What is Forex Trading?
Forex is short for foreign exchange, which designates the trading of one currency for another. For instance one may trade U.S. dollars for British Pounds, USD/GDP, in the currency market.
There are several reasons why someone may wish to do that, for instance to use forex trading as a hedge against currency fluctuations, or to process financial transactions that involve different currencies.
From a personal investment perspective, we’ll be looking at forex trading to simply earn a profit on the trades, involving buying a certain currency and then selling it later, hopefully at a profit.
There are three types of forex markets, the spot market, the forward market, and the futures market. In this article we’ll be looking at the spot market, which comprises the overwhelming majority of forex trades these days, which are contracts that are immediately settled and not on some future date, and are the type that individual investors focus on as well.
Let’s say that you expect the Euro to gain in value relative to the U.S. Dollar. So you would purchase Euros with U.S. dollars, and then look to exchange the Euros back to USD at some point in the future, realizing a profit.
Of course the trade can go the other way as well, just like all financial trades, and forex trading is generally more risky than trading things like stocks, even though currencies are far more stable than stocks are.
This just means that it may not be wise to risk money that you cannot afford to lose in forex trading, like all of your retirement savings for instance. However, one may wish to use a portion of this, an amount that they are comfortable with, to provide some spice to their investing, and forex trading can definitely provide that, for reasons we will soon explain.
The Forex Market Dwarfs All Other Markets
It is estimated that the size of the forex market is about 5 trillion dollars per day. That’s simply a gigantic amount of money changing hands, an amount far bigger than any other financial market, including the worldwide stock market.
The main benefit to traders is that this provides tremendous liquidity to the market, meaning that you can open and close positions at will, 24 hours a day, every business day, at very tight spreads.
While forex markets do not stay open this long, there are several major forex markets located throughout the world, in different time zones, that assure 24 hour a day coverage and availability to traders. This can be a big benefit for casual traders in particular, who may be busy at work during normal market hours in other markets, but can trade forex at whatever time of day they please.
Like all financial transactions, there is a buyer and a seller, a bid and an ask price, and the difference between them is called the spread. This is why the price is different if you go down to your bank and buy a foreign currency, and you will pay a significant spread between what they ask for it and what they give you to redeem it back.
So this is an example of a financial transaction without a lot of liquidity, at least at the point that the transaction is made, the bank. There’s the bank, there’s you, only two parties here, and while you could go to another bank, banks generally don’t compete much on the local level for foreign exchange rates.
However, on the forex market, with these trillions of dollars changing hands each day, this is what you call liquidity, and at any given moment there are a lot of people looking to both buy and sell, so the spreads you see are extremely tight. It’s always to the benefit of investors that spreads be as tight as possible, and this aspect of forex trading is just perfect.
Other Advantages of Forex Trading
Forex trading also has the benefit of not being governed by an exchange, like a stock exchange for instance, and all trading is done directly between traders, electronically, over the counter as they call it. Over the counter markets do exist with other financial instruments, stocks for instance, but often these are instruments that aren’t traded enough to be traded on an exchange. That’s far from the case with foreign currency transactions though, so that’s another benefit to the investor.
What this does is keep transactional costs extremely low, as exchanges do add costs to trading, and you also need to often pay significant brokerage fees. With forex trading, these fees are kept extremely small, and the smaller the fees, the more investors get to keep for themselves.
This is a lot bigger deal than it may appear, as many profitable forex trades involve only very small movements in price, so if transactional costs were higher, this would eat up a disproportionate part of that profit, and make it harder to trade profitably.
Having all this liquidity means that you can trade pretty much instantly, without having to worry about when your trade will be processed, or in a lot of cases, wait for the market to re-open. Forex markets aren’t open on the weekend, and are only open 5 days a week, but due to differences in time zones, this actually works out to being open 5 ½ days a week, not just 5.
Investments will often involve quite a number of different instruments to trade, like for instance the thousands of stocks that are available to be traded in a stock market. Even if you stick to the high volume stocks, that still involves a lot of stocks to look at, and to decide among.
While there are a lot of different currencies out there, most forex trading involves just the major ones. Forex trading involves trading a currency pair, one currency for another, and generally trading U.S. dollars for another currency, or vice versa. There are only a few major currency pairs that comprise the bulk of forex trading, so this limits the field and makes selecting and tracking them much easier and simpler than having to track countless potential plays.
Even More Advantages To Forex Trading
With a lot of financial trading, there is a bias toward going long so to speak, and long means trading with an expectation that an instrument will increase in value. So for instance you may buy a stock hoping to sell it later at a higher price and make a profit that way.
You may also want to short the stock so to speak, meaning pledge to buy it later and sell it now, and this can be a profitable move if you expect that the price of a stock will decline. However, stock markets aren’t that fond of a lot of short selling, and have rules that make it more difficult to short sell than buy.
With forex trading, there is no long and short position, as every forex trade involves going long with one currency and short on the other one. So there are no barriers to this and it’s just as easy to trade a currency that you expect to decline as it is for one you expect to gain in value, and all forex trading is actually a combination of the two, a movement of value between two currencies.
Forex trading also does not involve market risk like many other financial instruments do. Market risk is the tendency for the market in general to decline together, and not all instruments go down, but most can, and they can go down a lot. There is no such market risk with forex trading because you are playing both sides, and both currencies in your currency pair can go down relative to other currencies, but they cannot both go down relative to each other.
The advantage that individual forex traders find most appealing though, although this is certainly a double edged sword, is the amount of leverage that they can have with a forex trade. While one may buy stocks on margin for instance, putting up just part of the purchase price and borrowing the rest, we call that a leveraged trade.
With forex trading, instead of having to put up, say, 50% of the cost of the security, you can put up as little as 1%, and hold positions 100 times larger than you could without the leverage. So for instance, with $1,000, you can do a forex trade worth $100,000.
Then, as the currency pair moves, you make the difference on the $100,000, not the $1,000 you put up. This is only possible due to the extreme stability of currencies versus other types of instruments, and the movements here are much smaller. However, due to all this extra leverage, you can make more money from these small movements.
You can also lose more money as well, and this is why forex trading can be riskier than some other types of investing or trading, and this risk must be accounted for. If your trade is leveraged 100:1, and you lose 1%, you’ve lost all your money.
Now currencies rarely move that much in a short period of time, and you can get out of the trade anytime you want, and holding on to something through this relative big loss would be foolish, and traders that lose tend to do it more slowly than this, but this can happen.
So with all the advantages of forex trading, it does come with a fair bit of risk, especially if you don’t know what you are doing. As with all investments, the more adept you are at investing, in this case trading, the better you will do. Forex trading is as close to a zero sum proposition as you will see, therefore some win, some lose, in pretty close to equal amounts, and you want to do your best to be on the winning side as much as possible.