Forex means foreign exchange and refers to the acquisition or sale, in exchange for another, of one currency. For several purposes, typically for trading, or tourism, foreign exchange is the process of converting one currency into another currency. Forex is the world’s largest market and the transactions that exist in it impact everything from the price of garments imported from other countries to the cost you pay for any product on a holiday trip to another country.
The foreign exchange market is where currencies are traded and it is very crucial since currencies need to be exchanged in order to conduct international trade and business. If you are living in India and want to buy a smartphone from South Korea, either you or the company that you buy the smartphone from has to pay them in Korean currency ‘Korean Won’. This means that the Indian importer would have to exchange the equivalent value of rupees into won. The same goes for traveling. A European tourist in India can’t pay euros to see the Taj Mahal because it’s not accepted in the local market. As such, the tourist has to exchange the euros for the local currency, at the current exchange rate.
One distinctive characteristic of this global economy is that foreign exchange does not have a central marketplace. Instead, currency trading is conducted over the counter (OTC) electronically, which means that all transactions take place over computer networks between traders worldwide, rather than on a single centralized exchange. The market is open 24 hours a day, five and a half days a week, and in the main financial centers, currencies are traded worldwide in almost every time zone.
Forex trading is, at its simplest, equivalent to the exchange of currencies that you would do when going abroad: a trader buys one currency and sells another, and the exchange rate fluctuates continuously depending on supply and demand.
Among institutional traders, such as people who work for banks, fund managers, and multinational companies, a large majority of trade activity takes place in the forex market. These traders do not actually intend to take physical ownership of the currencies themselves; they will only speculate or hedge against potential fluctuations in the exchange rate. For example, a forex trader might buy U.S. dollars (and sell Rupees) if she believes the dollar will strengthen in value and therefore be able to buy more Rupees in the future. In the meantime, in the event the Rupees weaken, an American company with Indian operations could use the forex market as a hedge, meaning the value of their income earned there falls.
There are three distinct methods to trade on the forex market: spot, forward, and future.
- Spot forex market: The actual exchange of a currency pair in the spot forex market, which takes place at the exact point where the transaction is settled, i.e. ‘on the spot’, or within a short time. Dealers such as IG sell derivatives focused on the spot forex market over-the-counter.
- Forward forex market: A contract offers to purchase or sell a fixed quantity of a currency at a given price and to be settled in the future or within a period of future dates at a fixed date.
- Futures forex market: Similarly, traders can opt to purchase or sell a predetermined amount of a currency at a specific exchange rate at a future date for a standardized contract. This is achieved on an exchange, like the forward market, rather than individually.
Each market has its jargon. These are words to know before engaging in forex trading:
- Bid-ask spread: – Exchange rates are determined by the maximum amount that buyers are willing to pay for a currency (the bid) and the minimum amount that sellers require to sell, as with other assets (such as stocks) (the ask). The bid-ask spread is the difference between these two sums and the value trades will be executed at.
- Currency pair: – A currency pair is active in all forex trades. There are also fewer common trades, in addition to the majors.
- Lot: – Forex is exchanged in what is known as a ton, or a standardized currency unit. The average lot size is 100,000 currency units, although for trading, there are also micro (1,000) and mini (10,000) lots available.
- Leverage: – Some traders might not be able to put up too much cash to conduct a deal because of the huge lot sizes. Leverage, another word for borrowing money, allows traders, without the amount of money otherwise necessary, to participate in the forex market.
- Margin: – Trading with leverage, however, is not easy. Traders need to put down some cash as a deposit or what’s known as margin upfront.
- Pip: – A pip, short for percentage points, refers inside a currency pair to the smallest possible price change. A pip is equivalent to 0.0001 since forex values are quoted at least four decimal points.
Because forex trading involves leverage and margin are used by traders, forex trading has additional risks than other asset types. Currency rates fluctuate continuously, but in very small quantities, which means that to make profits, traders need to conduct massive trades (using leverage).
If a trader makes a winning bet, this leverage is perfect because it can magnify profits. It can also, however, magnify losses, even exceeding the initial borrowed number. Moreover, if the value of a currency falls too much, leverage consumers are vulnerable to margin calls that can cause them to sell their securities purchased at a loss with borrowed funds.
Besides, you should bear in mind that those who trade foreign currencies are small fish swimming in an ocean of experienced, professional traders, and the Securities and Exchange Commission alerts new traders to possible fraud or details that may be confusing.
Unlike stock markets, which can trace their origins back decades, the forex market is a truly modern market as we understand it today. Of course, since nations started to mint currencies, it has been around in the most fundamental sense that of citizens exchanging one currency to another for financial gain forex. Yet a new innovation is the modern forex markets. More major currencies were permitted to float freely against each other after the agreement at Bretton Woods in 1971. The prices of each currency differ, contributing to the need for foreign exchange services and trading.
Commercial and investment banks perform much of the forex market trading on behalf of their customers, but there are also speculative opportunities for specialist and private investors to exchange one currency against another.