What is Forex (FX)?
Forex – or the foreign exchange market, FX – is a decentralized market trading currency pairs and derivatives. Investors and traders try to profit through fluctuations in exchange rates. Although other markets may yield more profit margins than forex trading, it is still one of the most popular markets in the world.
Currency pairs are valued based on how many units of one currency are needed to buy one unit of another currency. Larger investment banks, smaller mid-level banks, dealers, and insurance companies are some of the players in the forex market.
With increased globalization in the last few decades, forex trading has become invaluable. It allows businesses, individuals, and governments to trade and establish themselves across borders.
Forex Markets Explained
The forex market allows participants such as traders, individuals, investment management companies, banks, and hedge funds to trade foreign exchange.
The forex market remains open 24 hours a day, 5 days a week, with the exception of holidays. This is primarily because forex exchanges in North America, Europe, Asia, and Australia have varying opening hours, which often coincide. Each trading day commences with the Australian and Asian markets, followed by the European markets and, ultimately, the North American markets.
It’s worth noting that the forex market operates on several holidays when traditional stock markets are not active, even though the level of trading activity may be reduced.
London is currently the largest forex hub, with several forex brokers having offices in the city. In 2022, it saw around $7 trillion in daily trades, coming up to 38.1% of global forex activity.
In terms of currencies, the US dollar, euro, and Japanese yen are the most traded ones.
When it comes to traders, JPMorgan Chase, UBS, and XTX Markets are some of the biggest.
Levels of the Forex Market
Instead of one exchange, the market is made up of a vast network of computers and brokers. It is divided into two tiers:
- The Interbank Market: This is for big banks and large financial institutions to trade currency derivatives and currencies for themselves or on behalf of their clients This may be for hedging or to fix their own exchange rates, amongst other purposes.
- The Over-the-Counter (OTC) Market: This is for individuals, where brokers and online platforms facilitate trade.
3 Main Types of the FX Market
Spot Forex Market: The spot market entails the exchange of currency between the buyer and seller right at the time of the trade. This is done at the present exchange rate. Hence, this is often the simplest and, as such, the largest forex market. Dealers, commercial banks, brokers, investment banks, and several other participants are all involved in spot markets.
Forward Forex Market: Two enter into an agreement to trade a set number of units of a currency at a given price sometime in the future.
Futures Forex Market: Forex futures are almost the same as forwards, however, they are traded on centralized exchanges. This goes a long way in making them quite a bit more liquid, safer, and more regulated than forwards.
Forex brokers can come in a variety of types. They are essentially middlemen and can be individuals, large financial services companies, or online brokers. The main duty of a broker is to match forex buyers with sellers of the particular quantity of currency that is required.
This may be tricky sometimes, as most of the players in the forex market can trade on a very large scale, such as huge banks. As such, they may not be appropriate matches for smaller or more infrequent traders.
Forex brokers can help clients make trades while also trying to keep losses to a manageable or affordable amount. As with brokers, their clients can also range from larger institutional ones to individuals operating on a much smaller scale.
These services are provided for a commission. Nowadays, online brokers are further opening up access to the market.
They provide a range of other facilities, such as free demo accounts, technical analysis tools, real-time price alerts, and learning courses.
Examples of Currency Pairs
Forex is always traded in currency pairs. The currency on the left is the base currency, while the currency on the right is the quote currency.
Each currency pair has a relative value already given to it, which is subject to market conditions and investor sentiment.
The currency pair represents how many units of the quote currency it will take to buy one unit of the base currency. Hence, if the EUR/USD pair is trading at 1.06 today, that means that it will take $1.06 to buy CAD 1 today.
Forex pairs can be further categorized into major, minor, and exotic pairs.
There are typically four major pairs which include:
Some currency traders may also expand the above list to include USD/CAD, AUD/USD, and NZD/USD. However, the above four are the ones that have always been traditionally considered major pairs.
These are highly liquid and very easily accessible to trade, with the smallest spreads. Due to the eurozone, the US, and Japanese economies being quite strong, these currency pairs are seen as some of the safest.
However, economic policies, such as interest rates and macroeconomic factors, do impact these pairs. These can be gross domestic product numbers and unemployment figures, amongst others.
The global shift of interest away from the US to other major players, such as China, is also starting to impact the strength of the US dollar.
Minor Currency Pairs
Minor currency pairs are also called cross-currency pairs. These are basically pairs that do not include the US dollar. They can be:
Although these currencies do not include the US dollar, they usually have another major currency, such as the EUR, GBP, CHF, or JPY. Minor currencies are usually used to diversify against risks in forex portfolios.
However, there is still considerable stability due to the presence of at least one major currency in the pair. They can also offer manageable spreads, although not as tight as major currencies.
Exotic currencies are much smaller currencies that do not have much of a widespread presence in international forex markets. Some of these are:
- AUD/SEK (Swedish Krona)
- GBP/HUF (Hungarian Forint)
- EUR/ZAR (South African Rand)
- GBP/CZK (Czech Republic Koruna)
- USD/ILS (Israeli Shekel)
Exotic currencies can be extremely volatile and very illiquid, as their markets are quite small and underdeveloped. As such, they carry a significant amount of risk.
However, they can also offer greater returns in the form of higher interest rates.
How Does Forex Trading Work?
Forex trading usually requires a significant amount of capital. Thus, it is more suited to large financial institutions, banks, and commercial clients. However, individuals can also get into forex trading, provided they have done thorough research.
Let’s delve into the essential steps required to commence forex trading.
1. Choosing the Right Trading Instrument
Choosing the appropriate instrument for forex trading can make a lot of difference to how successful a trader is. This depends on factors such as the amount of capital, leverage available, risk tolerance, and overall trading goals.
Spot trading: Spot markets usually mean that trades are done immediately, at whatever the exchange rate is at that moment. Spot markets are the most preferred by laymen, such as tourists. They also have the narrowest spreads and are highly accessible.
Spread Betting: It is a speculative strategy that involves trading derivatives and being able to go both long and short. Spread bets highlight two prices for an asset. These are the buying price, called the bid price, and the selling price, known as the ask price. A trader can choose to go with either price, depending on where they think the market will go next.
CFD Trading: Contracts for difference, or CFDs, are also derivatives, which involve speculating on a currency pair’s price movement without actually owning the pair. Like spread betting, CFDs also allow long and short positions. However, they also use a lot of leverage. This may magnify both profits and losses and can be disadvantageous at times.
More Derivatives: These can be futures or options contracts, amongst others. They can be useful for hedging risks and usually have a lot of liquidity.
2. Selecting a Currency Pair
Once the instrument is finalized, a currency pair is chosen to start trading with. Several new forex traders may choose to go with highly popular pairs such as the EUR/USD or USD/JPY. This could be due to the wealth of information and providers available for these pairs. This may also make them significantly easier to monitor.
3. Picking a Trading Strategy
After choosing the currency pair, traders select a trading strategy.
Nowadays, there are a number of both traditional and experimental forex trading strategies available, including:
- Swing trades: Swing traders keep trades for several weeks or a few months to capitalize on price fluctuations in the medium or short term. This is usually done by using mostly technical analysis, but some elements of fundamental analysis can also be incorporated.
- Scalp trades: Scalp trading is a very fast trading strategy in which traders will attempt to buy and sell stocks in a matter of seconds. At the most, the trade is held for two to five minutes. This allows them to take advantage of minute fluctuations in price, which can quickly add up depending on the size of the trades.
- Day Trading: Day trading can be seen as an extension of scalping, where trades are held for many hours, up to one day or one trading session. This lets traders profit from price movements throughout the trading session.
- Position trades: Position trading is more long-term and can see trades held for many months or years. Traders mainly use fundamental analysis for this strategy and do not really take short-term fluctuations into account.
- Trend trading: Trend traders look out for price trends indicators such as moving averages and relative strength indexes. They then base their strategy on this movement or trend.
- News trading: News traders are usually on the lookout for important business or macroeconomic news, such as interest rates, GDP, or earnings, which impact stock prices. They then try to take advantage of share price movements around the time of these news releases.
4. Executing the First Trade
Finally, after the trading strategy selection, traders make their first trade. Following this, the trader carefully monitors the position and tweaks the strategy or amount if the need arises.
With a number of online brokers offering free demo accounts now, a number of new traders choose to trade their strategies on them first.
This can provide a good insight into whether the strategy needs some work. It can also help traders see the volatility and risks of forex trading in general.
Pros and Cons of Forex Trading
Below is the list of pros and cons in forex trading.
There is also a wealth of news, technical analysis, pricing, strategies, and tools available online. This can be beneficial both for novice and expert traders. Online brokers have also made leveraging much easier now. In several cases, only the bid-ask spread influences trading costs, making them more transparent. This is especially true when it comes to major currencies such as the USD, GBP, CHF, and JPY.
The forex market is one of the most accessible in the world. One reason for this is its long opening hours. Another is the number of online trading platforms and brokers offering forex trading with relatively low account opening fees.
A number of forex derivatives rely heavily on leverage, which can lead to greater gains, with margins of 100:1 or even higher at times.
Fewer Fees and Simpler Taxes
Forex trading involves considerably fewer fees and commissions than traditional markets such as stocks and bonds.
The forex market is one of the most liquid in the world, with trillions of dollars worth of trade.
There is also a wealth of news, technical analysis, pricing, strategies, and tools available online. This can be beneficial both for novice and expert traders.
Online brokers have also made leveraging much easier now.
In several cases, only the bid-ask spread influences trading costs, making them more transparent.
This is especially true when it comes to major currencies such as the USD, GBP, CHF, and JPY.
Sometimes, they can also be less liquid than spot markets since forward agreements take place only between two parties. This may put smaller traders or individuals at a distinct disadvantage at times.
Lack of Centralized Trading
This is especially an issue in some forex derivatives markets, such as forwards, which can increase counterparty risk as well.
Forex trading can be extremely volatile, especially for short-term trades, which can make it difficult to establish an appropriate strategy.
Disadvantage for Smaller Traders
Big players such as institutional investors, investment banks, and similar largely dominate the forex market. As such, due to the volume of their trades and available capital, they may have a distinct advantage in trades. They may also be able to influence prices or have much greater access to information and tools.
Sometimes, they can also be less liquid than spot markets since forward agreements take place only between two parties.
This may put smaller traders or individuals at a distinct disadvantage at times.