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Foreign currency exchange
It’s the global market that allows the exchange of one currency for another.
The foreign exchange market, which is usually known as “forex” or “FX,” is the largest financial market in the world.
The foreign exchange market trades $5 TRILLION a day trade volume.
The forex market is open 24 hours a day and 5 days a week, only closing down during the weekend.
Forex trading is the simultaneous buying of one currency and selling another. Currencies are traded through a broker or dealer, and are traded in pairs.
For example the Pound and the U.S. dollar (GBP/USD) or the EURO and the Japanese yen (EUR/JPY).
Major Currencies pairs
EUR/USD Euro and US dollar
USD/JPY US dollar and Japanees yen
GBP/USD British pound and US dollar
USD/CHF Us dollar and Swiss frank
Unlike other financial markets like the New York Stock Exchange (NYSE) or London Stock Exchange (LSE), the forex market has neither a physical location nor a central exchange.
The forex market is considered an Over-the-Counter (OTC), or “interbank” market due to the fact that the entire market is run electronically, within a network of banks, continuously over a 24-hour period.
This means that the spot forex market is spread all over the globe with no central location. Trades can take place anywhere as long as you have an Internet connection!
The forex OTC market is by far the biggest and most popular financial market in the world, traded globally by a large number of individuals and organizations.
In an OTC market, participants determine who they want to trade with depending on trading conditions, the attractiveness of prices, and the reputation of the trading counterparty.
The dollar is the most traded currency, taking up 84.9% of all transactions.
The euro’s share is second at 39.1%, while that of the yen is third at 19.0%.
There are also other significant reasons why the U.S. dollar plays a central role in the forex market:
- The United States economy is the LARGEST economy in the world.
- The U.S. dollar is the reserve currency of the world.
- The United States has the largest and most liquid financial markets in the world.
- The United States has a stable political system.
- The United States is the world’s sole military superpower.
- The U.S. dollar is the medium of exchange for many cross-border transactions. For example, oil is priced in U.S. dollars. Also called “petrodollars.” So if Mexico wants to buy oil from Saudi Arabia, it can only be bought with U.S. dollar. If Mexico doesn’t have any dollars, it has to sell its pesos first and buy U.S. dollars.
One important thing to note about the forex market is that while commercial and financial transactions are part of the trading volume, most currency trading is based on speculation.
In other words, most of the trading volume comes from traders that buy and sell based on intraday price movements.
The trading volume brought about by speculators is estimated to be more than 90%!
The scale of the forex market means that liquidity – the amount of buying and selling volume happening at any given time – is extremely high.
This makes it very easy for anyone to buy and sell currencies.
From the perspective of a trader, liquidity is very important because it determines how easily price can change over a given time period.
A liquid market environment like forex enables huge trading volumes to happen with very little effect on price, or price action.
While the forex market is relatively very liquid, the market depth could change depending on the currency pair and time of day.
The Different Ways To Trade Forex
Traders came up with a number of different ways to invest or speculate in currencies.
The most popular ones are spot forex, currency futures, currency options, and currency exchange-traded funds (or ETFs).
Futures are contracts to buy or sell a certain asset at a specified price on a future date (That’s why they’re called futures!).
FX futures were created by the Chicago Mercantile Exchange (CME) way back in 1972, when bell bottoms and platform boots were still in style.
Since futures contracts are standardized and traded on a centralized exchange, the market is very transparent and well-regulated. This means that price and transaction information are readily available.
An “option” is a financial instrument that gives the buyer the right or the option, but not the obligation, to buy or sell an asset at a specified price on the option’s expiration date.
If a trader “sold” an option, then he or she would be obliged to buy or sell an asset at a specific price at the expiration date.
Just like futures, options are also traded on an exchange, such as the Chicago Mercantile Exchange (CME), the International Securities Exchange (ISE), or the Philadelphia Stock Exchange (PHLX).
However, the disadvantage in trading FX options is that market hours are limited for certain options and the liquidity is not nearly as great as the futures or spot market.
Exchange-traded funds or ETFs are the youngest members of the forex world.
A currency ETF offers exposure to a single currency or basket of currencies. Here’s a list of the most popularly traded currency ETFs.
ETFs are created and managed by financial institutions who buy and hold currencies in a fund. They then offer shares of the fund to the public on an exchange allowing you to buy and trade these shares just like stocks.
Like currency options, the limitation in trading currency ETFs is that the market isn’t open 24 hours. Also, ETFs are subject to trading commissions and other transaction costs
In the spot market, currencies are traded immediately or “on the spot,” using the current market price. this market is popular because of its simplicity, liquidity, tight spreads, and round-the-clock operations.
Forex brokers usually provide news, charts and research for free.
How does forex trading work?
In the forex market, you buy or sell currencies.
Opening a position of a trade in the foreign exchange market is easy. The mechanics of a trade are very similar to those found in other financial markets (like the stock market), so if you have any experience in trading, you should be able to pick it up pretty quickly.
The objective of forex trading is to exchange one currency for another in the expectation that the price will change.
More specifically, that the currency you bought will increase in value compared to the one you sold.
*EUR 10,000 x 1.19 = US $11,900
** EUR 10,000 x 1.27 = US $12,700
An exchange rate is simply the ratio of one currency valued against another currency.
For example, the USD/JPY exchange rate indicates how many U.S. dollars can purchase one Swiss franc, or how many Japanees yen you need to buy one U.S. dollar.
Currencies are always quoted in pairs, such as EUR/USD or USD/CAD. The reason they are quoted in pairs is because, in every foreign exchange transaction, you are simultaneously buying one currency and selling another.
Here is an example of a foreign exchange rate for the British pound versus the U.S. dollar:
GBP is base currency
USD is Quote currency
The first listed currency to the left of the slash (“/”) is known as the base currency (in this example, the British pound), while the second one on the right is called the counter or quote currency (in this example, the U.S. dollar).
When buying, the exchange rate tells you how much you have to pay in units of the quote currency to buy ONE unit of the base currency. In the example above, you have to pay 1.32507U.S. dollars to buy 1 British pound.
When selling, the exchange rate tells you how many units of the quote currency you get for selling ONE unit of the base currency.
In the example above, you will receive 1.32507 U.S. dollars when you sell 1 British pound.
The base currency is the “basis” for the buy or the sell.
If you buy EUR/GBP this simply means that you are buying the base currency and simultaneously selling the quote currency.
- You would buy the pair if you believe the base currency will appreciate (gain value) relative to the quote currency.
- You would sell the pair if you think the base currency will depreciate (lose value) relative to the quote currency.
First, you should determine whether you want to buy or sell.
If you want to buy (which actually means buy the base currency and sell the quote currency), you want the base currency to rise in value and then you would sell it back at a higher price.
In trader’s talk, this is called “going long” or taking a “long position.” Just remember: long = buy.
If you want to sell (which actually means sell the base currency and buy the quote currency), you want the base currency to fall in value and then you would buy it back at a lower price.
This is called “going short” or taking a “short position”. Just remember: short = sell.
“I’m long AND short.”
Forex quotes are quoted with two prices: the bid and ask.
In general, the bid is lower than the ask price.
The bid is the price at which your broker is willing to buy the base currency in exchange for the quote currency.
This means the bid is the best available price at which you (the trader) will sell to the market.
If you want to sell something, the broker will buy it from you at the bid price.
The ask is the price at which your broker will sell the base currency in exchange for the quote currency.
This means the ask price is the best available price at which you will buy from the market.
Another word for ask is the offer price.
If you want to buy something, the broker will sell (or offer) it to you at the ask price.
The difference between the bid and the ask price is known as the SPREAD.
On the EUR/USD quote above, the bid price is 1.23595 and the ask price is 1.23605. Look at how this broker makes it so easy for you to trade away your money.
- If you want to sell EUR, you click “Sell” and you will sell euros at 1.23595.
- If you want to buy EUR, you click “Buy” and you will buy euros at 1.23605.
In this example, the euro is the base currency and thus the “basis” for the buy/sell.
If you believe that the U.S. economy will continue to weaken, which is bad for the U.S. dollar, you would execute a BUY EUR/USD order.
By doing so, you have bought euros in the expectation that they will rise versus the U.S. dollar.
If you believe that the U.S. economy is strong and the euro will weaken against the U.S. dollar, you would execute a SELL EUR/USD order.
By doing so, you have sold euros in the expectation that they will fall versus the US dollar.
If you go to the super market or local store and want to buy a piece of biscuit, you can’t just buy a single piece of biscuit, because they come in packet minimum 10/12pieces or “lots” of 10/12.
In forex, it would be just as thoughtless to buy or sell 1 GBP, so they usually come in “lots” of 1,000 units of currency (micro), 10,000 units (mini), or 100,000 units (standard) depending on your broker and the type of account you have (more on “lots” later).
“But I don’t have enough money to buy 10,000 euros! Can I still trade?”
You can! With margin trading!
Margin trading is simply the term used for trading with borrowed capital.
This is how you’re able to open £1,250 or £50,000 positions with as little as £25 or £1,000.
You can conduct relatively large transactions, very quickly with a small amount of initial capital.
- You speculate that market are indicating that the British pound will go up against the U.S. dollar.
- You open one standard lot (100,000 units GBP/USD), buying with the British pound at 2% margin and wait for the exchange rate to climb. When you buy one lot (100,000 units) of GBP/USD at a price of 1.50000, you are buying 100,000 pounds, which is worth US$150,000 (100,000 units of GBP * 1.50000). If the margin requirement was 2%, then US$3,000 would be set aside in your account to open up the trade (US$150,000 * 2%). You now control 100,000 pounds with just US$3,000. We will be discussing margin in more detail later, but hopefully, you’re able to get the basic idea of how it works.
- Your predictions come true and you decide to sell. You close the position at 1.50500. You earn about $500.
When you decide to close a position, the deposit that you originally made is returned to you and a calculation of your profits or losses is done.
This profit or loss is then credited to your account.
In forex trading, there are some brokers who allow traders to have custom lots.
This means that you don’t need to trade in micro, mini or standard lots! If 1,542 is your favorite number and that’s how many units you want to trade, then you can!
For positions open at your broker’s “cut-off time” (usually 5:00 pm EST), there is a daily rollover interest rate that a trader either pays or earns, depending on your established margin and position in the market.
If you do not want to earn or pay interest on your positions, simply make sure they are all closed before 5:00 pm EST, the established end of the market day.
Since every currency trade involves borrowing one currency to buy another, interest rollover charges are part of forex trading.
Interest is PAID on the currency that is borrowed.
Interest is EARNED on the one that is bought.
If you are buying a currency with a higher interest rate than the one you are borrowing, then the net interest rate differential will be positive (i.e. USD/JPY) and you will earninterest as a result.
Conversely, if the interest rate differential is negative then you will have to pay.
Note that many retail brokers do adjust their rollover rates based on different factors (e.g., account leverage, interbank lending rates).
Please check with your broker for more information on rollover rates and crediting/debiting procedures.
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