Forex Tutorial: Foreign Exchange Risk and Benefits
  1. Forex Tutorial: Introduction to Currency Trading
  2. Forex Tutorial: What is Forex Trading?
  3. Forex Tutorial: Reading a Forex Quote and Understanding the Jargon
  4. Forex Tutorial: Foreign Exchange Risk and Benefits
  5. Forex Tutorial: Forex History and Market Participants
  6. Forex Tutorial: Economic Theories, Models, Feeds & Data
  7. Forex Tutorial: Fundamental Analysis & Fundamentals Trading Strategies
  8. Forex Tutorial: Technical Analysis & TechnicaI Indicators
  9. Forex Tutorial: How To Trade & Open A Forex Account
  10. Forex Tutorial: Currency Trading Summary

Forex Tutorial: Foreign Exchange Risk and Benefits


In this section, we'll take a look at some of the benefits and risks associated with the forex market. We'll also discuss how it differs from the equity market in order to get a greater understanding of how the forex market works.

The Good and the Bad
We already have mentioned that factors such as the size, volatility and global structure of the foreign exchange market have all contributed to its rapid success. Given the highly liquid nature of this market, investors are able to place extremely large trades without affecting any given exchange rate. These large positions are made available to forex traders because of the low margin requirements used by the majority of the industry's brokers. For example, it is possible for a trader to control a position of US$100,000 by putting down as little as US$1,000 up front and borrowing the remainder from his or her forex broker. This amount of leverage acts as a double-edged sword because investors can realize large gains when rates make a small favorable change, but they also run the risk of a massive loss when the rates move against them. Despite the foreign exchange risks, the amount of leverage available in the forex market is what makes it attractive for many speculators.

The currency market is also the only market that is truly open 24 hours a day with decent liquidity throughout the day. For traders who may have a day job or just a busy schedule, it is an optimal market to trade in. As you can see from the chart below, the major trading hubs are spread throughout many different time zones, eliminating the need to wait for an opening or closing bell. As the U.S. trading closes, other markets in the East are opening, making it possible to trade at any time during the day.

Time Zone Time (ET)
Tokyo Open 7:00 pm
Tokyo Close 4:00 am
London Open 3:00 am
London Close 12:00 pm
New York Open 8:00 am
New York Close 5:00 pm

While the forex market may offer more excitement to the investor, the risks are also higher in comparison to trading equities. The ultra-high leverage of the forex market means that huge gains can quickly turn to damaging losses and can wipe out the majority of your account in a matter of minutes. This is important for all new traders to understand, because in the forex market - due to the large amount of money involved and the number of players - traders will react quickly to information released into the market, leading to sharp moves in the price of the currency pair.

Though currencies don't tend to move as sharply as equities on a percentage basis (where a company's stock can lose a large portion of its value in a matter of minutes after a bad announcement), it is the leverage in the spot market that creates the volatility. For example, if you are using 100:1 leverage on $1,000 invested, you control $100,000 in capital. If you put $100,000 into a currency and the currency's price moves 1% against you, the value of the capital will have decreased to $99,000 - a loss of $1,000, or all of your invested capital, representing a 100% loss. In the equities market, most traders do not use leverage, therefore a 1% loss in the stock's value on a $1,000 investment, would only mean a loss of $10. Therefore, it is important to take into account the risks involved in the forex market before diving in.

Differences Between Forex and Equities
A major difference between the forex and equities markets is the number of traded instruments: the forex market has very few compared to the thousands found in the equities market. The majority of forex traders focus their efforts on seven different currency pairs: the four majors, which include (EUR/USD, USD/JPY, GBP/USD, USD/CHF); and the three commodity pairs (USD/CAD, AUD/USD, NZD/USD). All other pairs are just different combinations of the same currencies, otherwise known as cross currencies. This makes currency trading easier to follow because rather than having to cherry-pick between 10,000 stocks to find the best value, all that FX traders need to do is "keep up" on the economic and political news of eight countries.

The equity markets often can hit a lull, resulting in shrinking volumes and activity. As a result, it may be hard to open and close positions when desired. Furthermore, in a declining market, it is only with extreme ingenuity that an equities investor can make a profit. It is difficult to short-sell in the U.S. equities market because of strict rules and regulations regarding the process. On the other hand, forex offers the opportunity to profit in both rising and declining markets because with each trade, you are buying and selling simultaneously, and short-selling is, therefore, inherent in every transaction. In addition, since the forex market is so liquid, traders are not required to wait for an uptick before they are allowed to enter into a short position - as they are in the equities market.

Due to the extreme liquidity of the forex market, margins are low and leverage is high. It just is not possible to find such low margin rates in the equities markets; most margin traders in the equities markets need at least 50% of the value of the investment available as margin, whereas forex traders need as little as 1%. Furthermore, commissions in the equities market are much higher than in the forex market. Traditional brokers ask for commission fees on top of the spread, plus the fees that have to be paid to the exchange. Spot forex brokers take only the spread as their fee for the transaction. (For a more in-depth introduction to currency trading, see Getting Started in Forex and A Primer On The Forex Market.)

By now you should have a basic understanding of what the forex market is and how it works. In the next section, we'll examine the evolution of the current foreign exchange system.

Forex Tutorial: Forex History and Market Participants

  1. Forex Tutorial: Introduction to Currency Trading
  2. Forex Tutorial: What is Forex Trading?
  3. Forex Tutorial: Reading a Forex Quote and Understanding the Jargon
  4. Forex Tutorial: Foreign Exchange Risk and Benefits
  5. Forex Tutorial: Forex History and Market Participants
  6. Forex Tutorial: Economic Theories, Models, Feeds & Data
  7. Forex Tutorial: Fundamental Analysis & Fundamentals Trading Strategies
  8. Forex Tutorial: Technical Analysis & TechnicaI Indicators
  9. Forex Tutorial: How To Trade & Open A Forex Account
  10. Forex Tutorial: Currency Trading Summary
RELATED TERMS
  1. Forex Spot Rate

    The current exchange rate at which a currency pair can be bought ...
  2. Forex Market

    The market in which participants are able to buy, sell, exchange ...
  3. Forex Option Trading

    A security that allows currency traders to realize gains without ...
  4. Liquidation Level

    In forex trading, the specific value of a trader's account below ...
  5. Forex Broker

    Firms that provide currency traders with access to a trading ...
  6. Forex - FX

    The market in which currencies are traded. The forex market is ...
RELATED FAQS
  1. In the forex market, how is the closing price of a currency pair determined?

    The foreign exchange market, or forex, is the market in which the currencies of the world are traded by governments, banks, ... Read Answer >>
  2. How is the value of a pip determined?

    Learn how the pip is used in the pricing of a currency pair in forex trading, and see how the foreign exchange market is ... Read Answer >>
  3. What am I buying and selling in the forex market?

    The forex market is the largest market in the world. According to the Triennial Central Bank Survey conducted by the Bank ... Read Answer >>
  4. How does the foreign-exchange market trade 24 hours a day?

    The forex market is the largest financial market in the world, trading around $1.5 trillion each day. Trading in the forex ... Read Answer >>
  5. Can I trade a currency when its main market is closed?

    In the forex market, currencies from all over the world can be traded at all times of the day. The forex market is very liquid, ... Read Answer >>
  6. Where is the central location of the forex market?

    There is no central location of the foreign exchange market, often referred to as the forex (FX) market. Transactions in ... Read Answer >>

You May Also Like

Hot Definitions
  1. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  2. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  3. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  4. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  5. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  6. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
Trading Center