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What is Forex?

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July 15, 2019
by Taner Ozturk, Trading Expert

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Forex is an acronym for Foreign Exchange and refers to the trading of Global Currencies.

What is Forex?

Forex or FX is an acronym for foreign exchange, meaning the currency belonging to a country and/or market. In trading, forex relates to the buying and selling of these currencies in order to make a financial profit when the value of those currencies change. The forex market is the world’s most liquid market with daily trading volumes exceeding five trillion dollars; which is why it’s so attractive to investors. It’s the world’s most liquid market purely because of the need to exchange currencies to buy goods and services overseas.

A simple example about Forex

A simple example here would be the exchange of currencies for leisurely holidays. A person from the United States travelling to Italy cannot pay for hotels or food in USD. They must exchange their money for Euros because that is the local currency accepted in Italy. On a broader scale, we can think of a country’s imports and exports to other nations and the need to exchange currencies to a local unit.

Forex, an over-the-counter (OTC) decentralised market

Forex is an over-the-counter (OTC) decentralised market, which means it doesn’t run from a central exchange. Instead, foreign exchange rates and prices are set by supply and demand within the market itself. The main participants in the Forex market include international banks, corporations, governments and central banks, institutional investors and retail (individual) investors.

Forex trading vs Stock Trading

Unlike stock trading, OTC markets do not run from a central exchange. Forex rates are set by traders engaging in the market, determining the price of a currency through buying and selling (supply and demand). When trading forex, you are trading price movements of the underlying asset whereas stock trading involves buying shares in a company and therefore a share in ownership.

Forex holds more liquidity than stock trading

As mentioned, the forex market holds more liquidity than stock trading, exceeding global equities 25 times over. Liquidity is important because it generally equates to tighter spreads, lower transactions costs and overall easier trading. Typically, stock trading is suited to long-term investors looking to hold a stock and earn dividends, while short-term investors including day-traders and scalpers are more suited to the Forex market.

History of Forex

The Forex market was created after World War 2 in a bid to stabilise global economies by pegging the value of currencies to the price of gold. By 1971, forex had evolved into a free-floating market where exchange rates were determined by supply and demand. At the time, the forex market was mostly traded by banks and hedge funds. As technology advanced, forex trading moved online, becoming easily accessible to brokers and retail traders via the internet.

Benefits of trading Forex

Longer trading hours

One benefit of trading forex is longer trading hours compared to individual stock exchanges. The Forex market is open 24 hours a day, 5 days a week, moving through four main inter-bank sessions; Sydney, Tokyo, London and New York. The London session is the largest inter-bank session. Longer trading hours makes forex more accessible and attractive to traders across different time zones.

Use of margin and leverage

Another benefit of trading forex is the use of margin and leverage; a concept that allows investors to trade on small deposits with exposure to larger amounts of money. For example, a trader might only have $1,000 in their trading account but could have access to buy/sell up to $50,000 on a 50:1 leverage.

Allows traders to speculate on price movements

Forex also allows traders to speculate on price movements, whether the currency pair moves higher or lower. If the currency pair moves in your favour, you will make a profit. Unlike the stock market, making a profit in forex doesn’t necessarily mean the price has to increase in value.

Risks of trading Forex

No financial investment is without its risks and forex is no stranger to losses. A 24-hour market means prices are always moving and a flash crash can easily leave traders with a debt larger than their initial deposit. The use of margin and leverage can also risky when trading large amounts of money on small margin. A lack of risk management or a move in the wrong direction can result in margin calls, where traders are forced to pay the loss. Trading forex has been described by some as gambling due to buying and selling on speculation.

The difference between Spot Forex and Forward Forex

Forex spot price

There are two types of forex contracts; a spot price and a forward price contract. A spot price is an immediate or current rate available to a buyer. If a transaction has been made and funds are required immediately, the buyer has no choice but to pay the spot price. This could apply to property purchases or deposits required on purchases overseas. The standard delivery date for a spot rate is 2 days. The spot rate is generally quoted in the retail market and used by travellers wishing to exchange currencies at their bank or a foreign exchange company, as seen at airports.

Forex forward price / rate

A forward rate is a contract to buy or sell foreign currency on a specified future date, at a future price. This contract is binding between the two parties involved, regardless of the spot rate. It can also be used as a hedging technique alongside risk management, if you believe the rate will improve or decline by the forward date. Essentially a forward rate is used to quote a financial transaction that takes place in the future.
Both spot price contracts and forward price contracts can be executed through international banking facilities.

 

Currency pairs (major/minor/exotics)

The foreign exchange market allows traders and investors to buy and sell currencies and those currencies are quoted as pairs.
Take the AUD/USD pair for example. The value of the Australian dollar is being quoted against the United States dollar. If the AUD/USD rate is 0.726, then the Australian dollar is worth 72.6 U.S. cents. If you open a ‘buy position’ on the pair, then you are buying the Australian dollar while selling the United States dollar. This position would be opened on the view the Australian dollar would increase in value.

Major currencies pairs

There are more than 40 currency pairs that can be traded, with six ‘major’ pairs. Forex pairs can be traded on time frames ranging from just seconds to months. The six major pairs include:

  • EURO/USD
  • USD/JPY
  • GBP/USD
  • AUD/USD
  • USD/CHF
  • USD/CAD

Minor currencies pairs

All six major pairs can be traded with Eightcap through our trading software MetaTrader 4 (MT4) and MetaTrader 5 (MT5). Outside of the major pairs, there are also minor pairs and exotics that can be traded. Minor pairs are made up of different combinations of the major currencies, including:

  • EURO/GBP
  • EURO/CHF
  • GBP/JPY
  • NZD/USD
  • AUD/NZD

Exotic currencies pairs

Investors also have the option of trading exotic pairs. Exotic currencies refer to non-major currencies that are generally illiquid and trade at low volume. Exotics belong to developing or emerging markets and economies such as the Turkish Lira, South African Rand and Mexican Peso. Because of the nature of these economies, including political tension and instability, exotic currencies have higher volatility. Exotic currencies are traded against the majors with bigger spreads and higher margins.
Some exotic pairs offered by Eightcap include:

  • EUR/TRY (Euro vs Turkish Lira)
  • USD/PLN (US Dollar vs Polish Zloty)
  • USD/ZAR (US Dollar vs South African Rand)

What moves the Forex market?

Financial markets across the globe, including forex and stock markets can fluctuate or be influenced by several factors.

Economic data

The release of economic reports such as GDP, inflation, manufacturing and jobs data, retail sales and business confidence can all influence forex markets. The strength of an economy determines the value of its currency. Generally speaking, positive or strong economic reports can boost the currency’s value against its pair.

Interest rates

Central bank movements and decisions also weigh on global markets. Sometimes central banks use these decisions to manipulate the currency value to stimulate the economy. For example, in Australia, lower interest rates equate to a lower AUD. A lower AUD is good for trade and may help increase inflation.

Political forces

World leaders and elections can also influence the supply and demand of a currency. Sometimes nation leaders make comments on trade or commerce that could be beneficial or harmful to the economy. Brexit is an example of a political decision that has caused uncertainty among investors and markets, both forex and stocks. Towards the end of 2018, hostile trade negotiations between the United States and China also influenced markets.

Technical Analysis

This is a type of trading method carried out by technical traders or chartists. Economic data, interest rates and political forces are considered ‘fundamental’ influences, studied by fundamental traders. Technical traders, however, use charts to identify short-term and long-term trends in the market. By identifying trends, technical traders will then buy or sell the financial instrument. Technical analysis has the power to strengthen or weaken a currency.

What is spread in Forex trading?

Spread is a term that is used a lot in forex trading and can determine which broker you use. Spread is the difference between the BID (buy) and the ASK (sell) price of any given currency pair. A spread is represented by pips or points and is essentially a brokerage cost that replaces any transactions fees. A bid or a buy price is the highest price a currency pair will be bought, while an ask or a sell price is the lowest price a currency pair will be offered for sale. The smaller the spread, the more traders will save on brokerage fees.

What is a pip in Forex trading?

A pip or pips is another term regularly used in forex trading and is short for ‘point in percentage’. It’s a unit of measure for currency pairs and is the smallest amount in which a currency pair or quote can change. One pip can also be referred to as one point or 1/100th of the instrument’s value. For example, if the AUD/USD pair was quoted at 0.7239, it means for every Australian dollar, you will get 72.39 US cents. If the pair increased by one pip, the value would be 0.7240 or 72.40 US cents for every Australian dollar.

Good trading from Eightcap.
All times are AEDT.