Forex is shorthand for Foreign Currency and Exchange. Forex (FX) refers to currency trading where forex traders speculate on potential price changes in specific currency pairs.
Common FX pairs include GBP/USD (Great British Pound and United States Dollar), USD/CAD (United States Dollar and Canadian Dollar), EUR/USD (Euro and United States Dollar), and USD/JPY (United States Dollar and Japanese Yen).
Currencies vary from country to country. Sometimes, several countries share a currency, such as the Euro, across multiple European countries.
Foreign exchange exists so that one currency can be exchanged for another. This is used in commerce, tourism, and trading. Its purpose is to smooth the process of conducting international business.
While most investors are aware of stock market trading, cryptocurrencies, ETFs, and index funds, not everyone understands forex. Forex trading is an alternative form of investing in a category all its own.
How Forex works
A currency pair consists of a base currency on the left and a quote currency on the right. A forex trader temporarily bets money on the speculative price movements of the quote currency versus the base currency.
Someone trading the CAD/USD pair speculates on the Canadian dollar price against the United States dollar price.
While stocks are exchanged on recognized stock exchanges, there is no such physical establishment for forex. Currency trading consists of millions of electronic transactions via computers. This takes place in what’s known as the over-the-counter (OTC) market.
The forex market operates 24 hours a day across most of the world’s time zones, resulting in five and a half days of forex trading opportunities.
Currency values fluctuate constantly. These fluctuations are primarily caused by interbank trading on a vast scale. In fact, the forex market is the largest investment marketplace in the world.
It takes place via all the world’s most prominent financial hubs. These include New York, London, Tokyo, Frankfurt, Paris, Zurich, Hong Kong, Sydney, and Singapore.
Types of Forex
As long as people could barter for goods, there’s been a kind of currency market. But the forex market we speak of today has evolved in recent decades.
From 1944 to 1971, the Bretton Woods agreement determined that gold should back the United States dollar. From here, other currencies were then pegged to the value of the US dollar.
When this agreement ended in 1971, currencies began to float against one another unrestricted.
Banks saw an opportunity to make money from the price fluctuations, and so began the forex market we know today.
Nowadays, anyone with a computer connection can trade forex. Individuals can trade a wide variety of major and minor forex pairs at brokers offering Spread Betting or CFD trading accounts.
But that’s not necessarily a good thing.
Forex is a highly speculative and, therefore, risky investment strategy. Some individuals become very successful Forex traders, but it’s a fool’s errand for the majority and better left to experienced financial institutions.
The strength of a currency depends on various factors such as geopolitical climate and current events.
Many day-to-day events can impact a currency price. General elections, political speeches, referendums, natural disasters, unforeseen circumstances, economic data releases, interest rate adjustments, and quantitative easing all play a part in driving the currency value up or down.
The US dollar remains the most popularly traded currency, and it stands to reason that developing countries have less value in their currencies than the world’s richer nations.
The following currency pairs are estimated to make up around 80% of all forex trading volume.
GBP/USD, EUR/USD, USD/JPY, USD/CHF, AUD/USD, USD/CAD and NZD/USD.
What are the most popular Forex currency pairs?
The eight most widely traded international currencies include the United States Dollar (USD), the Euro (EUR), the Great British pound (GBP), the Canadian dollar (CAD), the New Zealand dollar (NZD), the Australian dollar (AUD), the Swiss franc (CHF), and the Japanese yen (JPY).
What is a pip?
Currency quotes are priced in pips. A pip is the smallest unit the quote can be denominated in. It is short for percentage in point or price interest point and represents a tiny measure of the change in a currency pair in the forex market.
A pip can be measured in terms of the quote or terms of the underlying currency. Traders must closely monitor the minuscule price movements of pips to keep track of their forex profit and loss balance.
Advantages of Forex
Forex traders can either earn the difference between currency interest rates or profit from fluctuations in the exchange rates.
There are many reasons currencies need to be exchanged, but this usually comes down to conducting foreign trade.
For instance, when people travel abroad, they need to use the local currency. Therefore, they exchange their domestic currency for the currency of the country they’re visiting. Or the bank does it automatically when using digital banking.
The same goes for importing and exporting. If a company in Japan wants to buy Scottish whisky, it must pay for the whisky in GBP. This means the importing company must exchange the value of its Japanese yen for pounds.
One key advantage to the forex market is its variety of flexible trading opportunities on a 24-hour basis.
Liquidity and volatility
Forex trading also enjoys high liquidity and volatility, which can provide fantastic opportunities to savvy traders.
As well as straight cash trades, also known as spot trades, derivatives trading is popular in the forex market.
For example, shorting a currency is common when a forex trader believes the currency is likely to lose value.
The unknown outcome of Brexit weighed heavily on the pound between 2016 and 2020, leading speculators to short the pound. It then began to rally as an end was in sight.
The most famous currency short took place in 1992, when legendary investor George Soros bet the value of the British pound would fall. He was right in spectacular fashion and, in one single trade, made a billion dollars for his fund.
This story goes to show the money-spinning potential in trading forex. And that’s why all the world’s biggest banks have forex trading desks.
The spread is the difference between the buy price and the sell price. If the two are wide apart, it costs the trader more to be in the trade. This leads to losses and lower-than-expected gains.
With the liquid nature of the forex market, tight spreads are an advantage.
They ensure a trader’s costs incurred are relatively low. While it might not make a big difference to individual trades, these narrow spreads help boost profits margins over the course of several.
Disadvantages of Forex
The advent of the internet brought all kinds of investment opportunities to the masses. Forex is one of them.
Before electronic markets, it was almost impossible for individual investors to access the currency markets. That’s because a large cash balance was necessary.
Risk of losses
Nowadays, investors can trade on leverage (borrowed funds), so the barrier to entry is lower. But this also makes it extremely risky.
Borrowing on margin can magnify losses very quickly.
The fact that currency values can alter with the slightest announcement or event, makes for a very unpredictable market. This also makes investors highly susceptible to sustained losses.
When Covid-19 was rampaging through Europe, the value of the Euro fell. Similarly, this occurred in the UK and US when the pandemic was at its worst there. This uncertainty has brought extreme volatility to the currency markets.
The European Central Bank (and its Central Bank peers) has the power to implement monetary policy and banking supervision measures to mitigate the effects of a crisis such as the pandemic.
Potential for manipulation
Forex markets do not constitute the same rigorous scrutiny afforded stock markets. Therefore, it’s potentially open to manipulation.
Large financial institutions are motivated to ensure currency prices fall in their favor. By flooding the market with large orders, they can potentially influence the prices with a level of precision that allows them to consistently profit.
But really, their opportunity to manipulate prices is not as easy as it may sound.
The banks involved in interbank forex transactions do not have to make disclosures, which makes operating in this territory dangerous. Therefore those participating in the interbank network must calculate both their sovereign and credit risk to stay protected.
The entire landscape is built on supply and demand. And this colossal market has such liquidity that manipulation of a currency price is complex.
Where’s the value?
- International currencies are exchanged in the global forex marketplace.
- Due to international time differences, the Forex (FX) market operates 24 hours a day on weekdays.
- For forex traders interested in trading round the clock, the 24-hour nature of the business provides endless opportunities.
- The extensive reach and variety of markets (commerce, finance, trade) ensure the forex market is the world’s largest and most liquid asset market.
- Forex traders pitch currencies against each other in the form of exchange rate pairs. CAD/USD is a currency pair for trading the Canadian dollar against the United States dollar.
- This market extends from spot (cash) markets into derivatives trading. This includes forex futures, options, and currency swaps.
- Sometimes forex traders are using it for portfolio diversification while others use it as an opportunity to hedge against risk. This is particularly true of big banks and institutions. It can be used to hedge against risks to international currency and interest rates, geopolitical events, and unforeseen circumstances.