What is Forex
Forex, also known as foreign exchange, FX or currency trading, is a decentralized global market where all the world's currencies trade. The forex market is the largest, most liquid market in the world with an average daily trading volume exceeding $5.3 trillion. All the world's combined stock markets don't even come close to this.
Forex is traded 24 hours a day, 5 days a week across by banks, institutions and individual traders worldwide. Unlike
other financial markets, there is no centralized marketplace for Forex, currencies trade over the counter (OTC) in whatever market is open at that time.
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 a new in Tokyo and Hong Kong. As such, the Forex market can be extremely active any time of the day, with price quotes changing constantly. Forex is a product quoted by all the major banks, and not all banks will have the exact same price.
A brief history of the Forex market
In 1876, something called the gold exchange standard was implemented. Basically, it said that all paper currency had to be backed by solid gold; the idea here was to stabilize world currencies by pegging them to the price of gold. It was a good idea in theory, but in reality it created boom-bust patterns which ultimately led to the demise of the gold standard.
The gold standard was dropped around the beginning of World War 2 as major European countries did not have enough gold to support all the currency they were printing to pay for large military projects. Although the gold standard was ultimately dropped, the precious metal never lost its spot as the ultimate form of monetary value.
The world then decided to have fixed exchange rates that resulted in the U.S. dollar being the primary reserve currency and that it would be the only currency backed by gold, this is known as the ‘Bretton Woods System’ and it happened in 1944 (I know you super excited to know that). In 1971 the U.S. declared that it would no longer exchange gold for U.S. dollars that were held in foreign reserves, this marked the end of the Bretton Woods System.
It was this break down of the Bretton Woods System that ultimately led to the mostly global acceptance of floating foreign exchange rates in 1976. This was effectively the “birth” of the current foreign currency exchange market, although it did not become widely electronically traded until about the mid 1990s.
HOW TO BUY AND SELL CURRENCY
All forex trades involve two currencies because you're betting on the value of a currency against another. Think of EUR/USD, the most-traded currency pair in the world. EUR, the first currency in the pair, is the base, and USD, the second, is the counter. When you see a price quoted on your platform, that price is how much one euro is worth in US dollars. You always see two prices because one is the buy price and one is the sell. The difference between the two is the spread. When you click buy or sell, you are buying or selling the first currency in the pair.
Let's say you think the euro will increase in value against the US dollar. Your pair is EUR/USD. Since the euro is first, and you think it will go up, you buy EUR/USD. If you think the euro will drop in value against the US dollar, you sell EUR/USD.
If the EUR/USD buy price is 1.12544 and the sell price is 1.12540, then the spread is 0.4 pips. If the trade moves in your favor (or against you), then, once you cover the spread, you could make a profit (or loss) on your trade.
TRADING ON MARGIN
If prices are quoted to the hundredths of cents, how can you see any significant return on your investment when you trade Forex? The answer is leverage.
When you trade Forex, you're effectively borrowing the first currency in the pair to buy or sell the second currency. With a US$5.3-trillion-a-day market, the liquidity is so deep that liquidity providers—the big banks, basically—allow you to trade with leverage. To trade with leverage, you simply set aside the required margin for your trade size. If you're trading 200:1 leverage, for example, you can trade £2,000 in the market while only setting aside £10 in margin in your trading account. For 50:1 leverage, the same trade size would still only require about £40 in margin. This gives you much more exposure, while keeping your capital investment down.
But leverage doesn't just increase your profit potential. It can also increase your losses, which can exceed deposited funds. When you're new to Forex, you should always start trading small with lower leverage ratios, until you feel comfortable in the market.
WHO TRADES FOREX?
The biggest Forex traders on the market are big international banks like Citigroup, UBS and Barclays, aiming to make a profit by taking advantages of price movements in the market. Between them, the biggest four banks trading Forex make up around 50% of all Forex trading. However, a huge number of individual traders also participate in the market.
Central banks and governments also trade Forex in order to control the supply of currency in their economy. And consumers, businesses and financial institutions all exchange currency when trading overseas, travelling abroad or investing in foreign markets