What is The Forex Market?
Forex (or also known as FX) is a short form of foreign exchange and refers to the process of converting one currency to another. It has recently become one of the largest markets in the world with an average daily volume of about 5.1 trillion US dollars (Statista, 2019). Are you interested in forex trading? This article will give you deeper insight into forex-related fundamentals, how the market runs and discover steps to begin to trade forex effectively.
The Definition of Forex Market
The forex (known as foreign exchange or FX) market is a global market for buyers and sellers to trade currencies directly at determined prices. It is also known as the decentralized or over-the-counter place where all transactions will be directly conducted between buyers and sellers. Moreover, most modern tradings now occur electronically – in other words via computer networks, but not in any centralized locations. So you can trade currencies 24/5 worldwide.
Normally, currency conversion is daily done by individuals, enterprises or banks for different purposes, for example traveling, commodity purchase or finance. Foreign exchange trades can be extremely large in scale, even entailing millions of dollars, so this unintentionally boosts the demand for swapping and consequently leads to the volatility of currency values.
Types of Forex Markets
Currently, there are three types of forex trading venues for financial institutions, companies and individual traders to conduct their transactions:
Spot market: support physical exchanges of currencies at the current prices.
When it comes to the forex market, many people usually think of the spot market as the majority of forex trading activities are performed on this venue. Previously, the future market gained in greater popularity because it provided investors or speculators a longer time for settlement. However, the introduction of mobile devices and the Internet has changed the way the trading works, more specifically allowing bilateral transactions to take place with agreed prices at the present. This turned the spot market (also called the physical or cash market) to the most popular forex trading place.
The current exchange rate value is also known as “the spot price,” which is determined by different factors such as current interest rates, predictions of currency’s future values, economic and political situations. After negotiations, both parties finalize the deal (or spot deal), then execute a transaction and eventually make in-cash payment within two days.
Forward market: provide forward contracts that customize a certain volume of a currency at an agreed price and in a specific time in the future.
Regularly forward transactions are privately carried out over-the-counter. Terms are decided since the execution of those agreements, which makes the exchange rate unaffected by the market price on that day. So forward contracts are illiquid and primarily used for hedging.
Future market: provide future contracts that regulate the standardized volume of currency with a predetermined price at the settlement date of the future.
Unlike forward agreements, future transactions are publicly made on a futures market (or futures exchange) and primarily used for speculation. Accordingly, when traders predict the value of a currency to go down or hold a short position, they will choose futures. In contrast, futures purchasers often go “long” or expect the price to increase. Besides, some future contracts are also signed to hedge the value movement and avoid losses.
Entities Running Forex Market
Before finding the answer, we should come back to the nature of the forex market: it is practically driven by supply and demand of currencies. So any participants who impact these two acts are capable of running the forex market, including central banks, commercial and investment banks, large corporations, brokers or individual investors.
Factors Affecting Forex Market
The forex market is volatile and complicated, so possibly being affected by many factors. In this part, however, we only mention macroeconomic elements because they are overarching drivers that influence currency’s price fluctuations or supply and demand of currencies.
- Capital market: Typical capital markets are stock or bond trading places. Particularly, governments, financial institutions or corporations often sell such financial instruments to both domestic and foreign investors for profits. Like commodity-driven markets, trades in those venues will affect price movements and eventually the forex trading.
- International trades: When the Japanese government wants to import goods from Germany, they must convert their money to Euros first. The higher demand for Euros will have positive impacts on their value. Besides, if trade deficits take place, the state has to sell more Japanese yens to buy Euros before payments for international commodities. This will put downward pressure on the value of yens.
- Political news: In March 2020, CNBC reported that the US dollar index increased over 4% against Chinese yuan. Although the United States now records the largest number of Covid-19 cases, its currency is still a secured asset due to its economic and political stability. Not only political situations but also regulations or policies have significant impacts on forex traders.
- Economic statistics: GDP (Gross Domestic Product) and inflation are the two most significant factors that affect the forex market. High GDP per capita can lead to currency appreciation. Meanwhile, increasing the price can either curb the buying decision or compel central banks to raise interest rates and limit inflation. So it can be said as a double-edged knife for currencies. Also, other economic factors such as employment rate or retail sales are considered to drive the forex value in reality.
Apart from the mentioned elements, other forces of the forex market can derive from policies of central banks or market sentiment that involve reactions of traders to news about the price direction.
What is The Forex Trading – The Definition of Forex Trading
Trading forex refers to the selling of one currency (also called the quote currency) to concurrently buy another (known as the base currency). Of which the base currency is the first currency of a forex pair whilst the quote currency is the second one. The value of a forex pair is calculated by how much of the quote currency is required to pay for one unit of the base currency.
To illustrate, just imagine you are going to speculate on the AUD/USD pair. The base and quote currencies are AUD and USD respectively. Accordingly, you plan to sell the US dollar and simultaneously buy the Australian dollar. The current price of AUD/USD is 0.70, so this means one Australian dollar is only worth 0.70 US dollars. In case you think the former currency can rise against the latter, which directly boosts the price of this forex pair, then you can decide to go long. If not, you can choose a short position or sell the pair.
Today, 80% of worldwide forex trading is conducted on such major pairs as EUR/USD, USD/JPY, USD/CHF, AUD/USD, USD/AUD and GBP/USD. Many investors and speculators are actually not interested in delivering or taking the delivery of currency itself, but more concerned with gaining profits from the price fluctuations.
Financial Preparation for Your First Forex Trading
Although no minimum investment is required, you should always ensure that your trading account will have enough capital and that your investment has to suit goals and trading strategy. However, risking all of what you have is not a wise idea even when you see great potential for success. Many experienced traders share that you shouldn’t bet over 1% of your capital in every trade.
Instruction to Trade Forex
The forex market is continuously changing and seems unpredictable to control. So any beginners should understand simple steps to help them start effectively:
- Choose the way you prefer trading Forex:
The primary participants in the market are large international banks as they often trade enormous amounts of currency every day. However, most individual investors are incapable of making such billion-dollar trades, so they can conduct transactions via a forex broker or forex CFDs.
CFD is an abbreviation of Contract For Difference – a derivative product, so its value is set based on the difference in the price of the underlying asset. When purchasers and traders get involved in CFD trading, they can speculate on currencies without having the ownership. Accordingly, buyers will agree on the difference in price between the time of opening and closing positions. If you go long, you will earn a profit if the price increases and get a loss if the value goes down. However, opening a short position is the opposite.
Trading via a broker – and occasionally with a bank – is also the same to CFD trading. You also bet on the price fluctuations of currency pairs without taking ownership of them.
- Know how the Forex market works:
As has been said above, forex is not traded in any centralized exchanges but a network of banks located in such large financial centers as New York, Tokyo, London, Zurich, Singapore, Paris, Sydney, Hong Kong and Frankfurt. However, instead of dealing directly with major banks, individual traders can choose a forex provider who will work with those banks on their behalf, find the best prices and quote prices on their market spread. Of which the spread is the difference in the bid (selling) price and the offer (buying) price. The wider the bid-offer spread is, the more disagreements parties have on prices.
Some forex trading providers can allow Direct Market Access (DMA), which means traders can directly make transactions in physical markets without any brokers.
- Open an account:
If you trade using CFDs, opening an account with leveraged providers is a good option. Those providers allow traders to open larger positions than their available capital. Not until you decide to engage in a trade, you are obliged to add funds.
- Devise a trading plan:
Designing a tremendous forex trading strategy is a necessity if you are a novice in this market. The strategy helps you to establish achievable goals, make rational decisions and even affords you certain structures before you open or close positions. More importantly, it needs to suit your initial trading purposes and existing finance. For example, if you choose a day trading plan, it means you prefer small movements of the currency pair’s value, so you can open and close in a single day. Meanwhile, position trading is more appropriate for those who open positions in a longer time and then get benefits from large price fluctuations. So which one suits you is the question you need to answer.
- Decide a suitable Forex platform:
Choosing a forex trading platform is especially important. Through this article, you understand that the market is always changing, so your chosen platform has to facilitate your tracking of price movements via portable devices. Best forex platforms that should be considered include MetaTrader series (MT4, MT5).
- Open, monitor and close the first position:
Once you have completed all those preparations, it is time you can begin your forex trading. You first open a position, observe a list of buy and sell prices, choose the volume and add limits in which your position is closed when it reaches a particular level. Opening a long position if you want to buy and a short one when you sell. Then you can follow the price fluctuation and monitor the profit of the position before deciding when to close it.
Forex Trading Risks
Traders can be confronted with common risk factors when participating in the forex markets. This is because forex assets are not standardized and even the trading is almost unregulated in some countries. Normally transactions conducted by banks are secured by the market pricing mechanism, so the market will impose offers and bids for certain currencies without fear of influencing their values. This makes the deal with banks more transparent. Meanwhile, retail traders often work with unregulated brokers, but unfortunately not all governments or markets issue policies to protect such individuals. Therefore their trading is riskier.
When doing forex trading, you should consider several risks as follows:
- Exchange rate: The risk is induced by fluctuations in the price of one currency compared to another.
- Interest rate: When a country has a high-interest rate, the demand for its currency will rise afterward. This leads to a rise in its value but also a downward pressure on other currencies if the country constantly increases the rate over time.
- Credit: This risk is related to the impossibility to pay the other party because the counterparty goes bankrupt or breaks contracts.
- Country: This risk appears when the government imposes some restrictions or policies that prevent trades from being well implemented.
- Liquidity: This risk is caused by the inability to end positions and convert assets to cash. This leads to massive losses.
- Leverage: If traders are required to give low margin deposits, a higher leverage level will be applied on their capitals. This means the greater risk they can get.
- Transaction: The risk is caused by failures in communicating, tackling and confirming orders.
- Ruin: The risk refers to the possibility to lose too much money that you cannot keep trading.
What is Forex Simplified: Conclusion
In reality, forex trading is more common and easier to understand than you thought. Just imagine when you plan to visit China next month, you must exchange your host currency, for example, British Pound, to Chinese Yuan (CNY) for shopping and dining in the country. What if you will not spend all those yuans? You can either keep such money as a souvenir or swap them to your currency. Apparently, if you choose the latter option, you do not receive the same British Pound amount. This happens because the exchange rate is always varying, let alone the buying and selling prices are always different even at the same time. Therefore many travelers can wait until the selling price is equal or greater than the initial buying one, then deciding to swap foreign currency for breaking even or profiting.
Similarly to the case when many companies want to buy commodities from another country, the higher demands of local currency they need for purchase activities, the more the value of such money increases. As a result, this constantly changes the exchange rate and many can base the execution of forex trading on this fluctuation for profits.