What Is Forex?

Have you ever thought of buying or selling money? It sounds kind of funny, but there is a way for you to do just that in the Forex market. Forex is a nickname for what is more formally known as the foreign exchange market.

The foreign exchange market is the largest financial market in the world. It is estimated that somewhere between 2 and 3 trillion dollars worth of currency is exchanged every day! To put this in perspective, the New York Stock Exchange (NYSE) averages roughly $50 billion dollars in volume per day. This means that the Forex market is roughly 50 times the size of the NYSE!

The Forex market is a pure market and free from any external control. It is considered a perfect market since the price of a currency is based solely on the supply and demand of a particular currency.

So, what exactly is exchanged on the foreign exchange market? Cold, hard cash. Well, more accurately bits of data that represent tangible currency, but the essence of Forex is trading one country’s currency against another. Let’s explore this further.

Forex Fundamentals

Currencies are traded in the Forex market relative to other countries’ currencies. This unique interaction results in currency being exchanged in pairs. For example, the Euro can be traded against the Dollar. Therefore you can buy a currency pair of EUR/USD (more on that later), which represents how many US Dollars one Euro is worth.

Forex markets do not have a physical site, meaning there isn’t a big building on Wall Street where a bunch of people yell and waive dollar bills in an attempt to get other people to buy them.

Instead, the Forex Market is considered an Over-the-Counter (OTC) market as it is run entirely through a continuous network of banks and brokers. This does not mean you purchase currency at your local drugstore, it just means that there isn’t a centralized location for exchange like many of the famous commodities markets.

The Forex markets involve a web of currencies from around the world, and currencies fluctuate in value frequently. A Forex trader will try to make a profit in the foreign exchange market by taking advantage of these market movements.

Quick History Lesson

Currency trading was historically based on a gold standard. This means that currencies were valued in terms of gold, rather than in terms of other currencies. The original gold exchange standard provided stability for currencies, but had a weakness of boom or bust patterns.

A historic accord was struck in 1944 at the United Nations Monetary and Financial Conference, commonly referred to as the Bretton Woods Agreement – famously named after the great Tiger Woods who presided over the conference. Just kidding, it was actually named after the resort where the conference took place – just checking to make sure you’re still awake and paying attention.

In the aftermath of the Great Depression and World War II, the Bretton Woods Agreement was designed to bring more economic security to the global marketplace and to ensure world peace.

The Bretton Woods Agreement evolved currency exchange in several ways, one of the changes was for the U.S. dollar to take the place of gold since it was designated as the reserve currency for all nations that signed the agreement. Ultimately, the dollar was not able to defend the fixed rate established by the Bretton Woods agreement and the decision was made to float the dollar.

The new floating currency system (established in 1971 by the Smithsonian Agreement) set the stage for today’s currency market. Since the prices of currencies were no longer tied to a standard such as gold or the dollar, one country’s currency could now be traded in relative terms against another country’s currency.

In recent years, the widespread use of the internet and personal computers-which began in the 1990s-has taken currency trading to a whole new level. It is now possible for almost anyone to open an account and participate in the Forex Market.

Major Currencies

There are hundreds of currencies throughout the world (most of which are tradable) but there are several key currencies which account for the majority of Forex volume. The most popular currencies are referred to as the major currencies. The majors are as follows:

  • Dollar (USD) – United States
  • Euro (EUR) – European Union Members
  • Yen (JPY) – Japan
  • Pound (GBP) – Great Britain
  • Franc (CHF) – Switzerland
  • Dollar (CAD) – Canada
  • Dollar (AUD) – Australia
  • Dollar (NZD) – New Zealand

Currency is always discussed in Forex with 3 letters (see acronyms in parentheses above). The first two letters designate which country the currency is from and the last letter identifies the name of the country’s currency. For example, the Australian currency is shown as “AUD” with “AU” signifying Australia and the “D” representing Australia’s currency of the dollar.

Types of Forex Markets

There are three potential markets for a Forex investor to trade currency. These markets are: the spot market, the forward market, and the futures market. The spot market is currently the largest market for exchange, however in the past the futures market was popular since investors could hold currency for long periods of time.

The spot market is where currencies are bought and sold according to their current price. A particular currency is exchanged for another currency based on the currently agreed upon exchange rate. These exchanges are typically facilitated by either a broker or a bank.

In the futures market, contracts are bought and sold based upon a standard size and settlement date on public commodities markets. Investors agree to buy or sell a fixed amount of a specific currency at a fixed exchange rate on a fixed date in the future.

Forwards markets are similar to futures markets; however the terms of a contract between two parties are determined by solely by the parties involved and don’t have to be based on a public commodities market.

Forwards and futures markets are often used to hedge against trades made in the spot market. Some investors will specialize in one type of market while others will try and use all of them to their advantage.

Open 24/7

Forex markets are the 7-Elevens of the financial world – not because they offer investors overpriced snack foods and frozen beverages, but because they are always open. You can pretty much trade currency any time of the day.

Transactions are conducted around the globe via telecommunications 24 hours a day starting on Mondays at 00:00 Greenwich Meantime (GMT) to 10:00 PM GMT on Friday. You are almost always guaranteed to find a broker who is willing to help you conduct a currency exchange in every time zone during the entire week.

This 24 hour availability is possible since there is overlap between the major currency hubs around the world throughout a day. The typical Forex day begins in Tokyo at 00:00 GMT (7:00 PM EST) and ends with the New York close at 22:00 GMT (5:00 PM EST).

Pros vs. Cons

As with any type of financial market, Forex offers several advantages along with a few disadvantages. We’ve made the following lists to illustrate some of the Pros and Cons to Forex trading:

Pros

  • The market is open 24 hours a day during the work week.
  • A trader can maintain an open position for any period of time.
  • No commissions, exchange fees, government fees, brokerage fees, etc. Brokers receive payment with the difference between buying and selling prices (called the bid-ask spread).
  • The ability to leverage investments. Brokers allow investors to control a larger amount of money than their principal investment which results in larger profit margins.
  • Many brokers allow trial or demo accounts, so you can practice trading before risking any of your own money.
  • Large number of participants and huge volume of transactions which result in less market influence/manipulation by traders.
  • Superior liquidity and speed. Forex transactions are conducted within seconds online.

Cons

  • The ability to quickly lose money. Currency markets pose substantial risk for unsophisticated investors and fluctuations in exchange rates can result in fast losses, magnified by leverage.
  • Forex scams. There are many unscrupulous people on the internet who try to scam people out of their money with Forex trading; be sure to thoroughly research all brokers before opening a Forex account.

The Choice Is Yours

Forex trading is an exciting and fast-growing marketplace. Exciting opportunities exist as Forex trading continues to evolve and grow.

If you are interested in learning more about Forex, we recommend that you continue to read our introductory articles and open a ‘Demo’account with a reputable Forex broker. You can then find out for yourself if Forex is for you.

Next: How You Can Make Money by Trading Forex