What Is Forex Trading ?
The foreign exchange market is the "place" where currencies are traded. Currencies are important to most people around the world, whether they realize it or not, because 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.
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What Is Forex Trading ?
The foreign exchange market is the "place" where currencies are traded. Currencies are important to most people around the world, whether they realize it or not, because 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.
The need to exchange currencies is the primary reason why the forex market is the largest, most liquid financial market in the world. It dwarfs other markets in size, even the stock market, with an average traded value of around U.S. $2,000 billion per day. (The total volume changes all the time, but as of August 2012, the Bank for International Settlements (BIS) reported that the forex market traded in excess of U.S. $4.9 trillion per day.)
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.
Spot Market and the Forwards and Futures Markets
There are actually three ways that institutions, corporations and individuals trade forex: the spot market, the forwards market and the futures market. The forex trading in the spot market always has been the largest market because it is the "underlying" real asset that the forwards and futures markets are based on. In the past, the futures market was the most popular venue for traders because it was available to individual investors for a longer period of time. However, with the advent of electronic trading, the spot market has witnessed a huge surge in activity and now surpasses the futures market as the preferred trading market for individual investors and speculators. 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.
What is the spot market?
More specifically, the spot market is where currencies are bought and sold according to the current price. That price, determined by supply and demand, is a reflection of many things, 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. When a deal is finalized, this 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.
What are the forwards and futures markets?
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 for the exchange in question upon expiry, although contracts can also be bought and sold before they expire. The 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. (For a more in-depth introduction to futures, see Futures Fundamentals.)
Note that you'll see the terms: FX, forex, foreign-exchange market and currency market. These terms are synonymous and all refer to the forex market.
The foreign exchange market (or forex market) is the largest financial market in the world. In fact, the market for currencies is several times larger than the stock market.
TUTORIAL: Introduction to Currency Trading
This is the place where one currency is exchanged for another, and it has a lot of unique attributes that may come as a surprise for new traders. Here we take an introductory look at the forex market and how and why traders are increasingly flocking toward this type of trading.
What Is Forex?
An exchange rate is the price paid for one currency in exchange for another. It is this type of exchange that drives the forex market.
There are more than 100 different kinds of official currencies in the world. However, most international forex trades and payments are made using the U.S. dollar, yen and euro. Other popular currency trading instruments include the British pound, Australian dollar, Swiss franc, Canadian dollar and Swedish krona.
Currency can be traded through spot transactions, forwards, swaps, and option contracts where the underlying instrument is a currency. Currency trading occurs continuously around the world, 24 hours a day, five days a week. (The line between profitable forex trading and ending up in the red may be as simple as choosing the right account. For more, see Forex Basic: Setting Up An Account.)
Who Trades Forex?
There are many players in the forex market:
Banks
The greatest volume of currency is traded in the interbank market. This is where banks of all sizes trade currency with each other and through electronic networks. Big banks account for a large percentage of total currency volume trades. Banks facilitate forex transactions for clients and conduct speculative trades from their own trading desks. When banks act as dealers for clients, the bid-ask spread represents the bank's profit. Speculative currency trades are executed to profit on currency fluctuations. (Currencies can provide diversification for a portfolio that's in a rut. Find out which ones you need to know, in Top 8 Most Tradable Currencies.)
Central Banks
Central banks are extremely important players in the forex market. Open market operations and interest rate policies of central banks influence currency rates to a very large extent.
Central banks are responsible for forex fixing. This is the exchange rate regime by which a currency will trade in the open market. Floating, fixed and pegged are the types of exchange rate regimes.
Any action taken by a central bank in the forex market is done to stabilize or increase the competitiveness of that nation's economy. Central banks (as well as governments and speculators) may engage in currency interventions to make their currencies appreciate or depreciate. During periods of long deflationary trends, for example, a central bank may weaken its own currency by creating additional supply, which is then used to purchase a foreign currency. This effectively weakens the domestic currency, making exports more competitive in the global market. (Central banks use these strategies to calm inflation, but they can also provide longer-term clues for forex traders. For more, see How Inflation-Fighting Techniques Affect The Currency Market.)
Investment Managers and Hedge Funds
After banks, portfolio managers, pooled funds and hedge funds make up the second-biggest collection of players in the forex market. Investment managers trade currencies for large accounts such as pension funds and endowments. An investment manager with an international portfolio will have to purchase and sell currencies to trade foreign securities. Investment managers may also make speculative forex trades. Hedge funds execute speculative currency trades as well.
Corporations
Firms engaged in importing and exporting conduct forex transactions to pay for goods and services. Consider the example of a German solar panel producer that imports American components and sells the final goods in China. After the final sale is made, the Chinese yuan must be converted back to euros. The German firm must exchange euros for dollars to purchase the American components.
Companies trade forex to hedge the risk associated with foreign currency translations. The same German firm might purchase American dollars in the spot market, or enter into a currency swap agreement to obtain dollars in advance of purchasing components from the American company in order to reduce foreign currency exposure risk. (Hedging against currency risk can add a level of safety to your offshore investments. For more, see Protect Your Foreign Investments From Currency Risk.)
Individual Investors
The volume of trades made by retail investors is extremely low compared to that of banks and other financial institutions. But the forex trade is growing rapidly in popularity. Retail investors base currency trades on a combination of fundamentals (interest rate parity, inflation rates, monetary policy expectations, etc.) and technical factors (support, resistance, technical indicators, price patterns).
Clearly, forex market participants trade currencies for very different reasons. Speculative trades - executed by banks, financial institutions, hedge funds and individual investors - are profit motivated. Central banks move forex markets dramatically through monetary policy, exchange regime setting, and, in rare cases, currency intervention. Corporations trade currency for global business operations and to hedge risk. (The use of margin to trade in the foreign exchange market can magnify profit opportunities. For more, see Adding Leverage To Your Forex Trading.)
Forex Traders Shape Business
The resulting collaboration of forex traders is a highly liquid, global market that impacts business around the world. Exchange rate movements are a factor in inflation, global corporate earnings and the balance of payments account for each country.
The popular carry trade, for instance, highlights how market participants influence exchange rates that, in turn, have spillover effects on the global economy. The carry trade, executed by banks, hedge funds, investment managers and individual investors, is designed to capture differences in yields across currencies. It is the process of borrowing low-yielding currencies and selling them to purchase high-yielding currencies. For example, if the Japanese yen has a low yield, market participants would sell it and purchase a higher yield currency. (For background reading on this strategy, check out Currency Carry Trades 101.)
When interest rates in higher yielding countries begin to fall back toward lower yielding countries, the carry trade unwinds and investors sell their higher yielding investments. An unwinding of the yen carry trade may cause large Japanese financial institutions and investors with sizable foreign holdings to move money back into Japan as the spread between foreign yields and domestic yields narrows. This may result in a broad decrease in global equity prices.
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