What is Forex Trading?
What Is Forex? The foreign exchange market is the "place" where
currencies are traded. Currencies are important to most people around
the world, whether they realize it or not, because currencies need to be
exchanged in order to conduct foreign trade and business. If you are
living in the U.S. and want to buy cheese from France, either you or the
company that you buy the cheese from has to pay the French for the
cheese in euros (EUR). This means that the U.S. importer would have to
exchange the equivalent value of U.S. dollars (USD) into euros. The same
goes for traveling. A French tourist in Egypt can't pay in euros to see
the pyramids because it's not the locally accepted currency. As such,
the tourist has to exchange the euros for the local currency, in this
case the Egyptian pound, at the current exchange rate. The need to
exchange currencies is the primary reason why the forex market is the
largest, most liquid financial market in the world. It dwarfs other
markets in size, even the stock market, with an average traded value of
around U.S. $2,000 billion per day. (The total volume changes all the
time, but as of August 2012, the Bank for International Settlements
(BIS) reported that the forex market traded in excess of U.S. $4.9
trillion per day.) One unique aspect of this international market is
that there is no central marketplace for foreign exchange. Rather,
currency trading is conducted electronically over-the-counter (OTC),
which means that all transactions occur via computer networks between
traders around the world, rather than on one centralized exchange. The
market is open 24 hours a day, five and a half days a week, and
currencies are traded worldwide in the major financial centers of
London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris
and Sydney - across almost every time zone. This means that when the
trading day in the U.S. ends, the forex market begins anew in Tokyo and
Hong Kong. As such, the forex market can be extremely active any time of
the day, with price quotes changing constantly. Spot Market and the
Forwards and Futures Markets There are actually three ways that
institutions, corporations and individuals trade forex: the spot market,
the forwards market and the futures market. The forex trading in the
spot market always has been the largest market because it is the
"underlying" real asset that the forwards and futures markets are based
on. In the past, the futures market was the most popular venue for
traders because it was available to individual investors for a longer
period of time. However, with the advent of electronic trading, the spot
market has witnessed a huge surge in activity and now surpasses the
futures market as the preferred trading market for individual investors
and speculators. When people refer to the forex market, they usually are
referring to the spot market. The forwards and futures markets tend to
be more popular with companies that need to hedge their foreign exchange
risks out to a specific date in the future. What is the spot market?
More specifically, the spot market is where currencies are bought and
sold according to the current price. That price, determined by supply
and demand, is a reflection of many things, including current interest
rates, economic performance, sentiment towards ongoing political
situations (both locally and internationally), as well as the perception
of the future performance of one currency against another. When a deal
is finalized, this is known as a "spot deal". It is a bilateral
transaction by which one party delivers an agreed-upon currency amount
to the counter party and receives a specified amount of another currency
at the agreed-upon exchange rate value. After a position is closed, the
settlement is in cash. Although the spot market is commonly known as
one that deals with transactions in the present (rather than the
future), these trades actually take two days for settlement. What are
the forwards and futures markets? Unlike the spot market, the forwards
and futures markets do not trade actual currencies. Instead they deal in
contracts that represent claims to a certain currency type, a specific
price per unit and a future date for settlement. In the forwards market,
contracts are bought and sold OTC between two parties, who determine
the terms of the agreement between themselves. In the futures market,
futures contracts are bought and sold based upon a standard size and
settlement date on public commodities markets, such as the Chicago
Mercantile Exchange. In the U.S., the National Futures Association
regulates the futures market. 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 counterpart to the trader, providing clearance and
settlement. Both types of contracts are binding and are typically
settled for cash for the exchange in question upon expiry, although
contracts can also be bought and sold before they expire. The forwards
and futures markets can offer protection against risk when trading
currencies. Usually, big international corporations use these markets in
order to hedge against future exchange rate fluctuations, but
speculators take part in these markets as well. (For a more in-depth
introduction to futures, see Futures Fundamentals.) Note that you'll see
the terms: FX, forex, foreign-exchange market and currency market.
These terms are synonymous and all refer to the forex market.
