“Forex“, also FX, is an abbreviation for Foreign Exchange. Foreign exchange takes place when one country’s currency is exchanged for another country’s currency. Forex is the largest financial market in the world, trading some $5 trillion daily.
Most trading is done in the Spot Cash market, conducted primarily by banks. Major banks around the world constantly exchange currencies for their customers for tourism, trade, and for their own accounts to speculate on the daily changing values of the currencies.
The Forex Exchange Rate
The exchange rate is the price paid for one currency in exchange for another. It is this exchange that drives the Forex market.
The rates quoted for each currency float up and down depending on supply and demand as well as other economic or geopolitical events, thus providing the opportunity to speculate on the movement of one currency against the other.
Forex Market Basics
Most international Forex trades and payments are transacted using the U.S. Dollar, British Pound, Japanese Yen, and the Euro.
Other popular trading pairs include the Australian Dollar, Swiss Franc, Canadian Dollar and New Zealand Dollar.
The Forex market operates 24 hours a day, opening at 5 pm each Sunday EST and closing at 4 pm on Fridays EST. Hence, most Forex brokers offer 24 hour Forex trading to day-traders worldwide. When dealing with ‘foreign exchange’ the transactions are always quoted in pairs.
For example, when exchanging Euros (the European Union currency) against US Dollars, the transaction would be quoted as EUR/USD. If we were exchanging dollars for Japanese Yen, the quote would be quoted as USD/JPY.
Forex Market Participants
Besides the banks, which usually trade for large customers, large international corporations have trading desks that trade Forex as a means of hedging their costs of exports and/or imports of goods and services.
Often this type of trading can also be done in the futures market. In addition, there are many brokerages that offer Forex trading for individual traders.
Forex trading is largely speculative, and because the Forex market is so liquid, traders can buy and sell currencies almost instantaneously and, therefore, manage their trades efficiently.
Nearly 90% of all Forex trading is speculative trading. Trading in Forex is done using both technical and fundamental analysis.
Breaking Down a Forex Quote
Here is how a quote would be shown: EUR/USD 1.17064. Thus, 1 Euro can be exchanged for $1.17064 US Dollars.
The inverse would be 1 Dollar exchanged for 0.85422 Euros. For example, if today we sell $1,000 against the Euro for .85422 cents per dollar and later we buy back the thousand dollars for 0.81422 cents per dollar we would gain 4 cents or $400 on the trade less any commission charges.
If the above trade was for $100,000 against the Euro, the profit would be $4000 for that same trade.
Danger Lurks Behind Forex Leverage
Because the Forex market is so liquid, it is also highly leveraged. This means that brokers and banks are prepared to lend up to 100 times the amount of cash funds you have on deposit to trade with. However, as the leverage increases, so does the risk associated with any trade.
The reason for the increase in risk is due to the fact of being leveraged means using the banks’ or brokers’ money and the margin for error becomes much smaller.
As with all trading, especially Forex trading, it is important to understand the economics behind currency valuation and the role that each country’s economic and geopolitical factors play, as well as the role that each country’s Central Bank plays in managing their country’s currency.