The foreign exchange market, also known as the FX or Forex market, is the largest and most traded financial market in the world.
The FX market has grown to a daily trade volume of over $5 trillion a day which is over 200 times bigger than the New York Stock Exchange.
Historically, the major players in the FX market were large central banks, multinational firms and big financial institutions.
While these organizations are still the major players in the market, the growth of online brokers and technology has made it possible for individual retail traders to access this market and trade on a level playing field with the big players.
Advantages of Trading Forex
The FX market has huge appeal for the retail trader as it is an extremely liquid market. A liquid market means that there are a huge number of buyers and sellers resulting in swift trade execution – both buying and selling – at any time within market hours.
2. Continuous Operation
The FX market is open 24 hours a day, 5 days a week meaning we can open and close trades at any hour of the day unlike other markets e.g. commodities and stocks. The highest volume of trading usually takes place as the various global markets open throughout the day – starting in Sydney, then Tokyo, then London and finishing in New York.
Due to the high level of liquidity in the FX market, most brokers will offer a higher leverage than other markets. We will discuss this in greater depth later. The basic concept is that a trader only requires a small percentage of the overall price of the position. For example, if we had a leverage of 200:1 and have $500 to invest, we could take a position of $100,000.
Therefore smaller movements in the price of a currency have a greater weight which can lead to greater gains on smaller investments. However, leverage does work both ways and can magnify losses.
4. Low Entry Level
Due to the high level of leverage, it is possible to open accounts with FX brokers from as low as $100. This is a much lower entry level than other types of investments.
5. Low Transaction Costs
An FX broker mainly generates their revenue from the difference between the buy and sell prices. This is called the spread and due to the high trading volumes it is quite a small fee when compared to the fees charged by a traditional stockbroker for example.
6. No Market Manipulation
It is impossible for one big player to corner or manipulate the FX market due to its size. Unlike other, smaller markets where a large institution may be able to affect the price by placing a big order, the FX market is so big this will not have a major impact. Government decisions, policies and reports, along with other global news stories are the most likely cause for large movements.
Participation in the Forex Market
Many of us will have participated in the FX market before if we have ever traveled to a country that has a different currency to our own. We have all seen the foreign exchange booths where different exchange rates are listed on a digital screen.
As an example, assume we are going on a holiday from the United Kingdom to the US and we see that the exchange rate on offer is 1 Pound for $1.50. This is the equivalent of $1 equalling approximately 67 pence.
We decide to exchange £1,000 for $1,500 dollars.
Now assume we didn’t spend all of our $1,500 dollars and return to the United Kingdom with $500 dollars one week later. The exchange rate has changed and now £1 equals $1 dollar 25 cents. This is the equivalent of $1 dollar equaling 80 pence.
This means that the dollar strengthened against the pound over that period of time. So we exchange our $500 dollars back to sterling at a rate of $1 dollar for 80 pence and get back £400 pound. We get more pounds for our dollars.
By default, we have just made a profit in the FX Market.
What is Traded?
A country’s currency is a direct reflection of what the market thinks about the current and future health of its economy. A recessionary, stagnant economy will result in a weak currency, while a surging, growing economy will result in a strong currency. We are therefore speculating on the strength and weaknesses of one economy or country against another.
Major & Minor Currencies
When trading FX, currencies are abbreviated into three letter symbols. For example, the euro is the EUR, the US Dollar is the USD, the Japanese Yen is the JPY, the UK pound is the GBP and so on. Currencies are generally split into two categories – the major currencies and the minor currencies.
As you would guess the majors are the currencies of the major global economies – the US, Japan, UK, Euro Zone, Canada, Australia, Switzerland and New Zealand.
A noticeable absentee is the Chinese Yuan as the Chinese government restricts trading of its currency. The majors are by far the most frequently traded currencies and make up around 90% of the FX market.
Minor or exotic currencies are so-called as they are the currencies of less prominent or emerging economies such as the Hong Kong Dollar, Mexican Peso, Swedish Krona, Hungarian Forint and so on. They are traded in smaller quantities when compared to the majors and often the cost of trade is much higher due to their illiquidity.