matching prices for their customers. So, each time someone offers to buy and sell, the market moves a bit.
The more people sell, the more the market goes down; the more people who buy, the market goes up.
It’s Econ 101
Forex trading is probably one of the best examples of basic economic principles of supply and demand.
Why people choose to buy and sell currencies depends on a myriad of factors. This is why we have technical, fundamental and sentiment analysis to try to figure out what Forex traders are planning on doing, and, from there, where the exchange rate will go.
But in the end, exchange rates change because of simple supply and demand.