The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices.
The foreign exchange market is the world’s most traded market, with turnover of $5.1 trillion per day.
(April 2016 Interbank Forex Market average daily volume from Bank for International Settlements.)
Advantages of Forex Trading
The biggest financial market in the world is the biggest market because it provides some advantages to its participants. Some of the major advantages offered are as follows:
1. Flexibility
Forex exchange markets provide traders with a lot of flexibility. This is because there is no restriction on the amount of money that can be used for trading. Also, there is almost no regulation of the markets. This combined with the fact that the market operates on a 24 by 7 basis creates a very flexible scenario for traders. People with regular jobs can also indulge in Forex trading on the weekends or in the nights. However, they cannot do the same if they are trading in the stock or bond markets or their own countries! It is for this reason that Forex trading is the trading of choice for part time traders since it provides a flexible schedule with least interference in their full time jobs. Transparency: The Forex market is huge in size and operates across several time zones! Despite this, information regarding Forex markets is easily available. Also, no country or Central Bank has the ability to single handedly corner the market or rig prices for an extended period of time. Short term advantages may occur to some entities because of the time lag in passing information. However, this advantage cannot be sustained over time. The size of the Forex market also makes it fair and
2. Trading Options
Forex markets provide traders with a wide variety of trading options. Traders can trade in hundreds of currency pairs. They also have the choice of entering into spot trade or they could enter into a future agreement. Futures agreements are also available in different sizes and with different maturities to meet the needs of the Forex traders. Therefore, Forex market provides an option for every budget and every investor with a different appetite for risk taking.
Also, one needs to take into account the fact that Forex markets have a massive trading volume. More trading occurs in the Forex market than anywhere else in the world. It is for this reason that Forex provides unmatched liquidity to its traders who can enter and exit the market in a matter of seconds any time they feel like!
3. Transaction Costs
Forex market provides an environment with low transaction costs as compared to other markets. When compared on a percentage point basis, the transaction costs of trading in Forex are extremely low as compared to trading in other markets. This is primarily because Forex market is largely operated by dealers who provide a two way quote after reserving a spread for themselves to cover the risks. Pure play brokerage is very low in Forex markets.
4. Leverage
Forex markets provide the most leverage amongst all financial asset markets. The arrangements in the Forex markets provide investors to lever their original investment by as many as 10 to 200 times and trade in the market! This magnifies both profits and gains. Therefore, even though the movements in the Forex market are usually small, traders end up gaining or losing a significant amount of money thanks to leverage!
Basic Forex Terminology
Before you start trading forex, it’s important to familiarise yourself with the basic forex terminology. There is plenty to learn, but below is a quick look at some of the most common terms used by traders.
Currency pair → forex is traded in currency pairs: one currency is bought, the other is sold. Together they make up the exchange rate.
Exchange rate → the rate of which one country’s currency can be exchanged for another currency
Base currency → the currency that comes first in the currency pair (e.g. in GBPUSD the GBP is the base currency)
Quote currency → the second currency quoted in a currency pair (e.g. in GBPUSD the quote currency is USD)
Long position (buy) → a long position refers to the purchase of an asset, with the expectation that its market value is set to rise
Short position (sell) → a short position refers to the sale of an asset, with the expectation that its market value is set to fall
Bid price → the market price for the sale of an asset
Ask price → the market price for purchasing an asset
Spread → the difference between the “bid” and “ask” prices (the selling price and the purchase price).
Appreciation → an increase in the value of an exchange rate
Depreciation/devaluation → a decrease in the value of an exchange rate
Gapping → An opening price significantly above or below the previous day’s close with no trading activity in between. This means that a limit or stop order could be filled at a price different from the desired order price.
Pips → a pip stands for “percentage in point”, and is the smallest price movement any exchange rate can make. It measures the amount of change in the exchange rate for a currency pair in the forex market. A pip is the fourth and final number after the decimal point (with the exception of Japanese yen-based currency pairs, which are displayed to only two decimal points). Pips are the means by which market profits and losses are quantified
Lot → forex is traded in lots. A standard lot is equivalent to 100,000 units of the base currency. This is $100,000 if you were trading in US dollars. A mini lot has 10,000 and a micro lot has 1,000 units.
Leverage → Leverage is a way for an investor to increase their trading power and manage a greater position on the market with a nominal investment. An online broker may offer leveraged trading for up to 30 times the value of a trader’s initial investment.
Margin → the minimum deposit needed to maintain an open position (e.g. with an open position of $150,000 and leverage of 30, the required margin is $5,000).
Risk management → involves the use of strategies in order to help control or reduce financial risk. An example is a stop-loss order which is used to potentially minimise losses on a trade.
Stop loss → a stop loss order is a risk management tool allowing a position to be closed, once it reaches a specific pre-set price. This can protect against further losses on an open position if prices continue in an unfavourable direction for the investor. Please note, that placing a normal stop loss order does not guarantee you will be filled at that particular market price due to slippage.
Take profit → a take profit order is a risk management tool allowing a position to be closed automatically, once it reaches a specific pre-set profit goal. This can protect against profits being lost in an unanticipated reversal of price direction before the investor can close the position.
Profit/Loss → the proceeds of a trade, which are from realised (closed) trade positions.