Forex is a portmanteau of foreign currency and exchange. Foreign exchange is changing one currency into another for various reasons, usually for commerce, trading, or tourism. According to a 2019 triennial report from the Bank for International Settlements, the daily trading volume for forex reached $6.6 trillion in 2019.
In Trading currencies, there are such large trade flows within the system that it is difficult for rogue traders to influence the price of a currency, which can be risky and complex. This system helps create transparency in the market for investors with access to interbank dealing.
What Is the Forex Market?
The foreign exchange market is where currencies are traded. Currencies are important because they allow us to purchase goods and services locally and across borders. International currencies need to be exchanged to conduct foreign trade and business.
One unique aspect of this international market is that there is no central marketplace for foreign exchange. Rather, currency trading is conducted electronically over the counter, which means that all transactions occur via computer networks among traders worldwide rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centers of Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich—across almost every time zone. This means that the forex market begins anew when the U.S. trading day ends in Tokyo and Hong Kong. As such, the forex market can be extremely active at any time, with price quotes changing constantly.
What is forex trading?
At its simplest, forex trading is similar to the currency exchange you may do while traveling abroad: A trader buys one currency and sells another, and the exchange rate constantly fluctuates based on supply and demand.
Currencies are traded in the foreign exchange market, a global marketplace open 24 hours a day, Monday through Friday. All forex trading is conducted over the counter (OTC), meaning there’s no physical exchange, and a global network of banks and other financial institutions oversee the market.
Most trade activity in the forex market occurs between institutional traders, such as those working for banks, fund managers, and multinational corporations. These traders don’t necessarily intend to take physical possession of the currencies themselves; they may speculate about or hedge against future exchange rate fluctuations.
How Currencies Are Traded
All currencies are assigned a three-letter code, much like a stock’s ticker symbol. While there are more than 170 currencies worldwide, the U.S. dollar is involved in most forex trading, so it’s especially helpful to know its code: USD. The second most popular currency in the forex market is the euro, the currency accepted in 19 countries in the European Union (code: EUR).
Other major currencies, in order of popularity, are the Japanese yen (JPY), the British pound (GBP), the Australian dollar (AUD), the Canadian dollar (CAD), the Swiss franc (CHF), and the New Zealand dollar (NZD).
All forex trading is expressed as a combination of the two currencies being exchanged. The following seven currency pairs—what are known as the majors—account for about 75% of trading in the forex market:
- EUR/USD
- USD/JPY
- GBP/USD
- AUD/USD
- USD/CAD
- USD/CHF
- NZD/USD
How do currency markets work?
Unlike shares or commodities, forex trading does not occur on exchanges but directly between two parties in an over-the-counter (OTC) market. The forex market is run by a global network of banks spread across four major forex trading centers in different time zones: London, New York, Sydney, and Tokyo. Because there is no central location, you can trade forex 24 hours a day.
There are three different types of forex markets:
- The spot forex market is the primary market where those currency pairs are swapped, and exchange rates are determined in real-time based on supply and demand.
- Forward forex market: Instead of executing a trade now, forex traders can also enter into a binding (private) contract with another trader and lock in an exchange rate for an agreed-upon currency on a future date.
- Future forex market: Similarly, traders can opt for a standardized contract to buy or sell a predetermined amount of a currency at a specific exchange rate at a date in the future. This is done on an exchange rather than privately, like the forwards market.
Most traders speculating on forex prices will not plan to take delivery of the currency itself; instead, they make exchange rate predictions to take advantage of price movements in the market.
What Moves the Forex Market
Like any other market, currency prices are set by the supply and demand of sellers and buyers. However, there are other macro forces at play in this market. Interest rates, central bank policy, the pace of economic growth, and the political environment in the country in question can also influence demand for particular currencies.
The forex market is open 24 hours a day, five days a week, which gives traders in this market the opportunity to react to the news that might only affect the stock market much later. Because so much of currency trading focuses on speculation or hedging, traders need to be up to speed on the dynamics that could cause sharp spikes in currencies.
Risks of Forex Trading
- Small market movements can have a big impact. Most FX trading products are highly leveraged. You only pay a fraction of the value of your trade up-front, but you are still responsible for the full amount of the trade.
- Exchange rates are very volatile. They tend to move around a lot, even within very short periods. There are significant investment risks as currency fluctuations may move against you, causing you to lose money.
- Currency markets are extremely difficult to predict. Many different factors affect exchange rates.
- Limited protection from risk management systems. Stop loss orders will only cap your losses. You may also pay a premium price to guarantee your stop-loss order.
- Forex scams and fraud. Offers and advertisements that sound too good to be true probably are. Read what the US Commodity Futures Trading Commission says about foreign currency trading fraud.
- Forex provider risks. If your FX provider becomes insolvent, you may not get your money back.
- Trading delays can severely affect results. You may not be able to make trades when you’d like to because of a lack of liquidity in the market, execution risk, or computer system problems.
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