The foreign exchange market, or forex, is one of the most exciting, fast-paced markets around. Until recently, forex trading in the currency market had been the domain of large financial institutions, corporations, central banks, hedge funds and extremely wealthy individuals. The emergence of the internet has changed all of this, and now it is possible for average investors to buy and sell currencies easily with the click of a mouse through online brokerage accounts.

Daily currency fluctuations are usually very small. Most currency pairs move less than one cent per day, representing a less than 1% change in the value of the currency. This makes foreign exchange one of the least volatile financial markets around. Therefore, many currency speculators rely on the availability of enormous leverage to increase the value of potential movements. In the retail forex market, leverage can be as much as 250:1. Higher leverage can be extremely risky, but because of round-the-clock trading and deep liquidity, foreign exchange brokers have been able to make high leverage an industry standard in order to make the movements meaningful for currency traders.

Extreme liquidity and the availability of high leverage have helped to spur the markets rapid growth and made it the ideal place for many traders. Positions can be opened and closed within minutes or can be held for months. Currency prices are based on objective considerations of supply and demand and cannot be manipulated easily because the size of the market does not allow even the largest players, such as central banks, to move prices at will.

The forex market provides plenty of opportunity for investors. However, in order to be successful, a currency trader has to understand the basics behind currency movements.

The foreign exchange market is the place where currencies are traded. Currencies are important to most people around the world, whether they realize it or not, because currencies need to be exchanged in order to conduct foreign trade and business. If you are living in the U.S. and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French 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 for traveling. A French tourist in Egypt cant pay in euros to see the pyramids because its not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate.

The need to exchange currencies is the primary reason why the forex market is the largest, most liquid financial market in the world. It dwarfs other markets in size, even the stock market, with an average traded value of around U.S. $2,000 billion per day.

One unique aspect of this international market is that there is no central marketplace for foreign exchange. Rather, currency trading is conducted electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney across almost every time zone. This means that when the trading day in the U.S. ends, the forex market begins anew in Tokyo and Hong Kong. As such, the forex market can be extremely active any time of the day, with price quotes changing constantly.

Spot Market and the Forwards and Futures Markets  

There are actually three ways that institutions, corporations and individuals trade forex: the spot market, the forwards market and the futures market. The forex trading in the spot market always has been the largest market because it is the underlying real 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. However, with the advent of electronic trading, the spot market has witnessed a huge surge in activity and now surpasses the futures market as the preferred trading market for individual investors and speculators. When people refer to the forex market, they usually are referring to the spot market. The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.

More specifically, 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 many things, including current interest rates, economic performance, sentiment towards ongoing political situations (both locally and internationally), as well as 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 bilateral transaction by which one party delivers an agreed-upon currency amount to the counter party 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.

Forwards and futures markets

Unlike the spot market, 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 Associationregulates 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 for 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.

When a currency is quoted, it is done in relation to another currency, so that the value of one is reflected through the value of another. Therefore, if you are trying to determine the exchange rate between the U.S. dollar (USD) and the Japanese yen (JPY), the forex quote would look like this:

USD/JYP = 119.50

This is referred to as a currency pair. The currency to the left of the slash is the base currency, while the currency on the right is called the quote or counter currency. The base currency (in this case, the U.S. dollar) is always equal to one unit (in this case, US$1), and the quoted currency (in this case, the Japanese yen) is what that one base unit is equivalent to in the other currency. The quote means that US$1 = 119.50 Japanese yen. In other words, US$1 can buy 119.50 Japanese yen. The forex quote includes the currency abbreviations for the currencies in question.

Direct Currency Quote vs. Indirect Currency Quote

There are two ways to quote a currency pair, either directly or indirectly. A direct currencyquote is simply a currency pair in which the domestic currency is the base currency; while an indirect quote, is a currency pair where the domestic currency is the quoted currency. So if you were looking at the Canadian dollar as the domestic currency and U.S. dollar as the foreign currency, a direct quote would be CAD/USD, while an indirect quote would be USD/CAD. The direct quote varies the foreign currency, and the quoted, or domestic currency, remains fixed at one unit. In the indirect quote, on the other hand, the domestic currency is variable and the foreign currency is fixed at one unit.

In the forex spot market, most currencies are traded against the U.S. dollar, and the U.S. dollar is frequently the base currency in the currency pair. In these cases, it is called a direct quote. This would apply to the above USD/JPY currency pair, which indicates that US$1 is equal to 119.50 Japanese yen.

When a currency quote is given without the U.S. dollar as one of its components, this is called a cross currency. The most common cross currency pairs are the EUR/GBP, EUR/CHF and EUR/JPY. These currency pairs expand the trading possibilities in the forex market, but it is important to note that they do not have as much of a following (for example, not as actively traded) as pairs that include the U.S. dollar, which also are called the majors.

As with most trading in the financial markets, when you are trading a currency pair there is a bid price(buy) and an ask price (sell). Again, these are in relation to the base currency. When buying a currency pair (going long), the ask price refers to the amount of quoted currency that has to be paid in order to buy one unit of the base currency, or how much the market will sell one unit of the base currency for in relation to the quoted currency.

The bid price is used when selling a currency pair (going short) and reflects how much of the quoted currency will be obtained when selling one unit of the base currency, or how much the market will pay for the quoted currency in relation to the base currency.

The difference between the bid price and the ask price is called a spread. If we were to look at the following quote: EUR/USD = 1.2500/03, the spread would be 0.0003 or 3 pips, also known as points. Although these movements may seem insignificant, even the smallest point change can result in thousands of dollars being made or lost due to leverage. Again, this is one of the reasons that speculators are so attracted to the forex market; even the tiniest price movement can result in huge profit.

The pip is the smallest amount a price can move in any currency quote. In the case of the U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese yen, one pip would be 0.01, because this currency is quoted to two decimal places. So, in a forex quote of USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies trade within a range of 100 to 150 pips a day. 

The Good and the Bad 

We already have mentioned that factors such as the size, volatility and global structure of the foreign exchange market have all contributed to its rapid success. Given the highly liquid nature of this market, investors are able to place extremely large trades without affecting any given exchange rate. These large positions are made available to forex traders because of the low margin requirements used by the majority of the industrys brokers. For example, it is possible for a trader to control a position of US$100,000 by putting down as little as US$1,000 up front and borrowing the remainder from his or her forex broker. This amount of leverage acts as a double-edged sword because investors can realize large gains when rates make a small favorable change, but they also run the risk of a massive loss when the rates move against them. Despite the foreign exchange risks, the amount of leverage available in the forex market is what makes it attractive for many speculators.

The currency market is also the only market that is truly open 24 hours a day with decent liquidity throughout the day. For traders who may have a day job or just a busy schedule, it is an optimal market to trade in. As you can see from the chart below, the major trading hubs are spread throughout many different time zones, eliminating the need to wait for an opening or closing bell. As the U.S.trading closes, other markets in the East are opening, making it possible to trade at any time during the day.

Opening A Forex Brokerage Account 

Trading forex is similar to the equity market because individuals interested in trading need to open up a trading account. Like the equity market, each forex account and the services it provides differ, so it is important that you find the right one. Below we will talk about some of the factors that should be considered when selecting a forex account.

Leverage is basically the ability to control large amounts of capital, using very little of your own capital; the higher the leverage, the higher the level of risk. The amount of leverage on an account differs depending on the account itself, but most use a factor of at least 50:1, with some being as high as 250:1. A leverage factor of 50:1 means that for every dollar you have in your account you control up to $50. For example, if a trader has $1,000 in his or her account, the broker will lend that person $50,000 to trade in the market. This leverage also makes your margin, or the amount you have to have in the account to trade a certain amount, very low. In equities, margin is usually at least 50%, while the leverage of 50:1 is equivalent to 2%.

Leverage is seen as a major benefit of forex trading, as it allows you to make large gains with a small investment. However, leverage can also be an extreme negative if a trade moves against you because your losses also are amplified by the leverage. With this kind of leverage, there is the real possibility that you can lose more than you invested although most firms have protective stops preventing an account from going negative. For this reason, it is vital that you remember this when opening an account and that when you determine your desired leverage you understand the risks involved.

Commissions and Fees  

Another major benefit of forex accounts is that trading within them is done on a commission-free basis. This is unlike equity accounts, in which you pay the broker a fee for each trade. The reason for this is that you are dealing directly with market makers and do not have to go through other parties like brokers.

This may sound too good to be true, but rest assured that market makers are still making money each time you trade. Remember the bid and ask from the previous section? Each time a trade is made, it is the market makers that capture the spread between these two. Therefore, if the bid/ask for a foreign currency is 1.5200/50, the market maker captures the difference (50 basis points).

If you are planning on opening a forex account, it is important to know that each firm has different spreads on foreign currency pairs traded through them. While they will often differ by only a few pips (0.0001), this can be meaningful if you trade a lot over time. So when opening an account make sure to find out the pip spread that it has on foreign currency pairs you are looking to trade.

There are a lot of differences between each forex firm and the accounts they offer, so it is important to review each before making a commitment. Each company will offer different levels of services and programs along with fees above and beyond actual trading costs. Also, due to the less regulated nature of the forex market, it is important to go with a reputable company.

Now that you know some important factors to be aware of when opening a forex account, we will take a look at what exactly you can trade within that account. The two main ways to trade in the foreign currency market is the simple buying and selling of currency pairs, where you go long one currency and short another. The second way is through the purchasing of derivatives that track the movements of a specific currency pair. Both of these techniques are highly similar to techniques in the equities market.The most common way is to simply buy and sell currency pairs, much in the same way most individuals buy and sell stocks. In this case, you are hoping the value of the pair itself changes in a favorable manner. If you go long a currency pair, you are hoping that the value of the pair increases. For example, lets say that you took a long position in the USD/CAD pair you will make money if the value of this pair goes up, and lose money if it falls. This pair rises when the U.S. dollar increases in value against the Canadian dollar, so it is a bet on the U.S. dollar.

The other option is to use derivative products, such as options and futures, to profit from changes in the value of currencies. If you buy an option on a currency pair, you are gaining the right to purchase a currency pair at a set rate before a set point in time. A futures contract, on the other hand, creates the obligation to buy the currency at a set point in time. Both of these trading techniques are usually only used by more advanced traders, but it is important to at least be familiar with them.

A trader looking to open a new position will likely use either a market order or a limit order. The incorporation of these order types remains the same as when they are used in the equity markets. A market order gives a forex trader the ability to obtain the currency at whatever exchange rate it is currently trading at in the market, while a limit order allows the trader to specify a certain entry price.