What is Forex (FX)? – Definition, Market Basics, How Large, and More
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What is Forex (FX)?
Forex (FX) refers to the marketplace where numerous currencies and currency derivatives are traded and the cash and currency derivatives traded there. Forex is a portmanteau of “foreign exchange.”
The forex market is the largest, most liquid market globally by trading volume, with trillions of dollars changing hands every day. It has no centralized location; instead, the forex market is an electronic network of banks, brokers, institutions, and individual traders (mostly trading through brokers or banks).
Many entities, from financial institutions to individual investors, have currency needs and may also speculate on the direction of a particular pair of currencies. They post their orders to buy and sell coins on the network to interact with other currency orders from other parties.
Market Basics of Forex
Forex Pairs and Quotes
When trading currencies, they list in pairs, such as USD/CAD, EUR/USD, or USD/JPY. These signify the U.S. dollar (USD) versus the Canadian dollar (CAD), the Euro (EUR) versus the USD and the USD versus the Japanese Yen (JPY).
They’re also a price associate with each pair, such as 1.2569. If this price was associated with the USD/CAD pair, it costs 1.2569 CAD to buy one USD.
If the price increases to 1.3336, then it now costs 1.3336 CAD to buy one USD. The USD has increased in value (CAD decrease) because it now costs more CAD to buy one USD.
In the forex market, currencies trade in lots called micro, mini, and standard lots. A micro lot is 1000 worth of given money, a mini lot is 10,000, and a familiar lot is 100,000.
It is different from going to a bank and exchanging $500 to take on your trip. When trading in the electronic forex market, trades take place in set blocks of currency.
And you can deal with whatever size you want within limits allowed by your trading account balance. For example, you can trade seven micro-lots (7,000) or three mini lots (30,000) or 75 standard lots (750,000).
How Large Is the Forex?
The forex market is unique for several reasons, the main being its size. Trading volume is generally enormous. As an example, trading in foreign exchange markets averaged $6.6 trillion per day in 2019, according to the Bank for International Settlements (BIS).
By comparison, this volume exceeds global equities (stocks) trading volumes by roughly 25 times.
The largest foreign exchange markets are located in major global financial centres like London, New York, Singapore, Tokyo, Frankfurt, Hong Kong, and Sydney.
How to Trade in Forex?
The forex market is open 24 hours a day, five days a week across major financial centres worldwide. It means that you can buy or sell currencies at any time during the week.
In the past, forex trading was limited mainly to governments, large companies, and hedge funds. But in today’s world, trading currencies is as easy as the click of a mouse.
And accessibility is no longer an issue because now anyone can trade on forex. Many investment firms, banks, and retail forex brokers offer individuals the chance to open accounts and trade currencies.
When trading in the forex market, you’re buying or selling a particular country’s currency relative to another currency. But there’s no physical exchange of money from one party to another.
That’s what happens at a foreign exchange kiosk—think of a tourist visiting Times Square in New York City from Japan. He may be converting his physical yen to actual U.S. dollars (and maybe charged a commission fee to do so), so he can spend his money while he’s travelling.
But in the world of electronic markets, traders are usually taking a position in a specific currency with the hope that there will be some upward movement and strength in the money they’re buying (or weakness if they’re selling) so they can make a profit.
A currency is always traded relative to another currency. If you sell a coin, you are buying another, and if you buy a currency, you are selling another.
In the electronic trading world, a profit is made on the difference between your transaction prices.
Forex (FX) Rollover
Retail traders don’t typically want to take delivery of the currencies they buy. They are only interested in profiting from the difference between their transaction prices.
Because of this, most retail brokers will automatically “roll over” currency positions at 5 p.m. EST each day.
The broker resets the positions and provides either a credit or debit for the interest rate differential between the two currencies in pairs being held. The trade carries on, and the trader doesn’t need to deliver or settle the transaction.
When the trade is closed, the trader realizes their profit or loss based on their original transaction price and the price they closed the business at. The rollover credits or debits could either add to this gain or detract from it.
Since the fx market is closed on Saturday and Sunday, the interest rate credit or debit from these days is applied on Wednesday.
Therefore, holding a position at 5 p.m. on Wednesday will result in being credited or debited triple the usual amount.
Forex Forward Transactions
Any forex transaction that settles for a date later than the spot consider a “forward.”
The price is calculated by adjusting the spot rate to account for the difference in interest rates between the two currencies. The amount of adjustment calls “forward points.”
The forward points reflect only the interest rate differential between the two markets. They are not a forecast of how the spot market will trade at a date in the future.
A forward is a tailor-made contract: it can be for any amount of money and settle on any date that’s not a weekend or holiday. As in a spot transaction, funds exchange on the settlement date.
Forex (FX) Futures
A forex or currency futures contract is an agreement between two parties to deliver a set amount of currency at a set date, called the expiry, in the future. Futures contracts trade on an exchange for fixed values of money and with set expiry dates.
Unlike a forward, the terms of a futures contract are non-negotiable. A profit is made on the difference between the prices of the contract bring and sold at it.
Most speculators don’t hold futures contracts until expiration, as that would require they deliver/settle the currency the deal represents.
Instead, speculators buy and sell the contracts before expiration, realizing their profits or losses on their transactions.
Market Differences in Forex
There are some significant differences between the forex and other markets.
It means investors help as strict standards or regulations as those in the stock, futures or options markets.
There are no clearing houses and no central bodies that oversee the entire forex market.
You can short-sell at any time because, in forex, you aren’t ever actually shorting; if you sell one currency, you are buying another.
Fees and Commissions
Since the market is unregulated, how brokers charge fees and commissions will vary. Most forex brokers make money by marking up the spread on currency pairs.
Others make money by charging a commission, which fluctuates based on the amount of currency traded. Some brokers use both approaches.
There’s no cut-off as to when you can and cannot trade. Because the market is open 24 hours a day, you can change at any time of day.
The exception is weekends or when no global financial centre is available due to a holiday.
The forex market allows for leverage up to 50:1 in the U.S. and even higher in parts of the world.
That means a trader can open an account for $1,000 and buy or sell as $50,000 in currency, for example. Leverage is a double-edged sword; it magnifies both profits and losses.
Example of Forex Transactions
Assume a trader believes that the EUR will appreciate against the USD. Another way of thinking of it is that the USD will fall relative to the EUR.
They buy the EUR/USD at 1.2500 and purchase $5,000 worth of currency. Later that day, the price has increased to 1.2550. The trader is up $25 (5000 * 0.0050). If the price dropped to 1.2430, the trader would be losing $35 (5000 * 0.0070).
Currency prices are always moving, so the trader may decide to hold the position overnight.
The broker will roll over the position, resulting in a credit or debit based on the interest rate differential between the Eurozone and the U.S.
If the Eurozone has an interest rate of 4%, and the U.S. has an interest rate of 3%, the trader owns the higher interest rate currency because they bought EUR.
Therefore, at rollover, the trader should receive a small credit. If the EUR interest rate were lower than the USD rate, then the trader would be debited at rollover.
Rollover can affect a trading decision, mostly if the trade could help for the long term.
Large differences in interest rates can result in significant credits or debits each day, which can significantly enhance or erode the profits (or increase or reduce losses) of the trade.
Most brokers also provide leverage. Many brokers in the U.S. provide power up to 50:1. Let’s assume our trader uses 10:1 force on this transaction.
If using 10:1 leverage, the trader does not require to have $5,000 in their account, even though they are trading $5,000 worth of currency.
They only need $500. As long as there have $500 and 10:1 leverage, they can trade $5,000 worth of currency. If they utilize 20:1 leverage, they only need $250 in their account (because $250 x 20 = $5,000).
The forex (FX) market is a network of institutions, allowing for trading 24 hours a day, five days per week, except when all markets close because of a holiday.
Retail traders can open a forex account and then buy and sell currencies. A profit or loss results from the difference in price the currency pair was bought and sold at.
Forwards and futures are another way to participate in the forex market. Forwards customizable with the currencies exchange after expiry. Many are not customizable and more readily used by speculators, but the positions often close before expiry (to avoid settlement).