You have probably heard the word “Forex” and wondered what people are talking about. Forex or FX is short for “foreign exchange.” Foreign exchange is where currency trading takes place. Forex was launched in the 1970’s when free exchange rates were introduced. Foreign exchange has evolved into the largest financial market in the world with average daily volume over 4 trillion. Access to Forex trading used to be limited to multinational corporations and banks .The Internet and new technologies have opened the Forex market to individual investors and traders.
The market that almost never sleeps
The foreign exchange market operates 24 hours per day, five days a week. One unique aspect of the foreign exchange market is there is no central marketplace. Currency trading is conducted electronically in an over-the-counter market (OTC.) This means that all currency transactions take place via computer networks between traders around the world rather than on one centralized exchange. Although there is no centralized exchange for foreign exchange there are important geographic centers around the world where currencies are actively traded and dealers will quote currency rates. These geographic centers include London, New York, Tokyo, Singapore, Frankfurt, Geneva, Zürich, Paris and Hong Kong.
What happens in the Forex market?
Markets are places where goods are traded and the same goes with Forex. In Forex markets the goods are currencies of various countries. For example you might buy euro with US dollars or sell Japanese Yen for sterling. In Forex you exchange one currency for another. The participants in the market determine the price of the currency.
What is traded on the Forex market?
Money is traded on the Forex markets, the simultaneous buying of one currency and selling of another. Most actively traded currencies include US dollar euro sterling Yen Swiss franc ,Australian and Canadian dollar
The main features of Forex trading are
- 24 hour trading, five days a week, with non stop access to global forex dealers
- Liquid markets allowing you to easily enter and exit trades
- Volatile markets offering profit opportunities
- Standard instruments for controlling risk exposure
- The ability to profit from rising and falling markets
- Leveraged trading with low margin requirements
- Many options for zero commission trading
- No fees except for the difference in the spread between buying and selling prices
The players
The major players in foreign exchange market are: speculators, corporations and governments, central banks, banking institution, hedge fund traders, investment accounts and retail brokers. The majority of Forex traders speculate on movements in exchange rates. 85% of all Forex trading is for speculative purposes. It's the speculative nature of the Forex market that makes it exciting, potentially very profitable and risky.
Why should Forex be of interest t to you?
You can buy and sell currencies seeking to make a profit on the price fluctuations in the foreign exchange market. Unlike the stock market where shares are purchased, Forex trading does not require physical purchase of the currencies but rather involves contracts for an amount and exchange rate of currency pairs. Regular daily fluctuations in currency exchange market average around 1%. Easy Forex turnover trading ratios range from 1:50 to 1:200.Because you can profit from rising and falling markets the wide range of daily price fluctuations in Forex markets creates numerous opportunities for profit.
How does one profit in the Forex market?
Like any other investment you're trying to buy low and sell high. The profit comes from the fluctuations in currency exchange market. For example if you think the USD will lose value against the EUR you can buy EUR on the Forex exchange. The Forex market is one of most liquid and volatile markets in the world. The liquidity and volatility in the foreign exchange market offers great potential for profits. Average investors can buy and sell currencies with the click of a mouse through online brokerage firms and Internet trading platforms.
Open 24 hours a day
Forex trades 24 hours a day five days a week. This opens the door to numerous trading opportunities. The ease of access to Forex dealers at any time of the day allows you to easily enter and exit trades. The Forex markets are highly speculative and speculation in Forex market contributes to volatility. The volatility of Forex markets offers numerous profit opportunities. You can profit on rising and falling markets. There are no restrictions on short sales that you will find in the equity markets. There are low margin requirements in Forex markets which enables you to trade with limited capital. Finally there are no commissions. The cost of trading is the difference in the price between the bid offer spread. The bid offer spread usually ranges between one and four pips of the major currencies and between seven and 10 for minor currencies and 20 more for the exotic currencies.
The risks and rewards of trading Forex
Before you decide to trade in foreign exchange markets you must consider the risks as well as rewards. Trading foreign exchange can be exciting and profitable but there also are significant risk factors that need to be considered.
Speculation
The risks and rewards in trading foreign exchange can be quite large. You could lose some or all of your investment and you should not trade with money you cannot afford to lose. Trading foreign exchange is speculation. Speculation is defined as the assumption of risk of loss in return for the uncertain possibility of reward. Foreign exchange markets are extremely liquid and volatile and can be traded with low margin requirements. The volatility and low margin presents great opportunities for making money and opportunity for loosing money.
Margin and leverage
You must understand the implications of margin trading and leverage offered in the foreign exchange trade.
Margin is defined as the amount of money required for initiating the buying or selling of a determined amount of currency. Basically margin is a security deposit taken on a trade in the Forex market. Margin trading refers to the leverage amount given to traders to trade the market. Forex traders are able to trade currencies with high-margin. Unlike the margin for trading stocks which is 2 to 1 and usually 15 to 1 margin for futures, the normal margin of Forex market can be 100 to 1, 150 to 1 or 200 to 1.
For example for every $1000 that you have in margin you can trade 100,000 of the currency. When trading Forex the huge margin allows traders to control a large sum of money with little cash. When you use margin you are essentially borrowing money to try to make even more money on the investment. Because of the increased amount of leverage in the Forex market there is a high level of financial risk in trading. The leverage is defined as the ratio of investment to the actual value of the investment. Using $1000 to buy a Forex contract with a 100,000 value is leveraging at 1 to 100 ratio. The $1000 is all you invest and risk, but that gains you make may be many times greater.
Summary
Forex trading is the simultaneous buying one currency and selling of another. Unlike other financial markets like the New York Stock Exchange, the Forex market has neither a centralized physical location nor a central exchange. Forex is considered an over-the-counter market with trades matched electronically typically via brokers and dealers within a network of banks.
Forex markets are noted for extreme liquidity and high leverage. The Forex market provides plenty of opportunity for investors because the markets trade twenty four hours a day and are easily accessible. Margin, leverage and volatility combine to create the opportunity for huge profit and the risk of loss in the foreign exchange markets. Successful traders must be aware of this risk and plan their trades to minimize the risks to the trading capital. Risk management is one of the key tools to successful foreign exchange trading. When you decide to trade foreign exchange you must determine how to make trading decisions. In the course of future articles we will discus how a trader might use fundamental or technical analysis to forecast currency price movement. We conclude this article with a list of terminology that you need to familiarize yourself with when trading foreign exchange market.
Terminology you need to know
In order to understand Forex you need to become familiar with a number of Forex terms. A good way to do this is to take a look at the Forex dictionary below.
Appreciation is one currency value grows stronger.
Ask Rate is the rate of trade via currency is for sale.
Aussie - Forex acronym for the Australian dollar.
Base Currency is the currency in which other currencies are quoted in a pair. Usually the US dollar is considered the base currency.
Bear Market is a market in which prices are declining.
Bid/Ask spread is the difference between the bid and offer price.
Broker is an individual or firm puts buyers and sellers together for a fee or commission.
Bull Market is a market which prices are rising
Cable - Forex acronym for GBP/USD
Clearing is a term used to refer to a process of settling a trade.
Commission is the fee that is charged by a broker/dealer.
Confirmation is a document that states the terms of a transaction.
Contract is the standard unit of trading.
Cross Rate is the exchange rate between any two currencies that are not of the country in which the currency pair is quoted. For example, in the U.S., a GBP/JPY quote would be considered a Cross Rate. The same quote would not be a Cross Rate in either the U.K. or Japan.
Currency is a unit of exchange. Any form of money that has been issued by a government/central bank is a currency. Currencies are used as a medium of exchange, i.e. they are used as a basis for trades.
Day Trading are trades in which positions are opened and closed on the same day.
Dealer is an individual/firm that takes one side of a position hoping to make a profit by closing out the position in a following trade with a different trader.
Depreciation is a fall in the value of a currency.
ECB European Central Bank, the main central bank of the European Union.
Fed Federal reserve, central bank of the United States, regulates interest rates.
Fibonacci Retracements - the levels with a high probability of trend break or bounce, calculated as the 23.6%, 32.8%, 50% and 61.8% of the trend range.
Foreign Exchange, Forex, FX is the simultaneous purchase or sale of one currency against the purchase or sale of another.
Forward is the predetermined and agreed upon exchange rate for the settling of a transaction at some agreed future date.
Fundamental Analysis is the analysis of economic and political information as it aims to determine future market movements.
Inflation is an economic condition in which the prices of goods rise, hence decreasing the purchasing power of consumers.
Initial Margin is the deposit given to a broker/dealer; it is the collateral required to enter into a position as a guarantee on future performance.
Interest-rate differential, the yield spread between two otherwise comparable debt instruments denominated in different currencies.
Leverage, investor funds needed for margin.
Limit Order is an order that sets restrictions on the amount of profit and loss it can make.
Liquidity is the ability of a market to accept large transaction without it impacting the stability of its prices.
Long Position is a position that increases in value in value if market prices increase.
Margin Call is when the broker/dealer request additional collateral to guarantee performance on a position that has moved against the investor.
Market Maker is a dealer who quotes both bid and ask prices, hence makes a two-sided market for any financial instrument.
Maturity is the date in which a financial instrument is expired or a transaction is settled.
Momentum - the measure of the currency's ability to move in the given direction.
Moving Average (MA) - one of the most basic technical indicators. It shows the average rate calculated over a series of time periods. Exponential Moving Average (EMA), Weighted Moving Average (WMA) etc. are just the ways of weighing the rates and the periods.
Offer is the rate at which a dealer is willing to sell.
Open position is a deal that has not yet been settled with a physical payment.
Overnight Trading are trades in which positions remain open until the next day.
Pips/Points is one unit of price change in the bid/ask price of a currency. It is the last digit in a rate; the fourth decimal place in an exchange rate.
Pivot Point - the primary support/resistance point calculated basing on the previous trend's High, Low and Close prices.
Position is the netted total holdings of a given currency.
Quote is an indicative market price, normally used for information purposes only and not for deals.
Rate is the price of one currency in terms of another.
Resistance - price level for which the intensive selling can lead to price increasing (up-trend).
Risk is an exposure to the chance of loss.
Roll-Over is a process in which the settlement of a transaction is pushed forward to another date.
Short Position is a position that increases in value if the market prices decrease.
Spread refers to the difference between the bid and offer prices for a currency pair.
Stop Loss Order is an order in which an open position is automatically liquidated at a specific price. Stop Loss Order minimized potential losses if the market moves in the opposite direction of the investor’s position.
Swap is the sale and purchase of a certain amount of a certain currency at a forward exchange rate.
Support - price level for which intensive buying can lead to the price decreasing (down-trend).
Technical Analysis is an analysis of historical market trends in an effort to forecast future market movements.
Transaction Cost is the cost of making a financial transaction whether it is buying or selling.
Trend - direction of market which has been established with influence of different factors.
Volatility - a statistical measure of the number of price changes for a given currency pair in a given period of time.
Test your knowledge
- True or false
Foreign Exchange, Forex, FX is the simultaneous purchase or sale of one currency against the purchase or sale of another.
- Foreign exchange markets are highly speculative and this makes foreign exchange _______.
- liquid
- volatile
- less risky
- True or false
Margin in foreign exchange allows you to control a large amount of a currency with limited capital.
- Foreign exchange markets are very liquid and this offers you easy ______and _____for your trades.
- entry and exit
- profit and loss
- leverage and margin
- True or false
There are no commissions when trading foreign exchange: your cost to trade is the spread the difference between the bid and ask price of the currency your trading.
Answer key
- True
- b, volatile
- True
- a, entry and exit
- True
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