What is Forex (FX)?
Forex (FX) is a market, where currencies are being exchanged. Forex market is the biggest liquid market in the world where every day people exchange trillions of dollars. It doesn’t have a fixed location, it’s rather an electronic network of banks, institutions, brokers and single traders (who mostly trade through brokers or banks). They post their orders to sell or buy currencies in a network so that they can communicate with parties on the other side of orders. Forex market is open 24 hours a day, five days a week except on holidays. Currencies are possible to trade on holidays if the global market is open for business.
Forex pairs and quotations
When trading currencies, they are put in pairs, for example USD/CAD, EUR/USD or USD/JPY. These represent the USA dollar (USD) versus Canadian dollar (CAD), euro (EUR) versus USD and USD versus Japanese jen. Every pair has a price, for example 1.2569. If that price is linked to the USD/CAD pair, it means that in order to buy one USD it costs 1.2569 CAD. If the price goes up to 1.3336, you will have to pay 1.3336 CAD in order to buy one USD. The value of USD has gone up (CAD has decreased).
In Forex market currencies are being traded in lots, which are called micro, mini and standard lots. A micro lot is worth 1000, mini lot 10 000 and standard lot 100 000 currencies. It’s different from when you want to go to the bank and exchange your 450 dollars. In the electronic Forex market currencies are traded in blocks, but you can trade with as many blocks as you wish. For example you can trade seven micro lots (7000) or three mini lots (30 000) or 75 standard lots (750 000).
How big is the Forex market?
Forex market is unique because of many reasons, mostly because it is so big. According to the data of Bank for International Settlements, currencies are traded in an average of 5.1 trillion dollars a day. The largest currency markets are located in bigger financial centres like London, New York, Singapur, Tokyo, Frankfurt, Hongkong and Sydney.
How to trade on the Forex market?
Forex market is open 24 hours a day, five days a week. That means you can sell and buy currencies any time during the week days. In the past currencies were traded mostly only by governments, big companies and hedge funds. In the modern world trading is as easy as a click of the mouse. Accessing it is not a problem, which means anyone can do it. Many investing companies, banks and forex brokers offer possibilities to open accounts and trade currencies.
When trading in the forex market, you buy or sell a certain currency compared to another currency and there is no physical money exchanging from one person to another. That is what goes on in foreign exchange kiosks. Imagine a Japanese tourist visiting the Times Square in New York. He can exchange his jens to dollars (and they may take commission for it), so that he can spend money during the trip. In the world of electronic markets, a trader buys a certain currency in hopes of it’s value increasing in time so that they can earn a profit. If you are selling a currency, you are buying another and if you are buying a currency you are selling another.
A spot trade is with immediate handover, which for most currency pairs is two working days. The biggest exception is USD/CAD buying or selling, which is one working day. Saturdays, sundays and nation-wide holidays are not included in working days. In the christmas and easter period some spot trades may take up to six working days. Money is not exchanged on trading day but on settlement day.
The US dollar is the most actively exchanged currency. On the second place is euro, next jen, pound and francs. Market movements are influenced by combinations of speculations, economical strenght and growth and changes in interest rates.
Forex (FX) rollover
Retail traders usually don’t want the delivery of a currency they have bought. They are only interested in the profit they can get. Because of that many retail traders rollover currency positions every day at 17.00 EST. The broker resets positions and offers either credit or debet. When a trade is closed, the trader realises their profit or loss according to the initial trading price and the price they closed the trade with. Rollover credits or debits can either increase or decrease that profit.
Since the FX market is closed on holidays and weekends, the interest rate credit or debit is applied on wednesdays. For that reason, holding a postion on wednesday until 17.00, usually brings a result of triple credits or debits.
Forex (FX) forward transactions
Any Forex transaction that settles on a date later than spot, is regarded as a forward transaction. The price is calculated by corrigating the current exchange rate in order to take account of the differences in two currency pairs interest rates. The corrigation amount is called forward points. Further points reflect only the interest rate difference of two markets. Those are not a prediction of how the spot-market will transact in the future.
A forward transaction is a customized contract that can cost any amount and with what you can settle any date, except the weekend and holidays. Just like in spot-trading, the currencies are exchanged on a settlement date.
Forex (FX) futures
Forex or currency futures contract is an agreement between two parties, in order to offer a pre-determined amount on a pre-determined date (that is called expiry). Futures contracts are exchanged to pre-determined currencies and expiry. Negotiation is not are not possible, like they are with forward transactions. The profit is calculated from the price difference of buying and selling the contract. Most speculators don’t keep futures contracts until they expire, because in that case they would have to settle the currencies represented in the contract. Instead they buy and sell contracts before they expire so that they can realise their profit or loss.
Differences between forex and the other markets
Theres some big differences between forex and other markets.
- Less rules: This means that investors are not restricted with strict standards and regulations as they are on markets of stocks, futures or oppositions. No clearing houses or central bodies. You can always sell short; if you are selling one currency, you are buying another.
- Fees and commissions: Since the market is not regulated, brokers price fees and commissions differently. Most forex brokers earn money from the price difference of different currency pairs. Others earn money by asking for commissions that fluctuate depending on the currency being traded. Some brokers use both ways.
- Complete access: You can trade with no restrictions any time, except on weekends and holidays.
- Advantage: The forex market allows for a advantage of up to 50:1 in USA and even higher in some parts of the world. That means a trader can open an account with 1000 dollars and buy and sell for as much as 50 000 dollars. That advantage increases both the profit and loss.
Example of a forex transaction
Let’s pretend a trader believes that EUR will go up against USD. Another possibility would be that USD goes down against EUR. The trader buys EUR/USD with a price of 1.2500 and buys currencies worth 5000 dollars. Later that day the price has increased to 1.2550. The profit is 25 USD (5000 x 0.0050). If the price had dropped to 1.2430, the trader would lose 35 dollars (5000 x 0.0070).
Currency prices are always moving, so the trader may decide to keep a postion overnight. The broker rollovers their postion, resulting in credit or debit consequent of the interest rate of euro zone and USA. If the interest rate of euro zone is 4% and the interest rate of USA is 3%, the trader gets the higher interest rate since they bought euro. The trader should get a small credit in case of a rollover. If the interest rate was lower for euro, the trader is debited on a rollover.
A rollover can affect trading decisions, especially if the trading has been going on for long. Big differences in interest rates can bring important credits or debits, that can significantly increase or decrease the exchange profit.
Most brokers also offer leverage, in the USA it’s mostly up to 50:1. Let’s pretend our trader uses a leverage of 10:1 in a trade. If they use a 10:1 leverage, the trader doesn’t have to have 5000 dollars on their account even though they are trading currencies valued at 5000 dollars. The trader will only need 500 dollars. If they would use a leverage of 20:1, they would only need 250 dollars on their account (250 x 20 = 5000).
It shows the power of leverage, that a 25 dollar profit comes pretty quickly, considering the trader only needs a capital of 500 or 250 dollars (may be even less if using a bigger leverage). The bad part is that if the trader only has 250 dollars on their account and they lost the trade they will lose all of their capital.