Disclaimer: This article has been produced using publicly available content for educational purposes only and does not constitute trading advice or a solicitation to buy or sell any financial instrument.
The world's biggest market is the exchange of currencies known as Forex, foreign exchange, or currency exchange. In 2019, the average daily trade volume of Forex was $5.1 million US Dollars. Understanding the Forex market provides traders with the ability to make a profit within one of the most accessible global markets there is. In this article we will cover:
- What is Forex?
- Where is Forex traded?
- How does the Forex market work?
- How do you read a Forex symbol?
- What are the three Forex markets?
What is Forex?
Forex refers to the foreign exchange market. The foreign exchange market is where currencies are traded. It is the largest market by daily trade volume which is approximately $5 Trillion USD per day! Currencies facilitate transactions both within a country and for transactions between countries. As globalization, the term used to describe increasing international trade, continues to grow across the world, so has the importance of foreign exchange markets that enables the globalization phenomenon. Imagine you live in the US and want to buy tea from England, either you or the company you're buying through would have to buy the tea from the British seller in British Pounds. Therefore you would have to exchange your US Dollars for an exchange rate specified amount of British Pounds (We'll explain this later). International travel is also fueled by foreign exchange. If you travel from America to Spain you would find it difficult to buy anything with your US Dollars because the Euro is the currency used in Spain. You couldn't buy a ticket for a Barcelona football game using Dollars, rather you would have to exchange your Dollars for Euros. As a tourist you have to exchange your currency for the local currency of the country you are visiting at the specified exchange rate.
The following words are synonymous with Forex: FX, foreign exchange, currency exchange.
Where is Forex traded?
The Forex market is unique in how it is traded because there is no central marketplace that is used. Instead, transactions occur all over the world using electronic Over-The-Counter (OTC) networks of traders and brokers. This is different from a central exchange, for example New York Stock Exchange, where people buy stocks on the exchange. OTC enables people and institutions to trade with anyone across the world. This means that the Forex market is open almost 24 hours a day for 5 days a week.
How does the Foreign Exchange Market Work?
The basic principle of any trading is that you expect the value of an asset to either increase (so you buy it) or decrease (so you sell it). In the case of Forex, the asset is a currency. That currency represents and is influenced by many factors about the state (or states in the case of the Euro) including economic strength, tourism, trade flows, interest rates, and geopolitical risk. The basic economic principle of supply and demand apply to currency. For example, if more people want to buy Japanese Yen then the demand is higher and this will cause the price to increase. If a central bank issues more of a currency (quantitative easing) then supply of that currency is higher and the price will decrease.
How to read Forex Symbols?
USD/CAD = 1.31
The currency on the left hand side is the base currency, which is US Dollars in this example. The currency on the right hand side is the quote or counter currency, which Canadian Dollar in this case. What this whole symbol represents is the price of the quoted currency against one unit of the base currency. So the above example means that one US Dollar is worth 1.31 Canadian Dollars.
What are the different types of Forex Markets?
Foreign Exchange Spot Market
Generally, a spot market (or “cash market”) is one in which trades of assets at the current price are delivered immediately. In Forex spot markets, the current price is determined by aforementioned factors that affect supply and demand (interest rates, economic strength, trade flows, etc). A “spot deal” occurs when one party agrees to give the counter party a specified amount of one currency in exchange for a specified amount of another currency. The ratio of the delivered currency vs the received currency is called the exchange rate.
Forex Forwards Market
Unlike the spot market, in the forwards market (and the futures market) you aren't buying the actual currency. Rather, you are buying a contract that gives you claim to a certain currency, at a specific price, at some point in the future. Forward contracts are sold OTC between two parties that are able to negotiate the terms themselves. The terms of these contracts aren't standardized like a futures contract. The main purpose of forward contracts are for large organizations to hedge against currency fluctuations.
Forex Futures Market
Like the forwards market, the Forex futures contract involves the trade of contracts that give you a right to buy a specific currency, at a certain price, in the future. However, unlike the forwards market, futures contracts terms are standardized, regulated, and sold on an exchange. The National Futures Association regulates the US Forex futures market.
Rounding Up
The forex market is the market where currencies are traded. Currency is an essential part of life for people all around the world as it enables them to buy and sell things. Differences in economic strength, interest rates, political stability, and other factors creates changes of supply and demand of a currency. Supply and demand directs the value or price of any asset including currency. These changes in value open the possibility for traders to make a profit by correctly predicting swings. The three types of Forex market are spot markets, forwards markets, and futures markets. Spot markets involve the immediate exchange of currency between two markets. Forward and futures markets involve the purchase of contracts that give the buyer a right to buy a currency at specific price at a point in the future. Forward contracts are privately sold OTC between traders whereas futures contracts are sold on regulated exchanges.
