Foreign exchange is the process of changing one currency into another for various reasons, usually for commerce, trading, or tourism. According to a 2022 triennial report from the Bank for International Settlements (a global bank for national central banks), the daily trading volume for forex reached $7.5 trillion in 2022.
The foreign exchange (forex or FX) market is a global marketplace for exchanging national currencies.
Because of the worldwide reach of trade, commerce, and finance, forex markets tend to be the world’s largest and most liquid asset markets.
Currencies trade against each other as exchange rate pairs. For example, EUR/USD is a currency pair for trading the euro against the U.S. dollar.
Forex markets exist as spot (cash) and derivatives markets, offering forwards, futures, options, and currency swaps.
Some market participants use forex to hedge against international currency and interest rate risk, speculate on geopolitical events, and diversify portfolios, among other reasons.
The most unique aspect is that it lacks a central marketplace. Instead, currency trading is conducted electronically over the counter (OTC). This means that all transactions occur via computer networks among traders worldwide rather than on one centralized exchange.
The market is open 24 hours a day, five and a half days a week. Currencies are traded worldwide in the major financial centres of Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich—across almost every time zone. This means the forex market begins in Tokyo and Hong Kong when the U.S. trading day ends. As such, the forex market can be highly active at any time, with price quotes changing constantly.
Forex is traded primarily via spot, forwards, and futures markets. The spot market is the largest of all three markets because it is the “underlying” asset on which forwards and futures markets are based. When people talk about the forex market, they are usually referring to the spot market.
The forwards and futures markets tend to be more popular with companies or financial firms that need to hedge their foreign exchange risks out to a specific future date.
Spot Market
The spot market is where currencies are bought and sold based on their trading price. That price is determined by supply and demand and is calculated based on several factors, such as:
- Current interest rates
- Economic performance
- Geopolitical sentiment
- Price speculation
A finalized deal on the spot market is known as a spot deal. It is a bilateral transaction in which one party delivers an agreed-upon currency amount to the counterparty and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, it is settled in cash.
Although the spot market is commonly known as one that deals with transactions in the present (rather than in the future), these trades take two days to settle.
Forwards and Futures Markets
A forward contract is a private agreement between two parties to buy a currency at a future date and a predetermined price in the OTC markets. In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves.
A futures contract is a standardized agreement between two parties to take delivery of a currency at a future date and a predetermined price. Futures trade on exchanges and not OTC. In the futures market, futures contracts are bought and sold based on a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange (CME).
Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments that cannot be customized. The exchange acts as a counterparty to the trader, providing clearance and settlement services.
Both types of contracts are binding and are typically settled for cash at the exchange in question upon expiry, although contracts can also be bought and sold before they expire. These markets can offer protection against risk when trading currencies.
In addition to forwards and futures, options contracts are traded on specific currency pairs. Forex options give holders the right, but not the obligation, to enter into a forex trade at a future date.
Using the Forex Markets
There are two distinct features of currencies as an asset class:
- You can earn the interest rate differential between two currencies.
- You can profit from changes in the exchange rate.
So, you can profit from the difference between two interest rates in two different economies by buying the currency with the higher interest rate and shorting the currency with the lower interest rate. For instance, before the 2008 financial crisis, shorting the Japanese yen (JPY) and buying British pounds (GBP) was common because the interest rate differential was substantial. This strategy is sometimes referred to as a carry trade.
Forex for Hedging
Companies doing business in foreign countries are at risk due to fluctuations in currency values when they buy or sell goods and services outside of their domestic market. Foreign exchange markets provide a way to hedge currency risk by fixing a rate at which the transaction will be completed. A trader can buy or sell currencies in the forward or swap markets in advance, which locks in an exchange rate.
Locking in the exchange rate helps them reduce losses or increase gains, depending on which currency in a pair is strengthened or weakened.
Forex for Speculation
Factors like interest rates, trade flows, tourism, economic strength, and geopolitical risk affect the supply and demand for currencies, creating daily volatility in the forex markets. This creates opportunities to profit from changes that may increase or reduce one currency’s value compared to another. A forecast that one currency will weaken is essentially the same as assuming that the other currency in the pair will strengthen.
So, a trader anticipating price movement could short or long one of the currencies in a pair and take advantage of the movement.
How to Start Trading Forex
Trading forex is similar to equity trading. Here are some steps to get yourself started on the forex trading journey.
Learn about forex: While it is not complicated, forex trading is an undertaking that requires specialized knowledge and a commitment to learning.
Set up a brokerage account: You will need a forex trading account at a brokerage to get started with forex trading.
Develop a trading strategy: While it is not always possible to predict and time market movement, having a trading strategy will help you set broad guidelines and a road map for trading.
Always know your numbers: Once you begin trading, check your positions at the end of the day. Most trading software already provides a daily accounting of trades. Make sure that you do not have any pending positions to be filled and that you have sufficient cash in your account to make future trades.
Cultivate emotional equilibrium: Beginner forex trading is fraught with emotional roller coasters and unanswered questions. Discipline yourself to close out your positions when necessary.
Forex Terminology
The best way to get started on the forex journey is to learn its language. Here are a few terms to get you started:
Forex account: A forex account is used to make currency trades. Depending on the lot size, there can be three types of forex accounts:
Ask: The ask is the price a seller is willing to accept for a security, which is often referred to as the offer price. Along with the price, the ask quote might also stipulate the amount of the security available to be sold at the stated price. The bid is the price a buyer is willing to pay for a security, and the ask will always be higher than the bid
Bid: A bid price is a price for which somebody is willing to buy something, whether it be a security, asset, commodity, service, or contract. It is colloquially known as a “bid” in many markets and jurisdictions.
Contract for difference: A contract for difference (CFD) is a derivative that lets traders speculate on price movements for currencies without owning the underlying asset.
Leverage: Leverage is using borrowed capital to multiply returns. The forex market is characterized by high leverages, and traders often use it to boost their positions.
Pros of Forex Trading
- Forex markets are the largest in terms of daily trading volume globally and therefore offer the most liquidity.
- This makes it easy to enter and exit a position in any major currency within a fraction of a second for a small spread in most market conditions.
- The forex market is traded 24 hours a day, five and a half days a week—starting each day in Australia and ending in New York.
- The broad time horizon and coverage offer traders opportunities to make profits or cover losses. The major forex market centers are Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich.
- The available leverage in forex trading means that a trader’s starting capital can rapidly multiply.
- Forex trading generally follows the same rules as regular trading and requires much less initial capital; therefore, it is easier to start trading forex than stocks.
- The forex market is more decentralized than traditional stock or bond markets. There is no centralized exchange that dominates currency trade operations, and the potential for manipulation—through insider information about a company or stock—is lower.
Cons of Forex Trading
- Leveraged trading can make forex trades much more volatile than trading without leverage.
- Banks, brokers, and dealers in the forex markets allow a high amount of leverage, meaning traders can control large positions with relatively little money.
- Leverage in the range of 50:1 is common in forex, though even greater amounts of leverage are available from certain brokers. Nevertheless, leverage must be used cautiously because many inexperienced traders have suffered significant losses using more leverage than was necessary or prudent.
- Trading currencies productively requires an understanding of economic fundamentals and indicators. A currency trader needs to have a big-picture understanding of the economies of the various countries and their interconnectedness to grasp the fundamentals that drive currency values.
- The decentralized nature of forex markets means it is less regulated than other financial markets. The extent and nature of regulation in forex markets depend on the trading jurisdiction.
- Forex markets lack instruments that provide regular income, such as regular dividend payments, which might make them attractive to investors not interested in exponential returns.
Forex Trading and Regulation
Forex trade regulation depends on the jurisdiction. Countries like the United States have sophisticated infrastructure and markets for forex trades. Forex trades are tightly regulated in the U.S. by the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC). However, due to the heavy use of leverage in forex trades, developing countries like India and China have restrictions on the firms and capital to be used in forex trading. Europe is the largest market for forex trades. The Financial Conduct Authority (FCA) monitors and regulates forex trades in the United Kingdom.