The Forex Market
The forex (short for Foreign Exchange) market is by far the world’s single largest marketplace where currencies are traded against each other. If you have ever traveled internationally, you have a personal experience of the forex market: you had to convert the currency of your homeland to the currency of the country you visited to be able to pay for any services used or goods purchased. While you may have noticed differences in the buying power of your currency depending on when and where you made the transactions, you probably did not realize that you were participating in the largest market in the world.
The forex market trades an estimated 2.5 to 3.8 trillion USD per day. Nobody really knows what the actual figure is, as there is no central marketplace for keeping tabs on all forex transactions around the world. The volume traded at the forex markets exceeds the combined volume of all the major exchanges trading equities, futures or any other financial instruments around the globe.
Historical roots of the forex market
Currency trading has a long history and can be traced back to the ancient ages, when foreign exchange started to take shape after the international merchant bankers introduces bills of exchange, which were transferable third-party payments that allowed flexibility and growth in foreign exchange dealings.
The modern foreign exchange market, which is characterized by consequent periods of increased volatility and relative stability, was born in the 20th century. By the mid 1930s, London became the leading center for foreign exchange and the British Pound served as the main currency to trade and the world reserve currency. In the old times foreign exchange was traded via cable on telex machines, giving the Pound the nickname "cable". In 1930, the Bank for International Settlements (BIS) was established in Basel, Switzerland to oversee the financial efforts of the newly independent countries that emerged after World War I, and to provide monetary relief to countries experiencing temporary difficulties in balance or payments.
After World War II, the British economy was in ruins and the US was the only Western country unscarred by war and even benefiting as the single largest supplier of military materials and equipment. As a result of the Bretton Woods Agreement the USD became the prominent currency of the entire globe. Nowadays, currencies all over the world are generally quoted against the USD. Although the Euro and the Chinese Yuan are getting more and more important either as reserve currencies or as the basis of international trade settlements, in financial crisis periods the US Dollar and the Japanese Yen are still considered as "safe haven".
The importance of the forex market
The impact of the forex market on the world economy cannot be exaggerated. The forex market interacts with every single entity in the world, including nations, corporations, institutions, and individuals. Every country has its own currency to facilitate its business and trade. The value of one currency compared to another depends on the economic health of the nations involved as well as the perception of stability and confidence in political climate in those countries. As conditions change, currency values fluctuate to reflect the new situations. These fluctuations create challenges for corporate financial officers and institutional fund managers, but also provide opportunities for traders who want to speculate on impending changes in currency values.
Changes in currency valuations have a significant impact on governments, corporations and financial institutions. Exchange rate fluctuations, particularly when they are abrupt, may affect the performance of bottom lines and the prices for many commodities and other markets. The forex market probably has a more pervasive influence on worldwide economic conditions than any other market, including crude oil.
The sun never sets in the forex market
Forex trading begins Monday morning in Sydney, Australia (which is Sunday afternoon in the US) and moves around the globe as business days begin in financial centers from Tokyo to London to New York, ending with the close of trading Friday afternoon in New York (Saturday morning in Australia). Anything that happens anywhere in the world at any time of day or night affects the forex market immediately. It is not necessary for an exchange to open before the effects can be seen. The forex market is always open for trading.
This means that not only is the forex market a decentralized marketplace, but there is also always a time zone somewhere in the world where currencies are being traded actively, while in other time zones traders sleep at the same time - making forex a near-seamless 24-hour market. Depending on your time zone, your broker or market maker, and respective trading platforms, you can trade currencies from Sunday evening to Saturday morning. With the ability to trade around the clock, currency traders have the advantage of customizing their trading schedule, as they can usually get in or out of the market at any time without waiting for an opening bell or encountering a market gap.
Why trade forex?
There are many advantages that make currency trading an increasingly popular investment vehicle of the information age:
Markets, such as equities, tend to be traded locally during the business day in their own time zones. For example, Wall Street traders focus on US stocks, European traders on European stocks, etc. All of these traders certainly should be aware of what is happening elsewhere as the global integration of the financial markets continues. However, an event in the UK that directly affects British stocks and may have a strong indirect impact on common stocks traded on other European exchanges, may not have the same effect - or any at all - in the US or Japanese equity markets.
Forex, on the other hand, is an asset class that is truly a global investment reflecting every economic development on earth. Whatever has an influence on currencies in Japan has an effect on what happens to currencies in London or Chicago.
Plenty of easily accessible information
Information about stocks is abundant, but so are the stocks. Finding a trade opportunity in the equities markets mean shifting through data on thousands of stocks, while a forex trader has only six major, and maybe two dozen second-tier currencies to research. Additionally, the vital information that moves equity markets, such as revenues and profits, is proprietary and private, accessible in real-time only for insiders. In contrast, governments or research institutions issue dozens of reports every months that influence the forex market, and all this information is widely and publicly disseminated by the financial media and released to every market participants at the same time.
Electronic trading platforms
With the advances of technology, specifically the Internet and online trading, most forex trade executions are instantaneous, getting traders in and out of positions with the click of the mouse once they make a trading decision. All of the benefits of electronic trading, such as real-time quotes, updates of positions or current account status are available to not just institutional players, such as banks or brokerage houses, but to individual retail traders as well.
With the size of the forex market, around-the-clock trading and electronic trade execution, illiquidity is not much of an issue in most venues of forex trading. There is always someone to take the other side of a position a trader may want to establish, no matter when the order is placed. Forex bid and ask quotes tend to be tight and slippage minimal.
Forex markets provide some of the highest leverage of any investment vehicle, up to 1:500. Traders need to come up with only a few hundred dollars to control a sizeable position worth 100.000 USD. As a result, a small move in a trader’s favor can produce a big return on an investment. However, traders must remember that leverage works both ways. A small move that is against a position can eat up the money in traders’ accounts very quickly if they are not nimble enough to take action and escape by cutting losses. What leverage gives, it can also take away.
Best for both Bears and Bulls
Unlike equity markets, there is no restriction on short selling in the forex market, no matter which way the currencies are moving against each other. Since currency trading involves buying one currency and selling another, a trader has the same ability to trade in a rising market as in a falling one. Trading equities, bears may be hampered by the uptick rule and the need to borrow stock from the broker they want to sell short, and in crisis times governments or exchange regulatory bodies may ban short selling in their efforts to restore confidence in the markets, providing unfair advantage for traders and investors owning long positions and/or with bullish bias.