Forex is the short form of Foreign Currency and Exchange. We do foreign exchange for various international trade and commerce purposes. The average daily forex trading volume is now over 6 trillion and the amount will become much larger in the coming years.
- Forex, also known as fx, is a global marketplace for exchanging currencies against one another.
- In forex, currencies trade against each other as a pair like AUDUSD, EURUSD.
- Besides cash or spot market, the forex market also facilitates currency swap, derivative market offering forwards, and futures.
- Due to the current globalisation and worldwide reach of trade, commerce, and finance, forex markets became the largest liquid asset markets in the world.
The Forex Market
Currencies traded in in foreign exchange market. To conduct a foreign trade currencies need to be exchanged. This currency exchanged can be happened directly or indirectly. If you are buying a foreign good or service then there must be a currency exchange either by you or by the company from where you are taking the goods or services.
There is no central marketplace for forex. Forex trading conducted electronically by using computer networks between traders around the world. This special market is open 24hrs a day. There are a number of financial centers for forex like New York, London, Tokyo, Sydney, Zurich, Frankfurt, Hong Kong, Singapore etc. That covers almost every timezone. This special configuration makes this market extremely active.
History of Forex
The forex market is converting one currency to another for taking financial advantage. It is a centuries-old business dating back to the Babylonian period. Forex is the most liquid and accessible market that has been shaped by a number of global events like Bretton Woods and the gold standard. The modern invention of forex is trading currencies via electronic medium, made it truly a new market. The value of individual currencies changing continuously and that is the main reason to have an electronic foreign exchange services.
Most of the forex trading is done by commercial and investment banks. There are so many individual traders and brokerages who are contributing the global forex trading.
Spot Market and Forwards market and Futures Market
The spot market, the forwards market, and the futures market are the three ways to conduct any kind of forex trading. Amongst them, the spot market is the biggest market and at the same time, it is the underlying real asset for forwards and futures markets. The futures market was the most popular trading venue in the past, as investors can trade on it for a longer period of time. But with the invention of electronic forex trading, the spot market became the biggest trading market that surpasses the forwards and futures market. Nowadays if you talk about the forex market, people normally referred it as the spot market. Companies that need to hedge their foreign currencies to minimise the risk of currency fluctuation mostly use the forwards and futures market.
In the spot market currencies are bought and sold at the current price. Supply and demand, current interest rates, the country’s economy, and various geopolitical sentiments determine the price of every currency. When a party delivers an agreed amount of currency in return for an agreed amount of another currency from the second party, a deal became finalised, which is also known as a spot deal. In the spot deal when a position is closed, the settlement is in cash.
In the spot market, we do trade the actual currencies, where as in the forwards and futures markets do not trade actual currencies. In these markets, the trader has to make a deal in contracts that claims a particular currency type, a specific price per unit in a future date for settlement.
In the forwards market, two parties bought and sold contracts based on agreed terms and conditions by both parties.
In the futures market contracts are bought and sold based on a standard size and settlement date on a public commodities market. The future contracts come with specific details, that include the number of units being traded, delivery and settlement dates, and non-customizable minimum price increments. In future markets, the exchange acts as a medium, who do the clearance and settlement.
Both the forwards and the futures are normally settled for cash at the exchange at the time of predefined settlement date. Contracts can also be traded before the settlement date of the expiry date. These unique markets can offer protection against risk when trading currencies on the volatile spot market. Big international corporations, normally use these markets to hedge against future exchange rate fluctuations.
Hedging in Forex
The currency market is extremely volatile and risky due to continuous price fluctuations. In forex, one can hedge currency risk by fixing a rate at which the transaction will be completed. Hedging can protect a currency pair from an adverse move. There are two strategies for hedging. One is to take an opposite position in the same currency pair and the other option is to buy forex options.
Speculation in Forex
The supply and demand for currencies depends on a number of factors like interest rates, trade volumes, country economy, geopolitical issues, etc. And due to these factors currency prices are changing continuously. If one can forecast that one currency will become weak and that will eventually strengthen the other currency, as in forex currencies are traded as a pair, one can make a profit from that speculation.
If you expect that the interest rate of Australia will rise and that will increase the demand for the Australian dollar and weaken the U.S. dollar then you can buy AUD and sell USD. If your speculation is right and you bought AUD and sold USD then you can make some profit from your trade.
Making profit from a forex trade
There are two ways to make a profit from a forex trade
One can earn from the interest rate difference from the two currencies, often known as swap in forex. If you can buy a currency with a higher interest rate and sell the other pair currency with a lower interest rate then you can make a profit from that currency pair trade. This type of trade is also known as carry trade.
One can profit from the changes in the exchange rate of currencies. If you buy a currency and over the period of time the price of that currency goes higher then you can also make a profit from that trade.
Risks in Forex Trading
Forex trading can be risky and complex if you do not have enough control over your trades. Forex instruments are not standardised and market regulations are changing continuously. In some countries, forex trading is completely unregulated and illegal.
Most of the small and individual traders do trade with relatively small and semi-regulated forex brokers. Those brokers can re-quote prices at the time of trading placement. Sometimes they do trade against their own customers. Depending on the brokers business location there might be some government and industry regulations but sometimes those regulations are not enough to save your trading fund.
One should spend some time to find a regulated and well-protected broker. Sometimes the broker becomes insolvent and takes all the funds with it.
Pros and cons of Forex Trading
The forex market is an extremely big market with heavy liquidity. This unique feature makes it easy to enter and exit with a trading position within a fraction of a second.
The forex market is open for 24 hours a day and five days a week. The market opens with the Australian market and ends with the New York market. It gives you the freedom to do trade anytime you want.
As the market is extremely big it’s impossible to take control by big institutions by placing big placements.
Forex brokers often offer high leverage. If you get high leverage you can place big trades by having a small amount of money in your account. But improper use of leverage can wipe out your whole fund in a matter of seconds. Before starting any kind of forex trading you have to understand the fact and use of leverage.
Forex market is continuously moving and there are numerous factors to track that cause those movements. A trader needs to have an overall concept of world geopolitical events and their effects and continuously follow those events. It is very hard to follow those events continuously.
Sentimental trading is very dangerous. Most of the forex traders do not know how to accept losses in time and make sentimental trading. Those eventually lose their whole fund.