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 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 the 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. The 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 by 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 counterpart to the trader, providing clearance and settlement.
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.
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.
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.
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.
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
Pro: 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.
Con: 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.
Pro: The forex market is traded 24 hours a day, five days a week—starting each day in Australia and ending in New York. The major centers are Sydney, Hong Kong, Singapore, Tokyo, Frankfurt, Paris, London, and New York.
Con: 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 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.