What is the Forex Market?
The forex market, also known as the foreign exchange market or FX market, is a marketplace where currencies are traded 24 hours a day, five days per week. Currency trading, which amounts to trillions on a daily basis, influences changes in exchange rates for all currencies and is the world’s largest financial market. The name forex is a mashup of two words: foreign and exchange.
Currency trading involves the trading, or the exchange, of one country’s currency for the currency of another country. The exchange of international currencies, primarily done by banks, institutions, and individual traders, enables businesses to conduct foreign trade.
Tip: There is no central, physical marketplace for the exchange of global currencies. Trading is done in the decentralized, over-the-counter market, or OTC market. This means that participants in the market trade with one another directly, without the formal oversight of an exchange. From the perspective of forex trading for beginners, individuals need to open a trading account through a forex broker to begin currency trading.
Forex History: From Where it Began to Today
Currency trading pre-dates the stock market by hundreds of years and goes back to ancient times.
By the 15th century, currency trading began to expand and take its pre-modern form. The House of Medici, the largest bank in Europe at the time, headquartered in Italy, opened banks in foreign locations to trade currencies on behalf of textile merchants.
The beginning of the modern form of currency trading probably began in 1880, the year of the gold standard, which made gold the basis of an international monetary system. This system was advanced in 1944 with the Bretton Woods Agreement, part of which helped to maintain currency exchange rates by requiring independent states to tie the value of their currencies to gold.
Bretton Woods was effectively ended in 1971 by U.S. President Richard Nixon. This brought about the end of fixed rate of exchange by 1973, and the beginning of a free market, free-floating currency system that still exists today.
A distinguishing aspect of modern forex trading is the carry trade, which enables a trader to borrow one currency, use it to purchase another, and then invest the funds. The purchased currency often offers higher interest rates than the borrowed currency does, giving the carry trade profit potential. No potential profits are guaranteed, though, until the funds are converted back to the currency that was borrowed.
Forex Trading: Spot FX, FX Forward & Futures
The forex market is the largest financial market in the world and it has many different features, benefits, strategies and risks. To keep it simple, there are three types of forex trading instruments: there are spot FX contracts, currency forward contracts, and currency futures.
- Spot FX contracts: When you place a spot trade on forex, you’re placing a trade that is the purchase or sale of a foreign currency for settlement in 1-2 days. Spot FX trading is done on the over-the-counter (OTC) market.
- Currency forward contract: Also known as FX forwards, a currency forward contract obligates the buyer and seller of the contract to make the transaction at a set price, at a predetermined time in the future. FX forwards trading is also done on the OTC market.
- FX futures: Forex futures are exchange-traded derivatives that are cash settled and primarily used for purposes of hedging or speculation.
Important: Currency forward contracts and forex futures work in similar ways but they are not the same thing. Like Spot FX, forwards are over-the-counter products, trading on the OTC market, whereas futures are exchange-traded. Another key difference to understand is that forex futures are primarily for hedging or speculation purposes, whereas Spot FX is used for the actual exchange of currencies.
Hedging With Forex
Hedging with forex is a strategy for minimizing (or eliminating) risk inherent in an existing exposure by taking a position that offsets it. The strategy is to create a net result that brings risk to as close to zero as possible.
For example, consider a scenario where a U.S. citizen’s wealthy uncle living in Europe has passed away, and where they are expecting to receive an inheritance of EUR 1 million. Furthermore, the inheritance is expected to be distributed in 3 months from now. For these 3 months, the inheritance value is exposed to currency risk; if the EUR depreciates in value versus the USD during this time, the inheritance will decline in value in USD terms. To hedge against that possibility, the currency risk could be mitigated by taking a short position in EUR/USD.
Direct hedging, which is a little different, involves having both a long position and a Short position in the same currency pair.
Currency Speculation With Forex
Currency speculation with forex involves the buying and selling of currencies for the primary purpose of making a profit. The basic means of making a profit with forex trading is to benefit from the change in the value of a currency pair. Factors that may impact currency levels include interest rates, inflation, trade flows, and/or geopolitical developments.
For a simple example of speculation with forex, a trader may expect a weak currency to appreciate in the future. To profit from this expected price move, the trader could buy a currency forward, and then reverse that position at a later date after the currency has appreciated.
It’s important to know that the spot FX rate and forward FX rate for a given currency pair are usually not the same, and that these rates can differ substantially. For example, EUR/USD may be quoted at 1.18 for a spot rate, but 1.20 for a 6-month forward rate. This means EUR 1 million could be purchased for USD $1.18m today, although it would cost USD $1.20m to arrange settlement for 6 months from now.
Plotted on a chart, the different rates for different forward dates represent what’s called the forward curve.
Beginners Guide to Forex Trading
Investors looking to get started with forex should begin with learning the basics of currency trading and the associated potential risks and rewards associated.
- Learn about currency markets: As with any other form of investing or speculation, successful traders are commonly those who understand how the markets work and follow forex market news, forex analysis, and economic data releases. Take time to gain knowledge about the nature of currencies, what factors influence price fluctuation, and how currency pairs trade on the FX market.
- Know the risk: You can make money with forex but you can also suffer losses. With so many influencing factors, such as interest rates, inflation, and geopolitical risks impacting currency values, price movements are typically difficult to predict.
- Practice currency trading: Investors can seek out a platform that offers practice accounts for FX trading. Trading in a practice environment is also called paper trading. Once a trader gains more understanding and comfort, they may consider opening a real forex account.
- Know your limits: Investors who have done their homework and begin forex trading should always decide how much they’re willing to risk on trades. It’s best not to risk more than you’re willing to lose. Current regulations will also limit the amount of leverage (amount of borrowed money) investors can use in currency trading.
- Protect against the downside: Learn how to use stop and limit orders, which can get you out of the market at a price that you set in advance. Stop orders can be used to limit potential losses to a set maximum.
Getting Started With Forex
Once an investor has learned about the ins and outs of currency trading on the FX market, the next steps would be to choose a forex broker and open a forex trading account.
Forex trading brokers are required to gather background information, such as your name, address, Social Security number, country of citizenship, and more. Although forex is a decentralized market, there are still regulations and compliance in place to protect account holders and brokers.
Before getting started with forex trading, it’s wise to educate oneself on some key trading terminology:
- Forex account types: There are three primary types of forex accounts, depending upon the amount of trading you plan to do. There are micro forex accounts for trading up to $1,000, mini forex accounts for trading up to $10,000, and standard forex accounts for trading up to $100,000. Institutions can trade in the tens and hundreds of millions of dollars, well above the individual forex account limits.
- Currency pairs: In the forex market, trades are made in currency pairs. One currency in the pair is the base currency being bought and the other currency in the pair is the quote currency being sold. A common currency pair is EUR/USD, in which the trader would buy Euros for U.S. dollars.
- Leverage: When you use leverage to trade in forex, you’re using borrowed money to amplify their returns. If the trade goes in the right direction, the trader can make significantly higher profit, whereas, if the trade goes in the wrong direction, the trader can lose significantly more money.
- Spread: The forex spread is the difference between the bid and ask price of a trade.
- Arbitrage: Arbitrage refers to riskless excess profits. Sometimes cross-currency arbitrage is possible in forex markets. Capturing any arbitrage could involve booking a spot FX trade and a forward FX trade in opposite directions, and investing the funds of the purchased currency during this time period. The total profit from doing so may exceed the investment return that was possible from simply investing in the originating currency.
Pros and Cons of Forex Trading
Although getting started on forex is relatively easy, it’s important to know the pros and cons of forex trading.
Pros of Forex Trading
- Easy access: The forex market is not only the largest financial market in the world, it may be the easiest to access. Depending on the broker, traders from all around the globe can open forex accounts with as little as $1.
- Low trading costs: For many currency trades, especially those with major currency pairs and narrow spreads, trading costs for forex can be lower compared than for stock trading.
- Quick profits: Depending on the forex broker, profits can be accessed and turned into cash quickly, making funds available for withdrawal immediately.
- Use of leverage: Forex traders can use leverage, or borrowed money, with up to a 50:1 ratio, compared to just 2:1 for stock account leverage limits. Leverage increases profit potential but it also increases the potential for losses.
- Flexible market hours: The FX market is open 24 hours per day, five days per week, which is extremely flexible compared to stock market hours, which are just 6.5 hours per day, five days per week, excluding national holidays.
- Liquidity: Because of the large number of traders, FX markets are usually highly liquid, especially among major currency pairs. This means that currency trades can easily be executed at a competitive price due to tighter spreads.
Cons of Forex Trading
- Complexity: The FX market consists of many national currencies that can be impacted by multiple macroeconomic events all around the world.
- Fair Value estimations: As compared to the valuation of stocks, which is usually based on visible company fundamentals, it can be very challenging to attempt to measure what a currency’s fair value should be.
- Volatility: While forex traders can use fluctuations in currency prices to their advantage, these fluctuations bring about added risk to the currency trader. If leverage is used, the trader is exposed to even more risk.
Bottom Line on Forex Trading
Forex trading can be profitable and it can be easy to get started. However, the learning curve is steep and traders face high risks and price volatility. Forex traders must have the willingness and ability to take risks, to continuously learn currency trading strategies, and to monitor market conditions regularly.