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In the last ten years, those who plan to improve their financial health through investment have heard about forex at least once. Besides stocks or bonds, forex has become progressively more prevalent among investors. Keep reading the article, you will find out what is forex trading and why it is that popular.
The Definition of Forex
The foreign exchange, commonly called forex or FX market is where both institutional and retail traders swap one currency for another for different purposes such as commerce or profit gaining. Because the value of one currency is different from that of another, investors would exploit this difference to earn extra money. However, they could incur a loss if the market moves against their expectation.
Unlike the stocks market, the origin of the forex market remains obscure although the modern forex market is believed to have been formed in the 1970s. Particularly, in this period, the Bretton Woods system was introduced to govern foreign currency transactions, so exchanging foreign currencies between countries then became widespread.
Initially, banks were the main participants and only retail traders who had a large trading capital and a good relationship with those banks were allowed to engage in the market. Today, the forex market is highly complex and fragmented with the larger attendance of individual traders who access the market through forex brokers. Having said that, central banks and commercial banks still dominate the market, followed by hedge funds and investment management firms. Therefore, forex is sometimes implicitly known as an interbank market, although there is still a retail trading market for individual investors to open positions.
According to the BIS report in January 2021, the forex market reached a daily turnover of US$7.6 trillion which is unevenly shared by foreign exchange swaps, spot transactions, outright forwards, currency forwards and other products. Thereby, forex is the largest money market in comparison to other financial markets.
Why is Forex so Popular?
Recently, the forex market has attracted much more investors for some reasons as follows:
Ease of Access
What interests investors in forex trading is its online presence. Particularly, currency conversion activities are not conducted in a central location but decentralized to major financial centers worldwide that open in different timeframes, except weekends and holidays.
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Today, with the support of advanced technologies and the Internet, the forex market is more accessible to retail traders by allowing them to open an account with forex brokers and then trade on customized trading platforms (e.g. MetaTrader 4 or MetaTrader 5). Different versions of platforms are developed for desktops, websites, Android and iOS operating systems of smartphones. Investors then can enter the market and open a position wherever they are, even on the go, as long as they have a well-connected portable device.
Besides, speculators easily update major news which significantly affects the value of currencies from an economic calendar. Even when they reach a professional level, they can base the fundamental and technical analysis on those news and price patterns to predict in which directions the market will move.
The Most Liquid Market
As the world’s largest financial market, forex provides the most liquid assets that are currency pairs. Those financial instruments are divided into different categories: majors, minors and exotics. Of which, majors that are formed by G8 currencies have the highest liquidity and accordingly the lowest volatility because they come from countries that are economically and politically stable and they are often traded in considerable volumes. This means traders are allowed to convert one major currency to another in a high turnover without moving the market too much.
Meanwhile, minors, or commonly called crosses, and exotics are less liquid and more volatile. When being compared to other markets, forex normally offers rather higher liquidity, therefore smaller spreads which are transaction costs paid to forex brokers after trades. Particularly, a spread is a difference between the bid price at which traders are willing to buy currencies and the ask price which the counterparty accepts to sell those currencies. In comparison with other financial markets, a forex spread is normally tighter.
For beginners, trading majors and some crosses in normal market conditions is beneficial because of their higher liquidity and smaller spreads, which therefore reduces the risk of losing money. However, the forex market is considerably affected by major news, supply and demand. So any important news announcements can render the market more volatile. Experienced investors can exploit the high volatility of some currency pairs, especially exotics, to make bigger profits.
No Ownership of Financial Assets Required
Those betting on foreign currencies do not need to hold real currencies for transactions. Normally, forex speculators are not interested in delivering or receiving foreign currencies from the counterparty, but rather profit from the price movement of a currency pair. For example, if you want to trade the EUR/USD pair, you can open a long or short position to buy or sell the euro (the base currency) without possessing it. This is called CFD trading, short for Contracts For Difference.
Wandering around financial markets, you will immediately realize that only forex allows you to trade 24 hours a day. This is another compelling factor that involves many more speculators in the market. As the global decentralized, over-the-counter (OTC) market, forex enables any transactions to take place on four trading sessions in London, New York, Tokyo and Sydney. Those sessions are consecutively open and closed as follows:
- Sydney: 10 PM on Sunday to 7 AM GMT+0;
- Tokyo: 12 AM to 9 AM GMT+0;
- London: 8 AM to 5 PM GMT+0;
- New York: 1 PM to 10 PM GMT+0 on the next Friday.
Thereby, always at least one trading session open and there is some time when two trading sessions cross. Unlike the US stock market that opens from 1.31 PM to 8 PM GMT+0, most currency pairs can be traded anytime in a day. This 24-hour access gives investors better trading opportunities. Accordingly, they can open a position whenever they are free without impacts on their working or family time.
However, the trading time for independent investors is limited to five weekdays. This is because the main participants in forex – mostly banks, hedge funds and investment management companies – stop all activities on their trading desks over weekends. Those key players contribute the majority of a daily trading volume, so their absence would result in a lack of liquidity. This is detrimental for both forex brokers and retail traders. Therefore, trading platforms are often closed on weekends as well. Also, the short break is a chance for traders to review trading strategies and plan trades for the next week to increase the win rate.
Leverage (Margin Trading)
Another major draw of forex trading is its comparatively high leverage. Generally speaking, leverage here means borrowing an amount of money from brokerage companies to invest in foreign currencies without interest rates. Leverage is often shown in different ratios such as 1:10, 1:100 or 1:1000. Assume you deposit US$100 in a trading account and want to magnify your investment up to 1000 times, you then can open many positions with the maximum capital of US$100,000 (= US$100 x 1000 times).
There is an implicit rule behind any investment; that is “use the money to make money”. This means the more money traders invest, the higher probability of financial returns is. So leveraging trading capital gives investors higher maneuverability of gaining bigger profits despite their small initial investment.
Normally, forex brokers offer relatively high leverage ratios which go accompanied by low margin requirements. Particularly, leverage is inversely proportional to margin which is a required amount traders should set aside their trading capitals to keep positions always open. If an account fails to reach the predetermined margin, in the worst case, it would be automatically closed by brokers without the permission of the account’s owner. So brokers will send a margin call to warn retail participants when they violate the margin requirements.
Having opened an account with a legitimate broker, new investors can choose paper trading before officially joining in real transactions. Market conditions on demo accounts simulate real-life situations without giving monetary risks. Accordingly, novice traders would be given a virtual capital already deposited on demo accounts to learn how currency pairs are traded on a trading platform, how the price fluctuates and then test trading strategies.
Supports From Multiple Sources
As the world’s fast-growing market, forex provides traders with a variety of learning sources that include education materials provided by forex brokers, market review sessions with personal analysts, webinars with financial experts, forums or groups on social networks. Forex investors, hence, learn from for fundamentals to practical experience shared by fellows and specialists. Receiving support from the big forex community has encouraged traders to engage in the market.
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