Overview
Forex, or foreign exchange, is the buying of 1 currency with that of another. Although
it is called foreign exchange, this is just a relative term. The terms domestic
and foreign is relative to the person using the term. What is foreign to
one person is domestic to another. Currency exchange would be the more proper
term.
The main reasons to exchange foreign currency for domestic currency is to pay for
goods and services in the foreign country, to invest in its financial assets, to
hedge against unfavorable rates of exchange in the future, or to profit from those
changes. Foreign currency holders need to convert it back to their domestic currency
to take profits, or so that businesses, governments, and other organizations can
use the money at home.
Hedging is exchanging currency to protect against unfavorable changes in
the future. Most hedgers are governments and businesses that need to buy
or sell in a foreign country sometime in the future. Speculators are people
who are exchanging currency purely for profit. Governments, usually through their
central banks, influence the exchange rate to some extent as well, either by buying
or selling foreign currency, or by creating or destroying domestic currency. Thus,
currency rates fluctuate because demand and supply for each currency fluctuates.
The foreign exchange market, often called the FX market, is an over-the-counter
(OTC) market. Its consists of a network of dealers—central banks, commercial
and investment banks, funds, corporations, and individuals. Transactions are done
electronically, usually over the Internet, and traders buy and sell through a broker.
Thus, the forex market operates as a spot market. Although there are futures
and forward contracts on currencies, most forex transactions use the spot market.
There is no central exchange for the spot market, and brokers and dealers are located
throughout the world, so the forex market is a 24 hour market during the weekdays.
Forex is the largest financial market in the world—over 2 trillion USD equivalent
values of currency are traded daily.
Currency rates are listed as pairs, and there are many sites on the Internet
that display current quotes. The rate of exchange is the amount of the foreign
currency that is equal in value to a unit of domestic currency, or, more generally,
it is the amount of currency received for each unit of the currency tendered. Thus,
for instance, the Great Britain pound (GBP) has recently passed the $2 mark in value.
That means that for an American trading dollars for British pounds, he needs $2
to get £1, equaling an exchange rate of 0.5.
Virtually every country, with some small exceptions, has its own currency, and most
of them can be traded. However, the currencies of a few countries are the most actively
traded, and constitute, by far, the largest volume of trades. The big 5 are the
United States dollar (USD), Euro (EUR), Japanese yen
(JPY), the British pound (GBP), and the Swiss franc
(CHF).
Each currency is symbolized using 3-letter ISO (International
Organization for Standardization) codes: the 1st 2 letters designate
the country, the 3rd designates the currency. The most famous illustration
of this is for the United States dollar—USD. However, sometimes the country
name or currency that is symbolized is not the most common name. Thus, the symbol
for the Swiss franc is CHF, where CH stands for Confederation Helvetica,
which refers to Switzerland, and MXN stands for the Mexican Nuevo Peso, even
though the most common name for Mexico’s currency is simply the peso.
Advantages of Forex Trading
There are many advantages to trading currencies for profit. There are usually no
commissions, because the trader deals directly with a market maker in that currency.
The market maker makes money from the spread, which is the difference between what
the market maker pays for a currency and the higher price at which he sells it.
The competition among market makers and the size of the currency market keeps bid/ask
spreads relatively low, but because there is no organized exchange for currencies,
the spreads are wider than for securities traded on exchanges, where price transparency
is much greater.
Because there are no organized exchanges for the foreign currency spot market, there
are no clearing fees or other exchange fees, and because the forex market is decentralized,
there are no government fees. The lack of organized exchanges and its decentralization
among worldwide trading centers creates a 24 hour market during the weekdays. The
large size of the market provides liquidity and fast transactions.
Investing in currencies is also a good way to diversify assets, because it has little
correlation with stocks or bonds. You can make money regardless of whether a currency
is rising or falling with respect to another currency. If the target currency is
expected to rise, you buy it, then sell it later at a higher price, hopefully; if
it is falling, you sell it short, then buy it later at a lower price, if you predicted
correctly. Thus, there is no up or down market in the FX market—if one currency
is up with respect to another, then the other, obviously, is down, and vice versa.
And because of the FX market’s huge size and decentralization, there is no possibility
that prices will be manipulated by accounting frauds. No Enrons or WorldComs in
this market—not even the possibility. Nor can such a huge market be cornered. And
because currency prices are not the result of what any single organization does,
there can be no insider trading. Nor can any bubble arise, as has happened to stocks
in the late 90’s, and to real estate more recently. The size of the market is simply
too vast and too interrelated for bubbles to form.
Opening an account to trade currencies requires very little money—in some cases,
as little as $100 in so-called mini-accounts. Many firms offer up to 200:1
leverage ratios in mini-accounts, so a trader with $100 in a mini-account can trade
up to $20,000 worth of currencies. Leverage greatly amplifies both profits and losses.