Forex is a portmanteau of foreign currency and exchange. Foreign exchange is the process of changing one currency into another currency for a variety of reasons, usually for commerce, trading, or tourism. According to a 2019 triennial report from the Bank for International Settlements (a global bank for national central banks), the daily trading volume for forex reached $6.6 trillion in April 2019.
- The foreign exchange (also known as FX or forex) market is a global marketplace for exchanging national currencies.
- Because of the worldwide reach of trade, commerce, and finance, forex markets tend to be the largest and most liquid asset markets in the world.
- Currencies trade against each other as exchange rate pairs. For example, EUR/USD is a currency pair for trading euro against the US dollar.
- Forex markets exist as spot (cash) markets as well as derivatives markets offering forwards, futures, options, and currency swaps.
- Market participants use forex to hedge against international currency and interest rate risk, to speculate on geopolitical events, and to diversify portfolios, among several other reasons.
What Is the Forex Market?
The foreign exchange market is where currencies are traded. Currencies are important because they enable purchase of goods and services locally and across borders. International currencies need to be exchanged in order to conduct foreign trade and business.
If you are living in the U.S. and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French for the cheese in euros (EUR). This means that the U.S. importer would have to exchange the equivalent value of U.S. dollars (USD) into euros. The same goes for traveling. A French tourist in Egypt can't pay in euros to see the pyramids because it's not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate.
One unique aspect of this international market is that there is no central marketplace for foreign exchange. Rather, currency trading is conducted electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney—across almost every time zone. This means that when the trading day in the U.S. ends, the forex market begins anew in Tokyo and Hong Kong. As such, the forex market can be extremely active any time of the day, with price quotes changing constantly.
A Brief History of Forex
In its most basic sense, the forex market has been around for centuries. People have always exchanged or bartered goods and currencies to purchase goods and services. However, the forex market, as we understand it today, is a relatively modern invention.
After the accord at Bretton Woods in 1971, more currencies were allowed to float freely against one another. The values of individual currencies vary based on demand and circulation and they are monitored by foreign exchange trading services.
Commercial and investment banks conduct most of the trading in forex markets on behalf of their clients, but there are also speculative opportunities for trading one currency against another for professional and individual investors.
There are two distinct features to currencies as an asset class:
- You can earn the interest rate differential between two currencies.
- You can profit from changes in the exchange rate.
An investor can profit from the difference between two interest rates in two different economies by buying the currency with the higher interest rate and shorting the currency with the lower interest rate. Prior to the 2008 financial crisis, it was very common to short the Japanese yen (JPY) and buy British pounds (GBP) because the interest rate differential was very large. This strategy is sometimes referred to as a "carry trade."
Why We Can Trade Currencies
Currency trading was very difficult for individual investors prior to the internet. Most currency traders were large multinational corporations, hedge funds or high net worth individuals because forex trading required a lot of capital. With help from the internet, a retail market aimed at individual traders has emerged, providing easy access to the foreign exchange markets, either through the banks themselves or brokers making a secondary market. Most online brokers or dealers offer very high leverage to individual traders who can control a large trade with a small account balance.
An Overview of Forex Markets
The FX market is where currencies are traded. It is the only truly continuous and nonstop trading market in the world. In the past, the forex market was dominated by institutional firms and large banks, who acted on behalf of clients. But it has become more retail-oriented in recent years and traders and investors of many holding sizes have begun participating in it.
An interesting aspect of world forex markets is that there are no physical buildings that function as trading venues for the markets. Instead, it is a series of connections made through trading terminals and computer networks. Participants in this market are institutions, investment banks, commercial banks, and retail investors.
The foreign exchange market is considered more opaque as compared to other financial markets. Currencies are traded in OTC markets, where disclosures are not mandatory. Large liquidity pools from institutional firms are a prevalent feature of the market. One would presume that a country’s economic parameters should be the most important criterion to determine its price. But that’s not the case. A 2019 survey found that the motives of large financial institutions played the most important role in determining currency prices.
There are three ways to trade Forex. They are as follows:
Forex trading in the spot market has always been the largest because it trades in the biggest “underlying” real asset for the forwards and futures market. Previously, volumes in the futures and forwards markets surpassed those of the spot market. However, the trading volumes for forex spot markets received a boost with the advent of electronic trading and proliferation of forex brokers. When people refer to the forex market, they usually are referring to the spot market. The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.
How Does the Spot Market Work?
The spot market is where currencies are bought and sold based on their trading price. That price is determined by supply and demand and is calculated based on several factors including current interest rates, economic performance, sentiment towards ongoing political situations (both locally and internationally) as well as the perception of the future performance of one currency against another.
A finalized deal is known as a "spot deal." It is a bilateral transaction in which one party delivers an agreed-upon currency amount to the counter party and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present (rather than the future), these trades actually take two days for settlement.
Forwards and Futures Markets
A forward contract is a private agreement between two parties to buy a currency at a future date and at a pre-determined price in the OTC markets. A futures contract is a standardized agreement between two parties to take delivery of a currency at a future date and at a predetermined price.
Unlike the spot market, the forwards and futures markets do not trade actual currencies. Instead they deal in contracts that represent claims to a certain currency type, a specific price per unit and a future date for settlement.
In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves. In the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange.
In the U.S., the National Futures Association regulates the futures market. Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments that cannot be customized. The exchange acts as a counterparty to the trader, providing clearance and settlement services.
Both types of contracts are binding and are typically settled for cash at the exchange in question upon expiry, although contracts can also be bought and sold before they expire. The currency forwards and futures markets can offer protection against risk when trading currencies. Usually, big international corporations use these markets in order to hedge against future exchange rate fluctuations, but speculators take part in these markets as well.
Note that you'll often see the terms: FX, forex, foreign-exchange market, and currency market. These terms are synonymous and all refer to the forex market.
Forex for Hedging
Companies doing business in foreign countries are at risk due to fluctuations in currency values when they buy or sell goods and services outside of their domestic market. Foreign exchange markets provide a way to hedge currency risk by fixing a rate at which the transaction will be completed.
To accomplish this, a trader can buy or sell currencies in the forward or swap markets in advance, which locks in an exchange rate. For example, imagine that a company plans to sell U.S.-made blenders in Europe when the exchange rate between the euro and the dollar (EUR/USD) is €1 to $1 at parity.
The blender costs $100 to manufacture, and the U.S. firm plans to sell it for €150—which is competitive with other blenders that were made in Europe. If this plan is successful, the company will make $50 in profit because the EUR/USD exchange rate is even. Unfortunately, the USD begins to rise in value versus the euro until the EUR/USD exchange rate is 0.80, which means it now costs $0.80 to buy €1.00.
The problem the company faces is that while it still costs $100 to make the blender, the company can only sell the product at the competitive price of €150, which when translated back into dollars is only $120 (€150 X 0.80 = $120). A stronger dollar resulted in a much smaller profit than expected.
The blender company could have reduced this risk by shorting the euro and buying the USD when they were at parity. That way, if the dollar rose in value, the profits from the trade would offset the reduced profit from the sale of blenders. If the USD fell in value, the more favorable exchange rate will increase the profit from the sale of blenders, which offsets the losses in the trade.
Hedging of this kind can be done in the currency futures market. The advantage for the trader is that futures contracts are standardized and cleared by a central authority. However, currency futures may be less liquid than the forward markets, which are decentralized and exist within the interbank system throughout the world.
Forex for Speculation
Factors like interest rates, trade flows, tourism, economic strength, and geopolitical risk affect supply and demand for currencies, which creates daily volatility in the forex markets. An opportunity exists to profit from changes that may increase or reduce one currency's value compared to another. A forecast that one currency will weaken is essentially the same as assuming that the other currency in the pair will strengthen because currencies are traded as pairs.
Imagine a trader who expects interest rates to rise in the U.S. compared to Australia while the exchange rate between the two currencies (AUD/USD) is 0.71 (it takes $0.71 USD to buy $1.00 AUD). The trader believes higher interest rates in the U.S. will increase demand for USD, and therefore the AUD/USD exchange rate will fall because it will require fewer, stronger USD to buy an AUD.
Assume that the trader is correct and interest rates rise, which decreases the AUD/USD exchange rate to 0.50. This means that it requires $0.50 USD to buy $1.00 AUD. If the investor had shorted the AUD and went long the USD, they would have profited from the change in value.
Forex Trading: A Beginner’s Guide
Forex Trading: A Beginner's Guide
Trading currencies can be risky and complex. The interbank market has varying degrees of regulation, and forex instruments are not standardized. In some parts of the world, forex trading is almost completely unregulated.
The interbank market is made up of banks trading with each other around the world. The banks themselves have to determine and accept sovereign risk and credit risk, and they have established internal processes to keep themselves as safe as possible. Regulations like this are industry-imposed for the protection of each participating bank.
Since the market is made by each of the participating banks providing offers and bids for a particular currency, the market pricing mechanism is based on supply and demand. Because there are such large trade flows within the system, it is difficult for rogue traders to influence the price of a currency. This system helps create transparency in the market for investors with access to interbank dealing.
Most small retail traders trade with relatively small and semi-unregulated forex brokers/dealers, which can (and sometimes do) re-quote prices and even trade against their own customers. Depending on where the dealer exists, there may be some government and industry regulation, but those safeguards are inconsistent around the globe.
Most retail investors should spend time investigating a forex dealer to find out whether it is regulated in the U.S. or the U.K. (dealers in the U.S. and U.K. have more oversight) or in a country with lax rules and oversight. It is also a good idea to find out what kind of account protections are available in case of a market crisis, or if a dealer becomes insolvent.
How to Get Started with Forex Trading
Trading forex is similar to equity trading. Here are some steps to get yourself started on the forex trading journey.
1. Learn about Forex: While it is not complicated, forex trading is a project of its own and requires specialized knowledge. For example, the leverage ratio of forex trades is higher as compared to those for equities and the drivers for currency price movement are different from those in equity markets. There are several online courses available for beginners that teach the ins-and-outs of forex trading.
2. Set up a brokerage account: You will need a forex trading account at a brokerage to get started with forex trading. Forex brokers do not charge commissions. Instead, they make money through spreads (also known as pips) between the buying and selling prices.
For beginner traders, it is a good idea to setup a micro forex trading account with low capital requirements. Such accounts have variable trading limits and allow brokers to limit their trades to amounts as low as 1,000 units of a currency. For context, a standard account lot is equal to 100,000 currency units. A micro forex account will help you become more comfortable with forex trading and determine your trading style.
3. Develop a trading strategy: While it is not always possible to predict and time market movement, having a trading strategy will help you set broad guidelines and a roadmap for trading. A good trading strategy is based on the reality of your situation and finances. It takes into account the amount of cash that you are willing to put up for trading and, correspondingly, the amount of risk that you can tolerate without getting burned out of your position. Remember, forex trading is mostly a high leverage environment. But it also offers more rewards to those who are willing to take the risk.
4. Always be on top of your numbers: Once you begin trading, always check your positions at the end of the day. Most trading software already provides with a daily accounting of trades. Make sure that you do not have any pending positions that need to be filled out and that you have sufficient cash in your account to make future trades.
5. Cultivate Emotional Equilibrium: Beginner forex trading is fraught with emotional rollercoasters and unanswered questions. Should you have held onto your position a bit longer for more profits? How did you miss that report about low GDP numbers that led to a decline in overall value for your portfolio? Obsessing over such unanswered questions can lead you down a path of confusion. That is why it is important to not get carried away by your trading positions and cultivate emotional equilibrium across profits and losses. Be disciplined about closing out your positions, when necessary.
The best way to get started on the forex journey is to learn its language. Here are a couple of terms to get you started:
Forex account: A forex account is the account that you use to make currency trades. Depending on the lot size, there can be three types of forex accounts:
- Micro forex accounts: Accounts that allow you to trade up to $1,000 worth of currencies in one lot.
- Mini forex accounts: Accounts that allow you to trade up to $10,000 worth of currencies in one lot.
- Standard forex accounts: Accounts that allow you to trade up to $100,000 worth of currencies in one lot.
Remember that the trading limit for each lot includes margin money used for leverage. This means that the broker can provide you with capital in a pre-determined ratio. For example, they may put up $100 for every $1 that you put up for trading, meaning you will only need to use $10 from your own funds to trade currencies worth $1,000.
Ask: An ask is the lowest price at which you are willing to buy a currency. For example, if you place an ask price of $1.3891 for GBP, then the figure mentioned is the lowest that you are willing to pay for a pound in US dollars. The ask price is generally greater than the bid price.
Bid: A bid is the price at which you are willing to sell a currency. A market maker in a given currency is responsible for continuously putting out bids in response to buyer queries. While they are generally lower than ask prices, in instances when demand is great, bid prices can be higher than ask prices.
Bear Market: A bear market is one in which prices decline for all currencies. Bear markets signify a market downtrend and are the result of depressing economic fundamentals or catastrophic events, such as a financial crisis or a natural disaster.
Bull Market: A bull market is one in which prices increase for all currencies. Bull markets signify a market uptrend and are the result of optimistic news about the global economy.
- It is important to know the terminology related to forex trading before you begin the actual trading process.
- While there is a significant overlap between standard finance terms, such as leverage and bid/ask prices, there are some terms, such as pips, forex accounts, and lot sizes, that are unique to currency trades.
Contract for Difference: Contract for Difference (CFD) is a derivative that enables traders to speculate on price movements for currencies without actually owning the underlying asset. A trader betting that the price of a currency pair will increase will buy CFDs for that pair while those who believe its price will decline will sell CFDs relating to that currency pair. The use of leverage in forex trading means that a CFD trade gone awry can lead to heavy losses.
Leverage: Leverage is the use of borrowed capital to multiply returns. The forex market is characterized by high leverages and traders often use these leverages to boost their positions.
For example, a trader might put up just $1,000 of their own capital and borrow $9,000 from their broker to bet against the euro (EUR) in a trade against the Japanese Yen (JPY). Since they have used very little of their own capital, the trader stands to make significant profits if the trade goes in the correct direction. The flipside to a high leverage environment is that downside risks are enhanced and can result in significant losses. In the example above, the trader’s losses will multiply if they the trade goes in the opposite direction.
Lot Size: Currencies are traded in standard sizes known as lots. There are three common lot sizes: standard, mini, and micro. Standard lot sizes consist of 100,000 units of the currency. Mini lot sizes consist of 10,000 units and micro lot sizes consist of 1,000 units of the currency. Some brokers also offer nano lot sizes of currencies, worth 100 units of the currency, to traders. The choice of a lot size has a significant effect on the overall trade's profits or losses. The bigger the lot size, the higher the profits (or losses) and vice versa.
Margin: Margin is the money set aside in an account for a currency trade. Margin money helps assure the broker that the trader will remain solvent and will be able to meet monetary obligations, even if the trade does not go her way. The amount of margin depends on the trader and customer balance over a period of time. Margin is used in tandem with leverage (defined above) for trades in forex markets.
Pip: A pip is "percentage in point" or "price interest in point". It is the minimum price move, equal to four decimal points, made in currency markets. One pip is equal to 0.0001. 100 pips is equal to 1 cent and 10,000 pips is equal to $1. The pip value can change depending on the standard lot size offered by a broker. In a standard lot of $100,000, each pip will have a value of $10. Because currency markets use significant leverage for trades, small price moves, defined in pips, can have an outsized effect on the trade.
Spread: A spread is the difference between the bid (sell) price and ask (buy) price for a currency. Forex traders do not charge commissions; they make money through spreads. The size of the spread is influenced by many factors. Some of them are size of your trade, demand for the currency, and its volatility.
Sniping and Hunting: Sniping and hunting is purchase and sale of currencies near predetermined points to maximize profits. Brokers indulge in this practice and the only way to catch them is to network with fellow traders and observe for patterns of such activity.
Forex Trading Strategies
The most basic forms of forex trades are a long trade and short trade. In a long trade, the trader is betting that the currency price will increase in the future and they can profit from it. A short trade consists of a bet that the currency pair's price will decrease in the future. Traders can also use trading strategies based on technical analysis, such as Breakout and Moving Average, to finetune their approach to trading.
Depending on the duration and numbers for trading, trading strategies can be further categorized into a further four types.
A scalp trade consists of positions that are held for seconds or minutes at most and the profit amounts are restricted in terms of the number of pips. Such trades are supposed to be cumulative, meaning small profits made in each individual trade add up to a tidy amount at the end of a day or time period. They rely on predictability of price swings and cannot handle much volatility. Therefore, traders tend to restrict such trades to the most liquid pairs and at the busiest times of trading during the day.
Day trades are short term trades in which positions are held and liquidated in the same day. The duration of a day trade can be hours or minutes. Day traders require technical analysis skills and knowledge of important technical indicators to maximize their profit gains. Just like scalp trades, day trades rely on incremental gains throughout the day for trading.
In a swing trade, the trader holds the position for a period longer than a day i.e., they may hold the position for weeks or days. Swing trades can be useful during major announcements by government or during times of economic tumult. Since they have a longer timeline, swing trades do not require constant monitoring of the markets througout the day. In addition to technical analysis, swing traders should be able to gauge economic and political developments and their impact on currency movement.
In a position trade, the trader holds the currency for a long period of time, lasting for as long as months or even years. This type of trade requires more fundamental analysis skills because it provides a reasoned basis for the trade.
Charts Used in Forex Trading
There are three types of charts used in forex trading. They are as follows:
Line Charts: Line charts are used to identify big picture trends for a currency. It is the most basic and common type of chart used by forex traders. They display the closing trading price for the currency for the time periods specified by the user. The trend lines identified in a line chart can be used to devise trading strategies. For example, you can use the information contained in a trend line to identify breakouts or a change in trend for rising or declining prices. While it can be useful, a line chart is generally used as a starting point for further trading analysis. You can read more about line charts here.
Bar Charts: Much like other instances in which they are used, bar charts are used to represent specific time periods for trading. They provide more price information as compared to line charts. Each bar chart represents one day of trading and contains the opening price, highest price, lowest price, and closing price (OHLC) for a trade. A dash on the left is the day's opening price and a similar dash on the right represents the closing price. Colors are, sometimes, used to indicate price movement, with green or white used for periods of rising prices and red or block for a period during which prices declined. Bar charts for currency trading help traders identify whether it is a buyer's market or a seller's market. You can read more about bar charts here.
Candlestick charts: Candlestick charts were first used by Japanese rice traders in the 18th century. They are visually more appealing and easier to read as compared to the chart types described above. The upper portion of a candle is used for the opening price and highest price point used by a currency and the lower portion of a candle is to indicate closing price and lowest price point. A down candle represents a period of declining prices and is shaded red or black while an up candle is a period of increasing prices and it is shaded green or white. The formations and shapes in candlestick charts are used to identify market direction and movement. Some of the more common formations for candlestick charts are hanging man and shooting star. You can read more about candlestick charts here.
What is Forex?
Forex refers to the exchange of one currency for another.
Where is forex traded?
Forex is traded at three places: spot markets, forwards market, and the futures markets. The spot market is the largest of all three markets because it is the “underlying” asset that forwards and futures markets are based on.
Why is forex traded?
Companies and traders use forex for two main reasons: speculation and hedging. The former is used by traders to make money off the rise and fall of currency prices while the latter is used to lock in prices for manufacturing and sales in overseas markets.
Are forex trades volatile?
Forex markets are amongst the most liquid markets in the world. Hence, they are less volatile as compared to other markets like real estate. The volatility of a particular currency is a function of multiple factors, such as the politics and economics of its country. Therefore, events like economic instability in the form of a payment default or imbalance in trading relationships with another currency can result in significant volatility.
Are forex trades regulated?
Forex trade regulation depends on the jurisdiction. Countries like the United States have sophisticated infrastructure and markets to conduct forex trades. Hence, forex trades are tightly regulated there by the National Futures Association (NFA) and the Commodities and Futures Trading Commission (CFTC). However, due to the heavy use of leverage in forex trades, developing countries like India and China have restrictions on the firms and capital to be used in forex trading. Europe is the largest market for forex trades. The Financial Conduct Authority (FCA) is responsible for monitoring and regulating forex trades in the United Kingdom.
Which currencies should I trade in?
Currencies with high liquidity have a ready market and, therefore, are exhibit smooth and predictable price action in response to external events. The United States dollar is the most-traded currency is the world. It features in six of the seven currency pairs with the most liquidity in the markets. Currencies with low liquidity, however, cannot be traded in large lot sizes without significant market movement being associated with the price. Such currencies generally belong to developing countries. When they are paired with the currency of a developed country, an exotic pair is formed. For example, a pairing of the US dollar (USD) with the Indian Rupee (INR) is considered an exotic pair.
How do I get started with forex trading?
The first step to forex trading is to educate yourself regarding the market's operations and terminology. Next you need to develop a trading strategy based on your finances and risk tolerance. Finally, you should open a brokerage account. For more details, see section above.
Pros and Cons of Trading Forex
The pros of trading forex are as follows:
- Forex markets are the largest in terms of daily trading volume in the world and therefore offer the most liquidity. This makes it easy to enter and exit a position in any of the major currencies within a fraction of a second for a small spread in most market conditions.
- The forex market is traded 24 hours a day, five days a week—starting each day in Australia and ending in New York. The broad time horizon and coverage offers traders several opportunities to make profits or cover their losses. The major forex market centers are Sydney, Hong Kong, Singapore, Tokyo, Frankfurt, Paris, London, and New York.
- The extensive use of leverage in forex trading means that you can start with little capital and multiply your profits.
- Automation of forex markets lends itself well to rapid execution of trading strategies.
- The forex market is more decentralized as compared to traditional stock or bond markets. There is no centralized exchange that dominates currency trade operations and the potential for manipulation, through insider information about a company or stock, is less.
- Forex trading generally follows the same rules as regular trading and requires much less initial capital; therefore, it is easier to start trading forex as compared to stocks.
The cons of forex trading are as follows:
- Even though they are the most liquid markets in the world, forex trades are much more volatile as compared to regular markets.
- Banks, brokers, and dealers in the forex markets allow a high amount of leverage, which means that traders can control large positions with relatively little money of their own. Leverage in the range of 100:1 is not uncommon in forex. A trader must understand the use of leverage and the risks that leverage introduces in an account. Extreme amounts of leverage have led to many dealers becoming insolvent unexpectedly.
- Trading currencies productively requires an understanding of economic fundamentals and indicators. A currency trader needs to have a big-picture understanding of the economies of the various countries and their inter-connectedness to grasp the fundamentals that drive currency values.
- The decentralized nature of forex markets means that it is less accountable to regulation as compared to other financial markets. The extent and nature of regulation in forex markets depends on the jurisdiction of trading.
- Forex markets lack instruments that provide regular income, such as regular dividend payments, that might make them attractive to investors not interested in exponential returns.
The Bottom Line
For traders—especially those with limited funds—day trading or swing trading in small amounts is easier in the forex market than other markets. For those with longer-term horizons and larger funds, long-term fundamentals-based trading or a carry trade can be profitable. A focus on understanding the macroeconomic fundamentals driving currency values and experience with technical analysis may help new forex traders to become more profitable.