Forex is a decentralized global market in which all the world’s currencies operate. The forex market is the largest and most liquid market in the world, with a daily volume of operations exceeding 5 trillion dollars. All the combined stock markets of the world do not even come close to this. But what does that mean to you? Take a closer look at currency trading and you may find some exciting trading opportunities that are not available with other investments.
Forex, or currency market, can be understood as a network of buyers and sellers who exchange currencies at an agreed price. It is the way in which retail investors, companies and central banks convert one currency into another. If you have traveled abroad, it is likely that you have traded forex.
A large number of transactions are carried out for practical reasons, but the vast majority of currency conversions are carried out by investors with the aim of making profits. The amount of currency converted on a daily basis can make the price movements of some of them extremely volatile. It is precisely this volatility that makes forex so attractive to investors: it provides greater opportunities to maximize profit, but also increases risk.
Unlike stocks or commodities, forex trading does not take place in markets, but is traded directly between two parties in an over-the-counter (OTC) market. The forex market is established through a global network of banks, spread across four main centres in different time zones: London, New York, Sydney and Tokyo. Because there is no physical place through which trades are processed, you can invest in forex 24 hours a day.
There are three different types of forex markets:
Spot forex market: the physical exchange of the currency pair, which takes place at the exact moment when the trade is liquidated or after a small margin of time.
Forex forward market: a contract is established to buy or sell a fixed amount of currency at a certain price, and whose maturity is on a fixed future date or within a range of future dates.
Forex futures market: a contract is agreed to buy or sell a certain amount of a given currency at a set price on a fixed date in the future. Unlike a forward, a futures contract is legally binding.
Most forex investors are not interested in receiving the physical delivery of the currency, but rather make predictions about exchange rates in order to make profits from price movements in the market.
A first currency is the currency that precedes the pair, while the next currency is called the second currency. Forex trading always involves buying one currency and selling another, and is therefore quoted as pairs: the price of a pair is determined by calculating how much a unit of the first currency is worth in the second currency.
The currencies of a pair are identified by a three-letter code, in which the first two usually correspond to the region and the third to the currency itself. For example, the GBP/USD is a pair formed by the British pound and the US dollar.
Most vendors classify currency pairs into the following categories:
Larger pairs. These are the seven pairs that make up 80% of the world’s forex trading, including EUR/USD, USD/JPY, GBP/USD and USD/CHF.
Minor pairs. These are traded less frequently, and usually contain major currencies other than the U.S. dollar. They include the EUR/GBP, the EUR/CHF and the GBP/JPY.
Exotic pairs. They are formed by a major currency against another of a small or emerging economy. They include USD/PLN, GBP/MXN and EUR/CZK.
Regional pairs. These are pairs classified by region, such as Scandinavia or Australasia. Includes EUR/NOK, AUD/NZD and AUS/SGD.
The forex market is made up of currencies from around the world, and the number of factors that can affect price movements makes it difficult to predict exchange rates. However, like most financial markets, forex is primarily affected by the laws of supply and demand, and it is important to understand what and how price fluctuations are caused.
Central banks control supply, and can take measures that significantly affect the price of their currency. Quantitative expansion, for example, involves injecting money into an economy, which can cause the price of the currency to fall.
Commercial banks and other investors tend to deposit their capital in promising economies. Therefore, if markets echo positive news about a given region, it will motivate investment and lead to increased demand for the regional currency.
Unless there is a parallel increase in the supply of that currency, the difference between supply and demand will cause its price to rise. Similarly, negative news can mean a brake on investment and a drop in the price of the currency. For this reason, currencies often reflect the economic health of the region they represent.
Market confidence, which is often related to news, can also play a major role in the movement of currency prices. If investors believe that a currency will move in a certain direction, they will invest accordingly and can convince others, thus causing demand to grow or decrease.