Summary - Some of the most exciting and profitable trading opportunities lie in the foreign exchange (or forex) market. In a global economy, it’s vitally important for corporations and governments to be able to exchange goods and services in their local currency. Yet the currency of a country is subject to fluctuations based on economic and political news. As consumers, we experience this difference in the cost of an overseas vacation. Companies experience these currency fluctuations in the way they increase or decrease their material costs. Forex traders seek to profit from these slight fluctuations in the value of one currency versus another. This desire to manage the risk associated with currency fluctuations is one reason the forex market is the largest market in the world. In fact, over 90% of trading takes place in the forex market.
There are eight major currencies in the forex market representing many of the strongest economies in the world. Of these, the U.S. dollar is the most highly traded currency. This would be expected because it remains the world’s leading reserve currency.
Forex trading used to be limited to institutional investors, governments, and corporations, but since the dawning of the Internet and online trading, even individual investors can participate in trading forex. One of the reasons for this is the concept of leverage which allows traders to take substantial currency positions while putting up as little as 0.25% of the overall trade value as their initial investment.
New York City may be the city that never sleeps. However, for investors, there is a market for five and a half days a week does not sleep. From the time the overseas markets open on Sunday night in the U.S. until the time the U.S. markets close on Friday, the foreign exchange (or forex) market is open. The forex market is highly significant to institutional investors, businesses, and governments for its ability to help traders manage the risk, and potentially profit from, currency fluctuations. In this article, we’ll take a deep dive to explain what forex is and the difference between the spot, forward, and futures markets. We’ll also provide a list of which currencies are considered the major currencies in forex, describe how to open a forex account and provide some basic principles about finding a profitable forex trading strategy.
What is forex?
Forex (FX) is an abbreviation for the foreign exchange market. The forex market is the largest in the world and has the highest liquidity. Over 90% of the trading that takes place on the forex market involves the U.S. dollar. The forex market trades at a pace that is 12 times greater than the futures market and thirty times greater than the global equities market.
Two common features of the forex market are that is a very liquid market and traders use high leverage to fund trades. These features make it an exciting, fast-paced market for investors. Currency trading was once the exclusive domain of institutional investors or extremely wealthy individuals. However, with the birth of the Internet and online trading, every investor can trade currencies through their online brokerage account.
Unlike a stock exchange, there is no central marketplace for forex trading. All forex trading is done electronically via over-the-counter (OTC) transactions. This is a reason why the forex market is open 24 hours a day, for five and a half days a week. This means that at any time during the day or night, the forex market can be very active. It also means that price quotes are constantly changing.
The three markets for forex trading
There are three distinct markets for forex trading: the spot market, the forwards market, and the futures market. Trading on these markets promotes an effective risk management strategy known as currency hedging. Corporations use forex trading to help protect their costs on products and services sold overseas. In the case of a forward or futures contract, some of the rates can be locked in for a year in advance to avoid the risk of currency fluctuations.
Let’s take a look at each of these markets:
- Spot Market– This is where currencies are bought and sold based on their current price for immediate delivery (although trades usually settle within two business days). In a spot deal, one party delivers an agreed-upon amount of one currency and receives a specified amount of a different currency at an agreed-upon exchange rate value. Positions are closed in cash. Like all assets, currency prices on the spot market are determined by supply and demand. In the case of forex trading, supply and demand are influenced by factors such as current interest rates, a country’s economic performance, investor sentiment regarding political and governmental stability, and investor perception of how one currency will perform against another.
- Forwards Market– This is where currency contracts are bought and sold OTC between a buyer and seller who set the terms for the contract between themselves. A futures contract is binding for both parties. The distinction between a forwards contract and spot deal is that the forward's contract is set for a set point in the future, unlike the spot market which is based on immediate delivery. A forwards contract allows traders to lock in currency prices, particularly when they’re anticipating one of the currencies to rise at a point in the future.
- Futures Market– This is similar to the forwards market except in the case of the futures market, the size and settlement dates of the contracts are determined by a public commodities market. In the United States, one of the most common commodities markets is the Chicago Mercantile Exchange. The Futures market is regulated by the National Futures Association. In the case of a futures contract, the exchange serves the role of being a counterpart to the trader, providing clearance and settlement.
What are the “Major” currencies in forex?
There are eight currencies that are known in forex circles as “The Majors”. They are:
- S. Dollar (USD)
- European Euro (EUR)
- Japanese Yen (JPY)
- British Pound (GBP)
- Swiss Franc (CHF)
- Canadian Dollar (CAD)
- Australian/New Zealand Dollar (AUD/NZD)
- South African Rand (ZAR)
These currencies are called the Majors because they offer the best trading conditions for investors. Some reasons for this are that these currencies have high liquidity, they are associated with countries that have significant financial power in the global economy, and they conduct a high volume of trade with each other. All of this means they have lower bid-ask spreads than other pairs. The following combinations of “major” currency pairs are among the best for meeting all these conditions:
The most widely traded currency, as you might expect, is the U.S. dollar. This is due to the size of the U.S. economy as well as the fact that the U.S. dollar is the preferred reference for most of the currency transactions done worldwide. The U.S. dollar is also the dominant reserve currency in the world which means that many foreign governments and institutions hold a significant amount of U.S. dollars as part of their foreign exchange reserves.
All of this does not mean that forex traders should never consider trading exotic currency pairs. However, doing so is usually left to natives of a particular country who are familiar with the economic and political issues in that country.
How to start trading in the forex market?
The first thing an individual investor will need is to open an account. There are a variety of forex brokers who will allow an investor to become a forex trader. Many of these brokers will provide a trading platform with free forex charting software for clients with trading accounts that are open and funded. In many cases, these software programs allow forex traders to establish a demo account. Investing in the foreign exchange market contains risk and some investors may need to review many forex trading strategies and even forex brokers before making a final decision on where to open an account.
The charting software is a key technical analysis tool for the forex trader. Forex charts present information that allows traders to analyze a currency pair. Remember, every forex trade requires a buyer who is purchasing one currency and a seller who is selling another. In order to execute a successful trade, investors need to know how much one currency in a pair is worth in relation to the currency they want to trade. On a forex chart, a currency pair will be listed similar to this:
EUR USD 1.28
This means that one Euro is worth $1.28. In this example, the base currency (the currency to be sold) is the Euro and the U.S. dollar is what is called the counter currency.
Forex charts allow traders to customize settings for technical indicators that are indicative of short-term price movements such as current price, volume, and open interest. The basic types of technical indicators include overlays (e.g. moving averages and Bollinger Bands) and oscillators (e.g. MACD, RSI).
For investors who are truly seeking to trade the forex market as a career, another good step would be to join a forex club. These clubs, which can be formal or informal, help provide education and a source of networking for club members. All members of a forex club are bound by the principles of the FX Global Code which helps ensure a transparent and global forex market.
What is a forex trading strategy?
Once traders have access to forex charts they will choose a trading strategy. A forex trading strategy is typically made up of trading signals. Many forex brokers have proprietary signals. But in reality, there are many individual investors who have come up with their own successful trading signals. There are many web sites that promote free forex signals. These signals are either manual (which means that the trader is actively looking for the trading signal and making an interpretation to buy or sell) or automated (the software uses an algorithm and executes a trade upon indication of a trading signal). In some cases, automated systems have been known to improve performance because they take the emotion out of trading.
Some components to consider in devising a forex trading strategy include:
- Market Selection – this means simply deciding which currency pairs to trade.
- Position Sizing – this means determining how large each position (i.e. how much money) is to control for the amount of risk in the trade.
- Entry Points – this means finding, or creating, rules that tell a trader when to enter a long or short position for the currency pair they want to trade
- Exit Points – this means finding, or creating, rules for when to exit a long or short position. This also means establishing rules to know when to get out of a losing position.
- Trading Tactics – this means having rules determining how the currency pairs will be bought and sold (spot market, forward market, futures market)
Of course, every forex trading strategy must be evaluated to determine how effective it is. In general, forex trading can be very successful when traders follow their own rules, or the rules set out by others. And like many trading strategies, changing too often can lead to less profitable trading. However, in some cases, traders may find that it’s time to make a switch. Some of the things they may look for include:
- The strategy does not match their risk tolerance (i.e. the strategy is too aggressive or too conservative)
- The market conditions have changed meaning that some trends are now obsolete
- The strategy is hard to understand. Simply put, if the trader doesn’t understand the rules, they are unlikely to be successful with it.
How does leverage work in a forex trade?
Currency trading is different from other kinds of trading because daily fluctuations in currency prices are typically very small. In fact, most currency pairs (i.e. two different forms of currency – one being bought the other being sold) move less than 1% in value during a trading day. To help take advantage of this small price movement, investors use leverage. Leverage means borrowing money that is needed to execute a trade. In the case of forex, this money typically comes from a broker. Forex trading allows investors to make a large investment while committing as little as 0.25% of the fund’s needed for the trade. Every trade requires a specific amount of margin. This is the amount that an investor must directly fund. However one of the appeals of forex trading is the opportunity to buy enormous positions in a currency.
As an example, a standard lot of USD/CHF is equivalent to $100,000 U.S. dollars. If the margin requirement is 1%, a trader would have to provide $1,000. They could use leverage for the rest. In this case, their margin-based leverage would be 100:1 (100,000/1,000). Investors may choose to put up more than the required margin for any trade.
The bottom line on forex
The forex market represents an enormous opportunity for investors for many reasons:
- The forex market is the largest in the world and has the highest liquidity.
- Over 90% of the trading that takes place on the forex market involves the U.S. dollar.
- The forex market trades at a pace that is 12 times greater than the futures market and thirty times greater than the global equities market.
As might be expected of the largest economy in the world, the U.S. dollar is the most traded currency. And the exchange rate between the U.S. dollar (USD) and the European Euro (EUD) is one of the most frequently cited in the financial news.
Forex trading requires a significant amount of leverage (i.e. money that investors borrow from a broker). For this reason, forex trading may add a level of risk that makes some investors uncomfortable. However, it can be a significant and profitable addition to an investor’s portfolio. Because of the risk involved as well as the volatility in this market, every trader should take time to establish a demo account with one or more forex brokers. This will allow time to fully understand the many trading strategies that can help investors not only identify a profitable currency pair to trade but also for when to enter and exit the trade.