The foreign exchange (forex) market is the largest financial market in the world. But what is forex, and how can you start forex trading? Read on to find out more.
What is forex trading?
Forex, also known as foreign exchange, FX or the currency market, is the largest financial market in the world. On average over $5 trillion worth of transactions take place every day. That’s around 100 times more than the New York Stock Exchange (NYSE) – the world’s biggest stock exchange.
As well as being traded by individuals and businesses, forex is also important for financial institutions, central banks, and governments. It facilitates international trade and investment by allowing companies that earn money in one currency to pay for goods and services in another.
There are a huge number of market participants looking to trade forex at any particular time, from individual speculators wanting to turn a quick profit, to central banks trying to control the amount of currency in circulation.
However, by far the most significant players in the forex market are the major international banks. Between them, Citigroup, Deutsche Bank, Barclays, JPMorgan and UBS account for around 50% of global forex trade.
How does forex trading work?
Unlike share trading, forex is an over-the-counter (OTC) market. This means that currencies are exchanged directly between two parties rather than through an exchange.
The forex market is run electronically via a global network of banks – it has no central location, and trades can take place anywhere via a forex broker of your choice. This also means that you can trade forex at any time, so long as it’s during trading hours in any one of the four major forex trading centres (London, New York, Sydney and Tokyo).
Forex prices are always quoted in pairs such as AUD/EUR, which stands for the Australian dollar versus the euro. This is because if you want to purchase Australian dollars you need to buy them with another currency, like euros.
When trading forex you are simultaneously BUYING one currency while SELLING another.
Each currency in a pair is known by a three letters currency code. In general, the first two letters stand for the country/region, and the last letter represents the currency. Taking USD/JPY as an example: USD stands for the US dollar, while JPY represents the Japanese yen.
Why do people trade forex?
Individuals and businesses participate in the forex market for two main reasons:
1. Speculation
The vast majority of forex transactions are made simply to make money. This means the person or institution making the trade has no plans to take delivery of the currency, they are just looking to turn a profit on movements in the market.
With major financial institutions always looking to profit from small changes in forex prices, many large trades can occur throughout the day. This activity means currency rates are some of the most consistently volatile financial markets in the world, which in turn provides more opportunity for speculators to make money.
2. Purchasing goods or services in another currency
Every time a transaction is made between two entities in different regions, a foreign exchange transaction needs to take place to pay for the goods or services exchanged. Transactions such as this happen globally, every second of every day.
Despite the number of transactions, the amount of currency traded is often very small compared to trades made by large speculators. Therefore, commercial trading tends not to have a big effect on short-term market rates.
Pros and cons of forex trading
Pros of forex trading:
- A variety of pairs to trade: There are 28 major currency pairs involving eight major currencies. A forex trader who loves volatility can easily switch from one currency pair to another; criteria for choosing a pair include convenient timing, volatility patterns, or economic developments.
- Accessibility: The forex market is among the most accessible markets for individual traders; traders can set up a forex account within a period of one to three days and begin trading with £50. Trading through most brokerages can be done online and traders have access to real-time market pricing, news, price charts, tools and strategies through online trading platforms. The forex market is open 24 hours a day and 5 days per week, so forex trading can more easily fit into traders’ schedules than other types of trading.
- High liquidity: The liquidity of a market is a measure of how active the market is. A liquid asset is one that can be more easily traded in a market, and is fewer degrees of separation away from cash. Forex, being a currency exchange market, has no degrees of separation from cash, which makes the forex market an incredibly liquid market at all times. Forex is readily traded on the market, and there are ample buyers and sellers, making the forex market a relatively stable one to invest in.
- Low costs: Forex trading can have very low costs; there are no commissions in a real sense, as most forex brokers make profits from the spreads between forex currencies. One does not have to worry about including separate brokerage charges, which eliminates an overhead.
- Lower levels of volatility: The volatility of a market is a measure of the amount it fluctuates in any given price cycle. Markets with low liquidity tend to have higher volatility, due to the absence of buyers, and greater degrees of separation from cash affecting rates of supply and demand. Because of this, forex markets tend to be less volatile due to the high liquidity of forex assets and the frequency of buyers and sellers. With a number of traders trading at the same time, prices tend to move in smaller increments.
- No central exchange or regulator: Being an OTC market operating across the globe, there is no central exchange or regulator for the forex market. Various countries’ central banks occasionally interfere as needed, but these are rare events, occurring under extreme conditions. This decentralised and deregulated market helps avoid any sudden surprises.
- Suits a number of trading styles: The forex markets run all day, which is very advantageous to short-term traders who tend to take positions over short durations, as well as traders who want to take long-term positions, which can last from days to several weeks.
Cons of forex trading:
- Complex price determination: Forex rates are influenced by multiple factors, such as global politics or economics; these can be difficult to analyse information and draw reliable conclusions to trade on.
- Lack of transparency: Due to the deregulated nature of the forex market dominated by brokers, forex traders actually trade against professionals. Being broker-driven means that the forex market may not be fully transparent; traders may not have any control on how their trade order gets fulfilled, may not get the best prices, or may get limited views on trading quotes as provided only by their selected broker.
- Lighter regulatory protection: As the forex market is an OTC market, trades are not carried out on a centralised exchange, and regulatory oversight is sometimes limited. Because of this, traders may need to investigate their broker’s reputation and trading practices before signing up for an account. Depending on which country they are operating in, they may also have less right to recourse if they feel they have not been treated fairly by their broker.
- Reliant on independent learning: In the stock market, a trader can seek professional assistance from portfolio managers, trade advisors, and relationship managers. Forex traders are completely on their own with little or no assistance, and disciplined and continuous self-directed learning are essential for forex trading.
- Can be tough to make money in the short term: As mentioned above, the forex market enjoys typically lower levels of volatility, which can be a problem for people looking to earn profits in the short term. To counteract the low levels of volatility in the forex market, some traders deploy high degrees of leverage when trading. This makes smaller movements in the market count for more, but with high rewards come high risk, and investing in this way can make the forex market a more tumultuous one than it would otherwise be.
- Fewer residual returns: Stocks and bonds often make regularly scheduled interest and dividend payments, which can enhance the long-term value of an asset. However, forex trading is mostly aimed at obtaining capital gains from appreciation of one of two currencies in a given currency pair.
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