Forex Trading: What is Forex?
Forex trading is a term used to describe individuals that are engaged in the active exchange of foreign currencies, often for the purpose of financial benefit or gain. That can take on the form of speculators, who are looking to buy or sell a currency with the goal of profiting from the currency’s price movement; or it can be a hedger that’s looking to protect their accounts in the event of an adverse move against their own currency positions.
The term ‘forex trader’ may describe an individual trader on a retail platform, a bank trader utilizing their institutional platform, or hedgers who may be either managing their own risk or outsourcing that function to a bank or money manager to manage the risk for them.
Forex Trading: The FX Market
The foreign exchange market, or forex (FX) for short, is a decentralized market place that facilitates the buying and selling of different currencies. This takes place over the counter (OTC) instead of on a centralized exchange.
Without knowing it, you have probably already participated in the foreign exchange market by ordering imported products such as clothing or shoes, or more obviously, buying foreign currency when on vacation. Traders may be drawn to forex for several reasons, including:
- The size of the FX market
- A wide variety of currencies to trade
- Differing levels of volatility
- Low transaction costs
- 24 hours a day trading during the week
This article will address traders of all levels. Whether you are brand new to forex trading or looking to build on your existing knowledge, this article seeks to provide a solid foundation to the foreign exchange market.
Forex Trading: Two Sides to Every Market
One unique aspect of the Forex market is the manner in which prices are quoted. Because currencies are the base of the financial system, the only way to quote a currency is by using other currencies. This creates a relative valuation metric that may sound confusing at first, but can become more normalized the longer that one works with this two-sided convention.
Forex trading in a pair does offer the trader a bit of additional flexibility, by allowing the trader or investor the ability to voice their trade against the currency that they feel most appropriate.
Let’s take the Euro for example, and let’s say a trader has optimistic projections for the European economy and would thusly like to get long the currency. But – let’s say this investor is also bullish for the US economy, but is bearish for the UK economy. Well, in this example, the investor isn’t forced to buy the Euro against the US Dollar (which would be a long EUR/USD trade); and they can, instead, buy the Euro against the British Pound (going long EUR/GBP).
This affords the investor or trader that extra bit of flexibility, allowing them to avoid ‘going short’ the US Dollar to buy the Euro and, instead, allowing them to buy the Euro while going short the British Pound.
Forex Trading: Base v/s Counter Currencies
One important distinction of a Forex quote is the convention: The first currency listed in the quote is known as the ‘base’ currency of the pair, and this is the asset that’s being quoted. The second currency in the pair is known as the ‘counter’ currency, and this is the convention of the quote, or the currency that’s being used to define the value of the first currency in the pair.
Let’s take EUR/USD as an example…
The Euro is the first currency in the quote, so the Euro would be the base currency in the EUR/USD currency pair.
The US Dollar is the second currency in the quote, and this is the currency that the EUR/USD quote is using to define the value of the Euro.
So, let’s say that the EUR/USD quote is 1.3000. That would mean that 1 Euro is worth $1.30. If the price moves up to $1.35 – then the Euro would have increased in value and, on a relative basis, the US Dollar would’ve decreased in value.
If an investor was bearish the Euro but bullish on the US Dollar, they could choose to ‘short’ the pair, expecting prices to fall; after which they could ‘cover’ the trade by buying it back at a lower price, and pocketing the difference.
Forex Trading: The Forex Market Explained
In a nutshell, the foreign exchange market works like many other markets in that it’s driven by supply and demand. Using a very basic example, if there is a strong demand for the US Dollar from European citizens holding Euros, they will exchange their Euros into Dollars. The value of the US Dollar will rise while the value of the Euro will fall. Keep in mind that this transaction only affects the EUR/USD currency pair and will not for example, cause the USD to depreciate against the Japanese Yen.
Forex Trading: What Drives the Flows?
In reality, the above example is only one of many factors that can move the FX market. Others include broad macro-economic events like the election of a new president, or country specific factors such as the prevailing interest rate, GDP, unemployment, inflation and the debt to GDP ratio, to name a few. Top traders make use of an economic calendar to stay up to date with these and other important economic releases that can move the market.
On a longer-term basis, one major driver of Forex prices are interest rates from the related economy, as this can have a direct impact of holding a currency either long or short.
What Explains the Popularity?
The foreign exchange market allows large institutions, governments, retail traders and private individuals to exchange one currency for another and the ‘core’ of the FX market is what’s known as the interbank market, which is where liquidity providers trade amongst each other.
The benefit of having forex trade between global banks and liquidity providers is that forex can be traded around the clock (during the week). As the trading session in Asia comes to a close, the European and UK banks come online before handing over to the US. The full trading day ends when the US session leads into the Asian session for the following day.
What makes this market even more attractive to traders is The around-the-clock liqu