Introducing Forex

Written By
Paul Tracy
Updated January 16, 2021

The Foreign Exchange market, usually called “forex” or “FX” is the largest market in the world, with trades amounting to trillions of dollars every day, dwarfing the size of global stock and fixed income markets. US stocks, even in very volatile times, typically trade less than $100 billion a day.

One appeal of forex is that with nearly 180 countries in the world, there are virtually an unlimited number of possible currency pairs for trading. A currency trade is the simultaneous buying of one currency and selling of another one. The currency combination used in the trade is called a cross (for example, the Euro/US Dollar, or the British Pound/Japanese Yen.). Given access to the right trading desks, any cross can be created. Even nonconvertible currencies, like the North Korean Won, are traded in fairly using cash settlements. However individuals should stick with only the largest currencies.liquid markets

Although you can trade in almost any currency, the major pairs offer the most safety for individual investors. These include any combination of the US Dollar, the Euro, Japanese Yen, British Pounds, Swiss Francs, and Canadian, Australian, and New Zealand Dollars. Trading in other currencies, such as the Mexican Peso or Brazilian Real is possible, but individuals may have difficulty getting in and out of these markets easily.

The forex markets were originally created to allow for international trade. If a company like Coca-Cola sells its products in China, it will be paid in Chinese Yuan, but will need to convert them to US Dollars in order to spend them on factories in America. Large banks have been involved in this type of transaction for hundreds of years.

Recently this market has been opened up to individual traders. Now, most forex trading is speculative, with only a small percentage of market activity representing governments' and companies' fundamental currency conversion needs.

Unlike trading on the stock market, the forex market is not conducted by a central exchange. Most currency trading occurs in the interbank market, which is best thought of as an over the counter market. Trading takes place directly between the two parties necessary to make a trade, whether over the telephone or on electronic networks all over the world. The worldwide distribution of trading centers means that the forex market is an almost 24-hour market. Trading actually runs from Sunday evening to late Friday afternoon New York time.

Although the markets are open almost all the time, there are better times to trade than others. Markets are most active in Tokyo, London, and New York. Outside of the times those markets are open, there is less liquidity in the markets meaning that it can cost more to get in or out of a trade. The best times to trade are when two of these markets are open, creating the greatest supply and demand from traders. Those times are between 2:00 AM and 4:00 AM EST when London and Tokyo are both open and from 8:00 AM until noon EST when both New York and London are trading.

Because you aren’t actually buying a physical product, forex trading can be confusing. You can think of buying a currency as buying a share of stock in a particular country. When you buy the Swiss Franc you are betting that the economy of Switzerland will be strong in the future. The trading price of any currency simply reflects what market participants think about the future direction of that country’s economy.

There are a number of benefits to trading forex. Even during stock market declines, there is always an opportunity to find profitable trades in the currency market. During the bear market of 2008 and early 2009, the Euro enjoyed gains against the US Dollar. In fact, almost every currency fared well against the Dollar during that time. While those who restricted their investments to the stock market suffered losses, forex investors were able to chase after sizable profits.

A widely advertised advantage of forex trading is that it is done without any commissions. This does not mean it is free to individual traders. Brokers make money by earning the difference between the bid-ask spread. When you are looking to buy something, whether it is a currency pair or a stock, there are actually two prices. The bid price is what the buyer is willing to pay; the ask price is what the seller is willing to sell for. The bid price is always lower than the ask price. This spread exists in stocks as well, and is usually only a few cents.

In forex, the spread between the bid and ask is almost always very small. This is because the markets trade so much and in so many locations that if the spread got too wide then smart investors would buy in the market with the lowest asking price and sell it in markets where there were higher bid prices. The fact that this can happen keeps the spreads fair and small for all players in the market.

To put some numbers to this spread idea, the retail transaction cost in forex is typically less than 0.25 percent for a complete trade, assuming normal market conditions. For stocks, the total trading cost is usually 1 to 3 percent, with larger traders paying less, after accounting for the spread, commissions, and fees.

Forex traders use leverage. This means that with only a small margin deposit, traders can control a much larger total contract value. As an example, many forex brokers offer 100 to 1 leverage. This means that with a $500 margin deposit, a trader would control $50,000 worth of currency. Often overlooked by beginning traders is that while leverage can help you make a lot more money, without risk management high leverage will lead to large losses.

Leverage allows small traders to try their hand at forex trading. At many brokers, accounts can be opened with only a few hundred dollars. If properly managed, even these small accounts can be profitable. The key is to follow a disciplined trading strategy, which can be developed using a free demo account that is available from most online brokers.

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