About Forex Introduction to Forex

What is "Off Exchange Retail Foreign Currency Market"

Off Exchange Retail Foreign Currency Market (FX or Forex) is the simultaneous buying of one currency and selling of another. It has no central trading location or exchange with many buyers and sellers. Most of the trading is conducted by telephone or through electronic trading networks. Banks, insurance companies, large corporations and other large financial institutions all use the forex markets to manage the risks associated with fluctuations in currency rates. In recent years, however, a number of firms have begun offering forex contracts to individual investors although individual investors make up a very small percentage of the forex market.

What is FX Trading

In an FX transaction, one currency is sold in exchange for another one. The rate expresses the relative value between the two currencies. Currencies are normally identified by a three-digit 'Swift' code. For instance, EUR = the euro, USD = the US dollar, CHF = the Swiss franc and so on. A full list of codes can be found here. A EUR/USD rate of 1.5000 means that €1 is worth $1.5. Sometimes, EUR/USD is referred to as a currency pair. The rate can be inverted. So a EUR/USD rate of 1.5000 is the same as a USD/EUR rate of 0.6666. In other words, $1 is worth €0.6666. The market convention is that most currencies tend to be quoted against the dollar, but there are notable exceptions, such as with the EUR/USD already mentioned, GBP/USD (UK sterling) and AUD/USD (the Australian dollar). This is not as confusing as it may sound.

Forex Rate Systems

Flexible Exchange Rate System
In a flexible exchange rate system, a currency is 'free' to float and its value is determined by market forces.

Major Influences on FX Prices

There are numerous factors that determine a free floating currency’s worth in the market, from international trade flow, economic and political conditions, the level of interest rates to simple short-term supply and demand.

Over-the-Counter Market

The Forex market is an 'over the counter market' (OTC), which means that there is no physical location and no central exchange and clearing hours where orders are matched. Instead, it operates 24-hours a day and 5.5-days a week via an electronic network of banks, corporations and individuals trading one currency for another. FX traders constantly negotiate prices between one another and the resulting market bid/ask prices are then fed into computers and displayed on official quote screens.

FX market participants

There are numerous different types of participants in the FX market and frequently they are looking for very different outcomes when they trade. This is why that although FX is often described as a 'zero-sum' game – what one investor makes is equal in theory to what another has lost. The broad, general practice of exchanging currencies is dominated by banks and other large institutions. Retail FOREX, however, is a small portion of currency trading that is "off exchange" and open to the retail investor. Participants in Forex trading include individuals, Forex dealers, and money managers to name a few.

Central Banks can also play an important role in the FX market, while international corporations have a natural interest to trade on account of their exposure to FX risk.

Spot FX versus Currency Futures

While most FX trading takes place OTC, there is also a quite vibrant and successful futures market. Typically, spot FX prices are for T+2 settlements. That means trades which are not closed out are settled in 2-working days. Futures tend to have a maturity of 3-months and so are settled quarterly, normally in March, June, September and December. This is why futures prices often look different from spot. The futures price includes the forward rates of currency pairs. Generally, futures prices are quoted as the US dollar versus the currency – in other words, a futures price is the inversion of the spot rate, plus the swap price to the maturity date. Again, this is not as complicated as it sounds. Where to trade is a matter of choice and both the OTC and the futures markets have their merits. But the OTC market does offer more flexibility and it is generally cheaper to trade in.

Advantage of FX Trading

24 Hour Market

FX is a global market that never sleeps. It is active 24-hours a day for 5.5-days a week. Most activity takes place between the time the New Zealand market opens on Monday, which is Sunday evening in Europe, until the US market closes on Friday evening.

Leverage

FX margin ratios tend to be higher than those available in equity because it is typically more liquid and it tends to be less volatile. The leveraged nature of FX trading means that any market movement will have an equally proportional effect on your deposited funds. This may work against you as well as for you. However, slippage could happen during news announcement or busy hours where the price movement was too quick. Increasing leverage increases risk.

Competitive Spreads

Spreads are the difference between the bid and offer price. Forex spreads are typically smaller than equity spreads. Just compare a 2-pip price in EUR/USD with a price in even the most active and liquid equity issue. The spread is the hidden, ‘intrinsic’ cost of dealing. Technology has made these tight prices available to almost everyone. Spreads may not be fixed, and can fluctuate in volatile market conditions, contact your broker for more information regarding spread prices.

Trading Opportunity Regardless of Market Direction

Prices can just as easily go up as down. If a trader believes a currency is about to depreciate, there are seldom restrictions on selling it although if the position is held for more than one day, there is a cost of carry to consider.