|It's the most liquid market in the world, generating $1.9 trillion in volume a day. It's open 24 hours a day, uses pips instead of points, there are no commissions, and the spreads are tight. What am I referring to? If you haven't guessed by now, I am referring to the foreign exchange or currency market. Those of you who have given some thought to trading the currency markets know that it is fast-moving and can be risky. Still intrigued? How do you know if it's the right market for you? |
WHAT IS THE FOREX MARKET?
The foreign exchange market, commonly referred to as the "forex" or "FX" market, is the largest financial market in the world, with a daily average turnover of approximately $1.9 trillion. Let's compare that to the worldwide daily market for equities, which is roughly $50 billion.
So what is the foreign exchange market? It is simply the buying and selling of currency pairs on an open market. The forex market is traded mainly through the 24-hour interbank currency market, which is the primary trading market for currencies.
The currency market is simply the simultaneous purchase of one currency and the sale of another. The currencies of the world are always traded in pairs — for example, euro/US dollar, US dollar/yen, and British pound/US dollar. So the best way to look at this is if you think the dollar is going to be higher than the euro, you would sell the euro/USD pair.
It is often said that the FX market follows the sun around the world, and here is what they mean. The forex market begins trading at 5 pm ET Sunday and ends on Friday 4 pm ET. To simplify further, just remember the forex market is open 24 hours a day, every working day. The forex market has no physical location or exchange to speak of. It is an over-the-counter (OTC) or interbank market. Participants deal directly with each other via the telephone or an electronic network. Trading takes place in financial centers all over the world, such as New York, Tokyo, Australia, London, and many other places as well. These centers are linked to each other in a unified market, so at any time around the clock there's a major financial center open.
HOW CURRENCY PAIRS WORK
As mentioned earlier, all currencies are quoted in pairs. Some of the more popular pairs are the euro/USD (euro and US dollar pair, also known as just the euro), the GBP/USD (British pound and US dollar pair, also known as the cable), or the USD/CHF (US dollar and Swiss franc pair, also known as dollar Swiss or the swissy).
The first listed currency of the pairs is called the base currency, while the second is called the counter or quote currency. The base currency is the basis for a buy or sell of the pair. Here is an example: If you bought the EUR/USD, you are buying the euro and selling the USD. Hence, if you sold the EUR/USD pair, you would be selling the euro and buying the dollar.
There are no commissions in the world of currency trading because the cost of the trade is built into the spread itself. As with all trades, there is a bid and an ask on the forex market, and the difference between the two is the cost of the trade. For example, EUR/USD: bid 1.3209 then ask 1.3212. That is a three-pip spread. The value of a pip is not set in stone, as it depends upon the dollar value of your account.
FACTORS THAT AFFECT THE CURRENCY MARKET
Currency prices are affected by a variety of economic and political conditions, the most important of which is interest rates and, to a lesser degree, inflation and political stability.
Occasionally, central banks of various governments intervene in the forex market in order to influence the value of their currency. They do this by either flooding the market with their domestic currency in order to lower the price, or by buying with the intent to raise the price. In simple terminology, news drives the market; whether that news is economic or political makes no difference.
When entering the forex market by opening an account, you are using leverage, which means you will be buying on margin. Margin is not a down payment, but rather a good faith deposit or performance bond used to ensure against trading losses. How margin is dealt with by a forex broker is different from one broker to another, and you will have to research that on your own.
One other thing to keep in mind is rollover. Usually at 5 pm ET, the firm will charge a rollover interest rate on open positions. Every currency trade involves borrowing one currency to purchase another, which makes interest rollover charges part of forex trading.
This article should have explained or cleared up any misconceptions that you may have had about the forex market. If you are interested in learning more about this market, I suggest you open a demo account with any one of the numerous forex brokers that offer such a service. The benefit of opening such an account is that it gives you the opportunity to test your system without testing your wallet.
Whenever you embark into trading a new security, it's always wise to tread the waters first. Only then will you know if it's the right market for you to trade.
John Devcic is a market historian and freelance writer. He may be reached at firstname.lastname@example.org.
Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.