Forex (FX) refers to the marketplace where various currencies and currency derivatives are traded, as well as to the currencies and currency derivatives traded there. Forex is a portmanteau of "foreign exchange." The forex market is the largest, most liquid market in the world by trading volume, with trillions of dollars changing hands every day. It has no centralized location, rather the forex market is an electronic network of banks, brokers, institutions, and individual traders (mostly trading through brokers or banks).
Many entities, from financial institutions to individual investors, have currency needs, and may also speculate on the direction of the movement of a particular pair of currencies. They post their orders to buy and sell currencies on the network so they can interact with other currency orders from other parties. The forex market is open 24 hours a day, five days a week, except for holidays. The forex market is open on many holidays on which stock markets are closed, though trading volume may be lower.
Forex Pairs and Quotes
When trading currencies, they are listed in pairs, such as USD/CAD, EUR/USD, or USD/JPY. These represent the U.S. dollar (USD) versus the Canadian dollar (CAD), the Euro (EUR) versus the USD and the USD versus the Japanese Yen (JPY). There will also be a price associated with each pair, such as 1.2569. If this price was associated with the USD/CAD pair it means that it costs 1.2569 CAD to buy one USD. If the price increases to 1.3336, then it now costs 1.3336 CAD to buy one USD. The USD has increased in value (CAD decrease) because it now costs more CAD to buy one USD.
In the forex market currencies trade in lots, called micro, mini, and standard lots. A micro lot is 1000 worth of a given currency, a mini lot is 10,000, and a standard lot is 100,000. This is different than when you go to a bank and want $450 exchanged for your trip. When trading in the electronic forex market, trades take place in set blocks of currency, and you can trade with whatever size you want within the limits allowed by your trading account balance. For example, you can trade seven micro lots (7,000) or three mini lots (30,000) or 75 standard lots (750,000), for example.
How to Trade in the Forex
The forex market is open 24 hours a day, five days a week across major financial centers across the globe. This means that you can buy or sell currencies at any time during the week. From a historical standpoint, foreign exchange trading was largely limited to governments, large companies, and hedge funds. But in today's world, trading currencies is as easy as a click of a mouse. Accessibility is not an issue, which means anyone can do it. Many investment firms, banks, and retail forex brokers offer the chance for individuals to open accounts and to trade currencies.
When trading in the forex market, you're buying or selling the currency of a particular country, relative to another currency. But there's no physical exchange of money from one party to another. That's what happens at a foreign exchange kiosk—think of a tourist visiting Times Square in New York City from Japan. He may be converting his physical yen to actual U.S. dollar cash (and may be charged a commission fee to do so) so he can spend his money while he's traveling. But in the world of electronic markets, traders are usually taking a position in a specific currency, with the hope that there will be some upward movement and strength in the currency they're buying (or weakness if they're selling) so they can make a profit. A currency is always traded relative to another currency. If you sell a currency, you are buying another, and if you buy a currency you are selling another. In the electronic trading world, a profit is made on the difference between your transaction prices.
Forex Market Differences
- Fewer Rules This means investors aren't held to as strict standards or regulations as those in the stock, futures or options markets. There are no clearing houses and no central bodies that oversee the entire forex market. You can short-sell at any time because in forex you aren't ever actually shorting; if you sell one currency you are buying another.
- Fees and Commissions Since the market is unregulated, how brokers charge fees and commissions will vary. Most forex brokers make money by marking up the spread on currency pairs. Others make money by charging a commission, which fluctuates based on the amount of currency traded. Some brokers use both these approaches.
- Full Access There's no cut-off as to when you can and cannot trade. Because the market is open 24 hours a day, you can trade at any time of day. The exception is weekends, or when no global financial center is open due to a holiday.
- Leverage The forex market allows for leverage up to 50:1 in the U.S. and even higher in some parts of the world. That means a trader can open an account for $1,000 and buy or sell as much as $50,000 in currency, for example. Leverage is a double-edged sword; it magnifies both profits and losses.
Example of Forex Transactions
Assume a trader believes that the EUR will appreciate against the USD. Another way of thinking of it is that the USD will fall relative to the EUR. They buy the EUR/USD at 1.2500 and purchase $5,000 worth of currency. Later that day the price has increased to 1.2550. The trader is up $25 (5000 * 0.0050). If the price dropped to 1.2430, the trader would be losing $35 (5000 * 0.0070). Currency prices are constantly moving, so the trader may decide to hold the position overnight. The broker will rollover the position, resulting in a credit or debit based on the interest rate differential between the Eurozone and the U.S. If the Eurozone has an interest rate of 4% and the U.S. has an interest rate of 3%, the trader owns the higher interest rate currency because they bought EUR. Therefore, at rollover, the trader should receive a small credit. If the EUR interest rate was lower than the USD rate then the trader would be debited at rollover.