The forex market provides a way for investors to profit off the fluctuations in foreign currency exchange rates. In fact, the word itself is an amalgam of “foreign” and “exchange.”
Forex, as the name indicates, is the process of exchanging one currency for another – for instance, as you would do if you were going on holiday to Montreal and needed to trade your U.S. dollars (USD) into Canadian dollars (CAD).
But when it comes to trading currency for profit rather than pleasure, the process is a little more complex.
- The foreign exchange market, or forex market, is where currency pairs are traded – whether you’re turning U.S. dollars to Canadian coins for a getaway to Montreal or leveraging cash to speculate on price fluctuations between two currencies
- Currencies always trade in pairs, such as CAD/USD, with the left side representing 1 native dollar and the right side representing the counter currency
- When trading forex, traders take positions based on what they think will happen between two pairs; just like stocks, these can be long or short positions
- Trading forex is one tool for hedging and speculation – and while it can bring great profits, it also comes at enormous risk
What is the Forex Market?
The forex market, where currencies are exchanged and traded for profit, is the largest market in the world by daily trading volume, making it one of the most liquid markets in the world. The market itself lacks a centralized venue for trades; in fact, it operates in multiple financial hubs around the globe, including:
- New York
- Hong Kong
As a result, the market is open 24 hours a day, 5 days a week – making it the only nonstop trading market in the world.
Moreover, thanks to the lack of a centralized marketplace, modern forex trades are conducted electronically OTC (over the counter) via a network of interbank trading terminals and computer networks.
While this provides speed and widespread access, it also means that the forex market is less transparent than other financial markets. OTC markets don’t require financial disclosures – and large liquidity pools from major institutional firms are a prevalent feature. (In fact, the motives of financial institutions trading forex often plays the most important role in determining currency prices.)
What is Currency?
Currency, in its base form, is a crucial element of any economy, as it’s what allows individuals to purchase goods and services, both locally and across borders. Currency exchanges facilitate this process – not just for travelers on holiday to Canada, but for international businesses seeking foreign trade, and the investors hoping to make a fast buck.
The value of each individual currency varies based on factors such as:
- Interest rates
- Economic strength
- Geopolitical events
- Forex market activity
Whatever the reason for it, the difference in value between currencies is what creates opportunities for forex investors to profit on currency exchanges. And while we won’t go too far into the details here – that’s an article for another day – let’s take a quick rundown of how currency works in the forex market.
Currency Pairs Primer
When you trade currency on the foreign exchange market, you always trade in pairs. Forex traders use symbols to designate specific currency – for instance, CAD is the Canadian dollar, USD is the U.S. dollar, EUR is the euro, and so on.
When trading, these designations are written as such: CAD/USD 1.300. In this formula, the left side represents the base currency equal to 1 unit, such as $1 or €1. The right side is the counter or quote currency.
The number is the value of the counter currency compared to the base currency. When the number rises, the base currency rises in value, meaning that one unit of the base currency can buy more of the counter currency. On the other hand, if the number falls, the base currency can buy less of the counter currency.
So, in the example CAD/USD 1.300, it takes $1.30USD to buy $1CAD. To find out how much it costs to buy currency in the reverse, flip the pair and divide 1 by the current rate – in this case, USD/CAD would be 0.77, or 77 Canadian cents to every 1 U.S. dollar.
Currency Pairs on the International Stage
There are four types of currency pairs of which to be aware in the forex market:
- The major pairs include the currencies that comprise most global forex trading, including EUR/USD, USD/JPY, and USD/CHF.
- The minor pairs are less frequently traded, but usually feature major currencies against each other (instead of the USD) such as EUR/GBP or NZD/JPY.
- Exotic pairs pit a major currency against smaller or emerging economies, such as GBP/ZAR, USD/THB, or JPY/NOK.
- Regional pairs are classified by regions, such as Australasia or Scandinavia, including EUR/NOK, AUD/NZD, or NZD/SGD.
What is Forex Currency Trading?
Now that we understand a bit more about the forex market and currency pairs, let’s tackle the real reason we’re here: forex currency trading as an investment tool.
Forex pairs are traded in lots, with the size of the lot dictating the type of forex account.
- A standard forex account trades up to $100,000 in one lot
- Mini forex accounts trade up to $10,000 in a single lot
- Micro forex accounts let you trade up to $1,000 in one lot
Prior to the internet, currency trading was mostly conducted by large hedge funds, multinational corporations, and commercial and investment banks who could front the capital required.
And while commercial and investment banks still make up the majority of forex trades today, the proliferation of the internet – and secondary market brokers willing to front massive leverage to their clients – means that individual and professional investors can seek their fortunes in the currency markets, too.
In fact, it’s not uncommon for a broker to allow leverage up to $1 for every $100 traded. In other words, a $10 investment can net an investor a micro lot up to $1,000 worth of currency. And while this can enhance an investor’s gains, it also enhances losses indiscriminately.
But how do investors make their fortunes (or not) in the forex market? It all comes down to two distinct features that make forex an attractive asset class:
- The ability to profit directly from changes in the exchange rate
- The ability to capitalize on the interest rate differential between two currencies by buying the currency with the higher rate and shorting the currency with the lower rate (sometimes known as a carry trade)
Trading Forex on the Spot Market
The most common way to trade forex is on the spot market. When the average person talks about forex, what they’re referring to is trading on the spot market. This is where currencies are bought and sold based on their trading price, which is determined by supply and demand and calculated according to factors such as:
- The current interest rate
- Economic performance
- Sentiment toward political situations
- The perception of future performance between two currencies
In spot deals, currencies are traded in bilateral transactions in which each party delivers and receives a specific amount of opposing currencies at the agreed-upon exchange rate value. When the position closes, the deals are then settled in cash. And although these deals involve current transactions, each trade takes two days for settlement.
Trading Forex on Futures and Forward Markets
You can also trade forex on both forwards and futures markets. Unlike the spot market, these transactions don’t involve actual currencies, but instead deal in contracts that represent claims to a currency type, price, and settlement date.
In a futures contract, a trader agrees to accept delivery of a currency at a future date and predetermined price. These contracts are fulfilled according to standardized parameters, such as the number of units traded, delivery and settlement dates, and minimum price increments.
Forwards contracts, on the other hand, are private agreements between two parties to buy currency at a future date and predetermined price. Forwards contracts differ from futures contracts in that they don’t follow standardized parameters – the two participating parties agree on the terms themselves. However, they’re just as legally binding as futures contracts.
These contracts tend to be more popular with companies that need to hedge their foreign exchange risk out to a set future date. And while the contracts are typically settled for cash upon expiry, they can also be bought or sold before the settlement date.
Why Trade Forex?
Traders and institutions typically trade forex for one of two reasons: to hedge against risk or speculate on price movements.
Hedging against risk is popular for international companies who want to mitigate the profit-eating potential of currency fluctuations. Forex markets provide this opportunity by fixing rates at which a transaction will be completed. To do so, a company can buy or sell currencies in forward-facing markets to lock in an exchange rate.
Typically, this occurs in futures markets, where contracts conform to standardized parameters – though these markets are less liquid than decentralized forward markets.
Investors and institutions may also take advantage of forex as a speculative tool. Factors such as interest rates, tourism, internal economic mechanisms, and geopolitical risk affect any given currency’s supply and demand hour by hour. In turn, this creates daily forex volatility – providing opportunities ripe for the plucking.
For example, an investor may believe that, thanks to Canada’s stance on grey goose migratory patterns, the U.S. dollar (which is currently 1:1 with the Canadian dollar) will fall in comparison. As such, they short the U.S. dollar and go long on CAD – and take home a hefty profit when prices fall to $0.70CAD per $1USD.
The Allure of Forex
Simply put, forex is alluring to many traders because of the massive, unbridled potential for profits. Many brokers allow traders to invest with enormous leverage – up to 100:1. This means that an investor can enhance their gains exponentially while investing very little of their own capital.
Additionally, as the forex market is so large and liquid, it’s easy to enter and exit a position in any major currency in a fraction of a second, 24 hours a day, 5 days a week.
Not to mention, investors can both hedge their currency risks in the forex market while at the same time profiting in speculative ventures. And because currency fluctuates on a dime due to national, international, and economic pressures, the constant tide of volatility means that opportunities for advancement crop up dozens of times per day.
The Risks of Forex
However, trading forex is complex and can be incredibly risky.
For instance, the interbank market that controls forex trading has varying degrees of oversight around the world. Not to mention, the OTC nature of forex trading means that the forex market is less transparent than other financial markets. Additionally, while the extreme leverage offered by many brokers makes it easy for traders to get involved in the market, such measures can bankrupt both traders and dealers alike.
As such, countries with relaxed rules pose greater risk to an investor’s capital in instances of market crisis, insolvent dealers, and even unregulated forex brokers who trade against their own customers. And because currency prices can move on a dime, it’s possible for a trader to think they’ve cinched their fortune – only to lose it all in seconds.
Moreover, attaining success requires both luck and an intimate understanding of economic fundamentals and indicators. Without a broad understanding of various countries’ economies – not to mention the global economy – grasping the intricacies of currency fluctuations is nearly impossible.
The Difference Between Forex and Cryptocurrency
Like forex, trading cryptocurrencies involves capitalizing on the price movements of currency. However, there are some key differences between the two. Chief among these is that forex is a well-established (if risky) venture, while cryptocurrency has only been around for a few years.
Additionally, forex involves a host of players – brokers, financial institutions, two economic systems, etc. – to trade currency (and skim profits) every step of the way. But crypto trading by definition is a peer-to-peer system, which means that currencies trade directly between two interested parties.
This brings about another difference between the two: namely, that currencies in the forex market are backed by a centralized government, while cryptocurrencies operate on decentralized networks. (Not to mention, it’s possible to mine some types of crypto coins – but if you make your own cash in most countries, you risk criminal charges.)
Liquidity is another major difference between cryptocurrency and forex. Whereas the forex market is enormous and the most liquid asset market in the world, the crypto market is much less so, especially in newer or less-circulated coins.
Moreover, whereas investors trading forex usually do so to profit off their positions as quickly as possible, some cryptocurrency investors hold their positions for days, weeks, or even years in the hopes that the currencies will perform in the long-term.