An Overview of the Foreign Exchange (Forex) Market

Forex market is an around-the-clock market where the currencies of nations are traded, typically via brokers. Foreign currencies are bought and sold across the globe, and traders’ investments increase or diminish in value based on market movements. Foreign exchange market conditions can change at any time in answer to current developments.

The main benefits of Forex trading are:

24-hour trading, 5 days a week with nonstop access to global Forex markets;
An immense liquid market providing opportunities to trade most currencies;
Volatile market offering unlimited profit opportunities;
Standardized instruments for controlling risk exposure;
Opportunities to gain in rising or falling markets;
Leveraged trading with small initial margin requirements;
Lots of opportunities for tight spreads and zero commission trading.

In Forex trading the investor’s goal is to profit from currency exchange-rate movements of a particular currency pairs. For example, on a definite date the Forex rate of EUR/USD is 1.2857. If an investor has bought 1000 Euros on that date, he has paid 1285.70 U.S. dollars. One week later the exchange-rate is 1.2883, which means the value of the euro (the numerator of the EUR/USD ratio) has increased in relation to the U.S. dollar. If investor sells his 1000 Euros, he receives 1208.30 dollars thus making a small loss.

When trading currencies, open long position when you expect the currency you are buying to rise relative to the other currency you are selling. If the currency you are buying moves upward, sell it back in order to close the position and receive your gain. An open trade (also called “an open position”) is a deal in which an investor has bought or sold a particular currency pair and has not yet closed his position.

Moreover, it is estimated that anywhere between 70% and 90% of the FX market is cash settled. In other words, the person or company that bought or sold the currency does not plan physical delivery of the bought or sold currency; rather, they were entirely speculating on the movement of that particular currency.

Exchange rate

By reason of currencies are traded in pairs and exchanged one versus the other when traded, the rate at which they are changed is called the exchange rate. The major currencies are traded against the US dollar (USD). The four next-most traded currencies are the euro (EUR), the Japanese yen (JPY), the British pound sterling (GBP) and the Swiss franc (CHF). These five currencies make up the majority of the market and are called the major currencies or “the Majors”. Some sources also include the Australian dollar (AUD) within the group of major currencies.

The first currency in the exchange pair is determined to as the base currency and the other currency as the counter or quote currency. The counter currency is thus the numerator in the ratio, and the base currency is the denominator. The cost of the base currency (denominator) is always one. Thus, the exchange rate shows a buyer how much of the counter or quote currency must be paid to receive one unit of the base currency. The exchange rate also tells a seller how much he receives in the counter or quote currency when selling one unit of the base currency. For instance, an exchange rate for EUR/USD of 1.3083 specifies to the buyer of Euros he must pay 1.3083 USD in order to receive 1 Euro.

At any given rate, if an investor buys any currency and directly sells it and there is no market move, the investor loses money. The cause for this is that the bid price, which indicates how much will be received in the counter currency for one unit of the base currency, is always lower than the ask price, which shows how much must be paid in the counter currency when buying one unit of the base currency. For instance, the EUR/USD bid/ask exchange rate at your local bank can be 1.3015/1.4015, representing a spread of 1000 pips (also called points, one pip = 0.0001, or one big figure). This spread is higher in parallel to the bid/ask rates that currency investors commonly encounter, like 1.3015/1.3018 (with a spread of 3 pips.) Generally speaking, tighter spreads are superior for investors since minimal fluctuations in exchange rates lead to substantial profit from a single trade.

Margin

Financial institutions and brokers need collateral to assure traders can pay in case of a loss. In Forex market the collateral is called “margin” and is also known as minimum security. In fact, the investor deposits some money to his trading account betrothed to cover his potential loses. Margin enables individual investors to open much bigger positions than their account value. Leveraged trading also enhances the velocity of gain or loss.

Leveraged financing

Leveraged financing or the so-called “trading on margin” is pretty common in Forex trading. The loan/leverage in the margined account is guaranteed by your initial deposit. This may result in being able to buy or sell USD 100,000 for as little as USD 1,000.

The private investors can trade currencies directly or indirectly on the spot market or on the derivatives market, trading with currency options, futures, forwards or swaps.

Spot deals

Spot deal is a direct exchange of one currency for another. The spot rate is the current exchange price, also called “the benchmark price.” Spot deals do not require immediate settlement or “on the spot” payment. The liquidation date, named also “value date,” is the second business day after the “deal date” (or “trade date”) on which the transaction is concluded between the two parties. The two-day settlement period provides time to affirm the agreement and handle the clearing and required debiting and crediting both parties’ accounts in diverse global locations.

Risks

Although Forex trading can lead to very profitable results, it is likewise speculative. There are exchange rate risks, interest rate risks, credit risks, and country risks involved. Nearly 80% of all currency transactions last a period of seven days or less, while excess than 40% last fewer than two days. Given the vastly short lifespan of the typical trade, technical indicators heavily determine entry, exit and order positioning decisions.