A Beginner’s Guide To Forex Trading
What is it?
The foreign exchange market is where currencies are traded. Currency is something that is important to many people around the world, whether they know it or not. Currency needs to be exchanged in order to conduct foreign trade.
Say you are living in the US, and you want to buy some goods from Spain, either you or the company that you buy the goods from has to pay the Spanish for the cheese in euros (EUR). This means that the U.S. importer would have to exchange the equivalent value of U.S. dollars (USD) into euros. The same goes when travelling. A British tourist in Egypt can’t pay in pounds to see the pyramids because it’s not the locally accepted currency. Therefore the tourist has to exchange for the local currency at the current exchange rate.
There is no central marketplace for foreign exchange. Currency trading is conducted electronically over the counter. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centres of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney—across almost every time zone. This means that even when the day ends in the UK, the market begins trading in Tokyo. Therefore the market is active at any time of the day.
A Quick History
The Forex market is a new market. Obviously in the basic sense of people converting currency is not a new concept, but the modern markets are. After the accord at Bretton Woods in 1971, more major currencies were allowed to float freely against one another. The values of individual currencies vary, which has given rise to the need for foreign exchange services and trading.
Spot Market and the Forwards and Futures Markets
There are three ways that corporations, individuals and institutions trade forex: the spot market, the forwards market, and the futures market. The spot market has always been the largest because it is the underlying asset that the forwards and futures markets are based on. In the past, the futures market was the most popular venue for traders because it was available to individual investors for a longer period of time. With the advent of electronic trading and more forex brokers, the spot market has seen a surge in activity and now surpasses the futures market as the preferred trading market for individual investors and speculators.
The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks to a specific date in the future.
The spot market is where currencies are bought and sold according to the current price. That price, determined by supply and demand, is a reflection of current interest rates, economic performance, sentiment towards ongoing political situations and the perception of the future performance of one currency against another. When a deal is finalized, this is known as a “spot deal.” It is a transaction by which one party delivers an agreed-upon currency amount to the counterparty and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present (rather than the future), these trades actually take two days for settlement.
The forwards and futures markets do not trade actual currencies. Instead, they deal in contracts that represent claims to a certain currency type, a specific price per unit and a future date for settlement. In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves.
In the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange. In the U.S., the National Futures Association regulates the futures market. Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments that cannot be customized. The exchange acts as a counterpart to the trader, providing clearance and settlement.
Both types of contracts are binding and are typically settled for cash at the exchange in question upon expiry, although contracts can also be bought and sold before they expire. The forwards and futures markets can offer protection against risk when trading currencies. Usually, big international corporations use these markets in order to hedge against future exchange rate fluctuations, but speculators take part in these markets as well.
Forex for Hedging
Companies doing business in foreign countries are at risk due to fluctuations in currency values when they buy or sell goods and services outside of their domestic market. Foreign exchange markets provide a way to hedge currency risk by fixing the rate at which the transactions will be completed.
To accomplish this, a trader can buy or sell currencies in the forward or swap markets in advance, locking in an exchange rate.
Hedging can be done in the currency futures market. The advantage for the trader is that futures contracts are standardized and cleared by a central authority. However, currency futures may be less liquid than the forward markets, which are decentralized and exist within the interbank system throughout the world.
Forex for Speculation
Factors which affect the market include interest rates, trade flows, tourism and economic strength. An opportunity exists to profit from changes that may increase or reduce one currency’s value compared to another. A forecast that one currency will weaken is essentially the same as assuming that the other currency in the pair will strengthen because currencies are traded as pairs.
Why We Can Trade Currency
Currency trading was difficult for individual investors prior to the internet. Most currency traders were large corporations, hedge funds or high net worth individuals because forex trading requires a lot of initial capital. With the internet, a retail market aimed at individual traders has emerged, this provides easy access to foreign exchange markets. Most online brokers can offer really high leverage to individual traders who can control a large trade with a small account balance.
Forex Trading Risks
Trading currencies can be risky and complex. The interbank market has varying degrees of regulation, forex instruments are not standardized. In some parts of the world, forex trading is almost completely unregulated.
The interbank market is made up of banks trading with each other around the world. The banks themselves have to determine and accept sovereign risk and credit risk, and they established internal processes to keep themselves as safe as possible. Regulations like this are industry-imposed for the protection of each participating bank. Since the market is made by each of the participating banks providing offers and bids for a particular currency, the market pricing mechanism is based on supply and demand. Because there are such large trade flows within the system, it is difficult for rogue traders to influence the price of a currency. This system helps create transparency in the market for investors with access to interbank dealing.
Most small retail traders trade with relatively small and semi-unregulated forex brokers/dealers, which can (and sometimes do) re-quote prices and even trade against their own customers. Depending on where the dealer exists, there may be some government and industry regulation, but those safeguards are inconsistent around the globe.
Most retail investors should spend time investigating a forex dealer to find out whether it is regulated in the U.S. or the U.K. (dealers in the U.S. and U.K. have more oversight) or in a country with lax rules and oversight. It is also a good idea to find out what kind of account protections are available in case of a market crisis, or if a dealer becomes insolvent.
The easiest way to get into Forex trading is to get in contact with us, we can offer you a variety of courses that are tailored to your skillset. You can also learn about our head trader and how forex trading has lead to success for him.