Financial markets largely depend on the economic conditions in the world. A rather enormous global marketplace is the Forex market. The word forex practically means Foreign Exchange. It involves the exchange of global currencies worldwide and it has trillions of dollars in volume every day.
This article covers the essentials of the forex market. It is important that you know what the forex market entails before embarking on forex trading.
What is the Forex Market?
To put it simply, the forex market is the market where foreign currencies are exchanged. There are a plethora of reasons why companies or individuals engage in forex trading. The most obvious reason would be that someone may need to use foreign currencies. To illustrate, if you reside in the US and want to purchase goods or services in Europe, then you can exchange USD with EUR before engaging in the transaction. Hence, exchanging foreign currencies is of much importance, especially now with increased globalization in the world.
While many people associate the forex market with centralized exchanges, forex trading is conducted in over-the-counter (OTC) marketplaces. This means that there is a large network of computers that are involved in currency transactions.
The forex market has nine major financial centers: Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich. The market is open five and a half days a week for each financial center, depending on their respective time zones. With that said, when the market opens in a financial center, it may open in another center with a different timezone. But how did the forex market emerge?
History of Forex
Practically speaking, the forex market is as old as currencies, meaning that people were always engaged in currency trading throughout the last centuries. But, the term forex market was not as sophisticated and developed as today. The internet gave rise to the advancement of many industries, including the financial markets. Because of the internet, the forex market is now globally used, and it has created vast opportunities for all types of traders, businesses, etc.
It was the 20th century that saw an increase in the volume of foreign exchange trading. The Bretton Woods agreement, which saw gold being the standard backing the USD, came to an end with President Nixon. After that, currencies were able to float with one another on a much larger scale.
This led to various banks, whether they were commercial or investment banks, could now trade foreign exchanges to protect their money from market fluctuations, but also to create profitable opportunities for themselves and their clients. Not only that you could earn from changes in the exchange rate, but you could also create profitable opportunities from changes in the interest rates among countries with different currencies (i.e. Japan with JPY and the UK with GBP in pre-2008) through a strategy known as carry trading.
Slowly after that, not only banks and institutional investors, but normal people started taking advantage and learning more about financial markets. Today, the forex market is now one of the biggest financial markets in the world, where trillions of dollars worth of currencies are exchanged on a daily basis.
Forex Market Features
As suggested, the FX market is not controlled by centralized institutions or exchanges. With no buildings or headquarters that control it, each participant plays an equal role in the market. However, OTC markets are dominated by large firms due to the enormous size of currencies that they exchange, either for hedging purposes or speculation.
While technical indicators could play a role in how these firms strategize their trades, forex trading largely depends on the economic state of the world and the countries involved. A more recent illustration would be Russia’s ruble devaluation, which came as a result of the sanctions that the EU and the US imposed. The latter was a consequence of Russia’s invasion attempt in Ukraine.
Besides the fundamental factors that affect forex trading, the overall market sentiment and the motives behind large key players create speculative opportunities for forex traders.
With that said, forex trading could be done on the spot market, forwards market, futures market, and the options market (beyond the scope of this article).
EUR/USD Pair in the 1-Week Chart. Source: Trading View
Spot Market
The spot market is one of the most used markets in forex. The name itself describes the nature of the trades that occur on the spot market. They are on the spot, spontaneous, and currencies are exchanged at their current rates.
Spot trades are bilateral and are the conventional agreement between a buyer and the seller. The rates are purely determined by supply and demand factors. However, while spot trading is done on the spot and is supposed to occur immediately, spot trades could take up to two business days until they are settled. Once a deal is finalized, it is known as a spot deal.
Forwards & Futures Market
Different from the spot market, forwards and futures markets do not include trades that occur on the spot. Instead, they are agreements between parties for buying or selling a certain currency at a later date and at an agreed price. The main difference between forwards and futures is that forwards trade in the OTC markets, while futures trade on centralized exchanges.
Both futures and forwards are agreements that are exercised at maturity, and the profit between the parties involved in the trade is a zero-sum game; one loses while the other profits or vice versa.
Since the futures market is not traded in the OTC market, they are regulated by large associations. In the US, National Futures Association (NFA) regulates the futures market.
Besides forwards and futures, investors can also use options in the forex market. Different from the former, options give you the right to buy or sell currencies, but not the obligation.
Forex Market Use Cases
The forex market has been used for a variety of reasons. Typically, besides arbitrage opportunities that appear momentarily in the market, forex is used for hedging or speculation.
Hedging
To put it simply, hedging using forex means minimizing the risk of huge rate fluctuations in the spot market. The main idea is that traders use forwards to lock in the price or the rate that they want to exchange currencies so that even if the rate changes in the future, the buyer/seller will complete the deal at the agreed price.
Looking at the business side of the trade, hedging could then mean that you would be buying at a higher price than if the spot rate is lower at maturity, meaning that profit may shrink. At the same time, if the rate/price in the spot market increases and you have an agreement to trade at a lower rate, you could have more profit. The same logic applies to both commodities and currencies. Nonetheless, you still lock your desired rate, which comes after thorough analyses that you do.
You could use both the forwards market and the futures market for hedging in forex. While futures are more regulated, there is less liquidity when compared to OTC markets for forward contracts.
Speculation
On the other hand, forex markets are largely used for speculation. If there is a feeling in the market that a certain currency may depreciate (such as the Russian Ruble after the war started), traders could short the RUB/USD pair and profit from the consequences. Speculation is largely determined by market sentiment and emotion. Saying that a currency may depreciate is essentially saying that its pair may appreciate. Hence, this creates vast trading opportunities for speculators.
Frequently Asked Questions (FAQ)
Are forex markets volatile?
Compared to other financial markets, forex markets are less volatile. Because of that, even though forex markets are volatile, it is relatively more stable compared to other financial markets, other things equal.
How does the forex market work?
The main idea behind forex markets is to buy one currency by selling another currency. Hence, forex trading involves a pair of two different currencies.
Is forex a gamble?
Even though forex trading is relatively unpredictable, it is not considered gambling as you can combine fundamental and technical analyses to predict what may happen with a certain pair.
Can you get rich trading forex?
Yes, you can get rich trading in forex. However, you should be highly experienced and do thorough research before you start trading in forex markets.
Who controls the forex market?
Trading in forex markets is done in OTC (over-the-counter) markets, meaning that it is decentralized. A network of computers controls the forex market together. Using futures in forex, however, entails a centralized exchange that overlooks the future agreements.
Takeaways
- The forex market is the market where foreign currencies are exchanged.
- Foreign exchange has been present throughout history, but it gained a lot of attention with the development of technology by the end of the 20th century.
- The FX market is not controlled by centralized institutions or exchanges.
- Forex trading could be done on the spot market, forwards market, futures market, and the options market
- Forex markets could be used for hedging or speculation, and sometimes even arbitrage opportunities.
