What is Forex?
Forex, or FX, is a shortened term that describes the Foreign Exchange Market, a marketplace where the world’s various currencies are traded. It is an interbank market which was created in 1971 when international trade transitioned from fixed to floating exchange rates. As a result of its incredible volume and fluidity, the FX market has become the largest and most significant financial market in the world.
The Forex market is the largest market in the world with daily reported volume of over 5.3 trillion (According to the to the 2013 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity conducted by the Bank for International Settlements-BIS), making it one of the most exciting markets for trading.
The FX market is considered an Over the Counter (OTC) or ‘interbank’ market, due to the fact that transactions are conducted between two counterparts over the telephone or via an elec tronic network. Unlike other financial markets that operate at a centralized location (i.e., the stock exchange), the worldwide Forex market does not have a central location. It is a global electronic network of banks, financial institutions and individual Forex traders, all involved in the buying and selling of national currencies. This structure eliminates fees for exchange and clearing, thereby reducing transaction costs.
A major feature of the Forex market is that it operates continuously five and half days a week from its opening session on Sunday afternoon (Eastern Time) to Friday afternoon (Eastern Time). Throughout this period, in any location, there are buyers and sellers, making the Forex market the most liquidmarket in the world.
The spot Forex market is unique to any other market in the world, as trading is available 24 -hours a day. Somewhere around the world, a financial center is open for business, and banks and other institutions exchange currencies, every hour of the day and nigh t with generally only minor gaps on the weekend. Essentially foreign exchange markets follow the sun around the world, giving traders the flexibility of determining their trading day.
|Time zone||New York Time||GMT|
|Tokyo Open||07:00 PM||00:00|
|Tokyo Close||04:00 AM||09:00|
|London Open||03:00 AM||08:00|
|London Close||12:00 PM||17:00|
|NY Open||08:00 AM||13:00|
|NY Close||05:00 PM||22:00|
Although foreign exchange is the most liquid of all markets, the fact that it is an international market and trading 24-hours a day, the time of day can have a direct impact on the liquidity available for trading a particular currency. The major dealer centers and time zones are that of Sydney, Tokyo, London, and New York. Therefore, traders must consider which players are in the market, since in the modern interconnected financial world, events that occur at any hour, in any part of the globe, can affect some or all parts of the investment community. The market’s 24-hour nature is a substantial attraction to traders that prefer to trade at all times of the day, or night.
Trade forex 24-hours a day
Currency trading is available twenty-four hours a day, starting on Sunday at 5pm EST with the opening of the market in Sydney and Singapore. A short while after, the Tokyo market opens. Then London, which opens at 2am EST on Monday. And, by daytime in N.Y., the currency market has already been very active for fifteen hours. With currency trading, you are able to decide when to trade. Trading stocks when the U.S. markets are closed is difficult and only offers limited liquidity. With forex, you can trade twenty-four hours a day, from Sunday a t 5 pm EST. until Friday at5pm EST.
Who Trades Forex
The main participants in the Forex market are: central banks, commercial banks, financial institutions, hedge funds, commercial companies and individual investors. The main reasons they participate in the Forex market are:
- Profit from fluctuations in currency pairs (speculating)
- Protection from fluctuating currency pairs which is derived from trading goods and services (Hedging)
With technological development, the World Wide Web has become a great trading facilitator, as it can provide individual investors and traders with access to all the latest Forex news, technology and tools.
The Forex OTC market is formed by different participants – with varying needs and interests – that trade directly with each other. These participants can be divided in two groups: the interbank market and the retail market.
The Interbank Market
Central Banks – National central banks (such as the US Fed and the BCE) play an important role in the Forex market. As principal monetary authority, their role consists in achieving price stability and economic growth. To do so, they regulate the entire money supply in the economy by setting interest rates and reserve requirements. They also manage the country’s foreign exchange reserves that they can use in order to influence market conditions and exchange rates.
Commercial Banks – Commercial banks (such as Deutsche Bank and Barclays) provide liquidity to the Forex market due to the trading volume they handle every day. Some of this trading represents foreign currency conversions on behalf of customers’ needs while some is carried out by the banks’ proprietary trading desk for speculative purpose.
Financial Institutions – Financial institutions such as money managers, investment funds, pension funds and brokerage companies trade foreign currencies as part of their obligations to seek the best investment opportunities for their clients. For example, a manager of an international equity portfolio will have to engage in currency trading in order to buy and sell foreign stocks.
The Retail Market
The retail market designates transactions made by smaller speculators and investors. These transactions are executed through Forex brokers who act as a mediator between the retail market and the interbank market. The participants of the retail market are hedge funds, corporations and individuals.
Hedge Funds – Hedge funds are private investment funds that speculate in various assets classes using leverage. Macro Hedge Funds pursue trading opportunities in the Forex Market. They design and execute trades after conducting a macroeconomic analysis that reviews the challenges affecting a country and its currency. Due to their large amounts of liquidity and their aggressive strategies, they are a major contributor to the dynamic of Forex Market.
Corporations – They represent the companies that are engaged in import/export activities with foreign counterparts. Their primary business requires them to purchase and sell foreign currencies in exchange for goods, exposing them to currency risks. Through the Forex market, they convert currencies and hedge themselves against future fluctuations.
Individuals – Individual traders or investors trade Forex on their own capital in order to profit from speculation on future exchange rates. They mainly operate through Forex platforms that offer tight spreads, immediate execution and highly leveraged margin accounts.
Why Trade Forex?
Advantages of Forex Trading
The main advantage of the Forex market is that it is a true 24-hour market. No matter what time it is, there are always buyers and sellers somewhere in the world actively trading Forex. In this way, investors can respond to breaking news immediately.
Leveraged trading, also referred to as margin trading, allow investors in the Forex market to execute trades up to $100,000 with an initial margin of only $1,000. It is important to remember that higher gearing creates greater profits if one correctly anticipates movements in Forex prices and vice versa.
The Forex market is more liquid than any other market in the world because there are always broker/dealers willing to buy or sell currencies. The Forex liquidity, particularly for major currencies, helps ensure price stability that enables investors to always open or close a position, receive a fair market price, and more importantly be less vulnerable to liquidity risk.
Forex market is much more cost efficient to invest in terms of both commissions and transaction fees. In general, the width of the spread in a FX transaction is less than 1/10 as wide as a stock transaction.
Here are some unique characteristics that are the source of its success:
- Forex markets operate 24 hours a day, 5 1/2 days per week
- Superior liquidity: the daily turnover of the FX market – estimated 5.3 Trillion Dollars in 2013 – which improves order execution and makes it easy to trade most currencies instantaneously
- You can profit from rising or falling markets
- Ability to make money in any directional movements – Long/short. A currency does not have to be increasing in value for it to be profitable
- The ability to sell first, and buy second. This is called shorting the market
- You can benefit from leveraged trading with low margin requirements
- Leverage up to 200:1 without putting up collateral. The ability to trade without investment capital needed up front leading to greater gains and losses
- There are standard instruments available to help you control risk exposure
- More historical and trend data available for analysis
- Ability to take advantage of world-wide economic and geopolitical issues that affect currency valuations
- Excellent Transparency: the Forex Market is transparent… you just need to keep yourself informed
- Impossible to manipulate the Forex due to the size of the market and the fact that it is a non-centralized exchange
- True diversification. Unlike NYSE, where you only but the US dollar
- The ability to focus on 4-6 major currencies instead of 1000′s of stocks
- Recession proof. The Forex makes money on the movements (up/down)
- The ability to get in and out of trades in minutes, or hours, or the ability to hold positions for days, weeks, and even months
- The moves and trends in this market can last for years and months while still providing plenty of short-term opportunities for day traders
- With larger sums of capital you have the ability to hedge you risk across currencies using « carry trading techniques » which make money on the interest rate differentials between the two currencies.
How To Trade Forex
Currencies are quoted in pairs, such as EUR/USD or USD/JPY. The first listed currency is known as the base currency, while the second is called the counter or quote currency. The base currency is the « basis » for the buy or the sell. For example, if you BUY EUR/USD you have bought euros and simultaneously sold dollars. You would do so in expectation that the euro will appreciate (go up) relative to the US dollar.
|EUR||Great British Pound||CAD||Canadian Dollar|
|GBP||Great British Pound||CAD||Canadian Dollar|
|USD||US Dollar||AUD||Australian Dollar|
|CHF||Swiss Franc||NZD||New Zealand Dollar|
The euro is the base currency or the « basis » for the buy/sell.
For example, if you expect the US economy to experience a recessionary period which will be unfavorable for the US dollar, you would execute a BUY EUR/USD order. Here, you have bought euros in expectation that they will appreciate versus the US dollar.
If you expect the US Federal Reserve will raise the overnight lending rate (Fed Funds) which will cause the Euro to weaken against the US Dollar, you would execute a SELL EUR/USD order. Here you have sold Euros in expectation that they will depreciate versus the US Dollar.
Using fundamental and technical analysis, the individual trader attempts to determine trends in the price movements of currencies, and by buying or selling currency pairs, attempts to gain profits. The most often traded currencies, the major currencies, are those of countries with stable governments and respected central banks that target low inflation. Currencies that often trade along with the U.S.
Dollar include the European Euro, the Japanese Yen, and the British Pound as they are the most liquid. A trader can trade these currencies in any combination.
Buying and Selling Currencies
Traders can generate profits (or losses) whether a currency is rising or falling by buying one currency, which is anticipated to gain value against another currency or selling one currency, which is anticipated to lose value against another currency. Taking a long position is one in which a trader buys a currency at one price and aims to sell it later at a higher price. Alternatively, a short position is one in which the trader sells a currency that he anticipates to depreciate and aims to buy the currency back later at a lower price.
Buying or selling currencies in response to economic or political events which occur are reactive, whereas buying or selling currencies on anticipated events is speculative. The bulk of currency activity is generated by market participants anticipating the direction of currency prices. In general, the value of a currency versus other currencies is a reflection of the condition of that country’s economy with respect to the other major economies.
It is the trader’s option to take either a conservative or a more risk-taking approach. Employing a conservative approach, the trader establishes and liquidates positions quickly and efficiently to capitalize on even the slightest of price fluctuations, using limit and stop orders to manage risk. A limit order is placed to ensure a position is established once a price level in the market has been reached. A stop order is placed to automatically liquidate a position at a chosen price level in order to limit potential loss on a particular trade. By placing orders in relation to technical support and resistance levels, the trader may profit incrementally from the minor price fluctuations that occur each day.
The margin deposit in Forex is an interest free good faith deposit or bond, unlike the stock market where margin is a down payment on a purchase of equity with an interest rate charge.
The margin requirement allows traders to hold a position larger than the account value. If the market moves against a trader resulting in losses such that the trader lacks a sufficient amount of margin, there is an automatic margin call. The Forex dealer closes the trader’s positions and limits the losses for the client because this stops the account from turning into a negative balance.
How does leverage work in the Forex market?
In Forex Trading, investors use leverage to profit from the fluctuations in exchange rates between two different countries. Leverage is a loan that is provided to an investor by the forex broker that is handling his or her online forex trading account.
When an investor decides to invest in the Forex market, he or she must first open up a margin account with a forex broker. Usually, the amount of leverage provided is either 50:1, 100:1, depending on the forex broker and the size of the position the investor is trading. Standard trading is done on 100,000 units of currency, so for a trade of this size, the leverage provided is usually 50:1 or 100:1.
To trade $100,000 for example, with a margin of 1%, an investor will only have to deposit $1,000 into his or her margin account. The leverage provided on a trade like this is 100:1. Leverage of this size is significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage provided by the futures market.
Although the ability to earn significant profits by using leverage is substantial, leverage can also work against investors. For example, if the currency underlying one of your trades move in the opposite direction of what you believed would happen, leverage will greatly amplify the potential losses.
As of 5pm EST, all open positions are subject to a daily rollover rate that a trader either earns or pays, depending on the established margin and currency traded. If the trader does not wish to earn or pay rollover on their established trade(s), simply close the position(s) before 5pm EST, the end of the market day.
Generally, in the FOREX industry, currencies bought on the “trade date” are deliverable in a client’s account in two business days the “value date”. However, if the trader does not want delivery of the currency, they can simply roll over the position to the next value date or close the position on the same trade date.
Rollover is calculated by taking the difference of the interest rate differential of the currency that is bought, and the one that is sold. If a client is buying a currency with a higher interest rate than the one he/she is borrowing, the net differential will be positive – and the client will earn rollover as a result.
How an FX Trade Works
In this market you may buy or sell currencies. The objective is to earn a profit from your position. Placing a trade in the foreign exchange market is simple: The mechanics of a trade are virtually identical to those found in other markets, so the transition for many traders is often seamless.
|A trader purchases 100,000 Euros when the EUR/USD rate was 1.5500||+100,000||-155,000|
|Later the trader exchanges his 100,000 euro back into US dollar at the market rate of 1.5700||-100,000||+157,000|
|In this example, the trader earned a gross profit of $2,000||-0||+2,000|