Tuesday, October 9, 2007

What is the Foreign Exchange Market

Foreign exchange, Forex or FX as it is know is the Planets oldest and largest financial market. It is the place where one countrys currency is exchanged for that of another. On average $2 Trillion exchanges hands every day in the form of currency transactions. This volume makes equity markets look minuscule by comparison. For example, the daily market for equities is $50 billion and the average daily value of futures contracts traded is roughly $30 billion.

Trading Hours
Foreign exchange is a 24-hours-a-day, interbank (or OTC) market. Since currencies are traded 24-hours-a-day there is no central exchange like you will find with the Worlds major stock markets. Proceedings begin in the financial centres of the Far East after the weekend and close in the US on a Friday evening. There are three main financial centres, each of which has specific opening and closing times. Tokyo: Open 19:00, close 04:00
London: Open 03:00, close 12:00
New York: Open 08:00, close 17:00
All times EST.

Who Participates?
The arrival and the growth of the Internet has allowed individual speculators to enter a market that was once dominated by large investment banks, multinational corporations, currency dealers and international money. There are currently countless on-line brokerage firms who offer access to the currency market. The advantages of this competitive market place are low spreads and very often, no commission on your trades.

Why Participate?
The main reasons for participation in the foreign exchange market are:

Actual currency exchange: From the small scale money exchanges made when you want to go on holiday to a foreign country to large multinationals changing profits made abroad into their domestic currency.
Hedging: Large multinationals often hedge against unwanted currency fluctuations that can harm profit figures.
Speculation for profit: It is estimated that 95% of foreign exchange participation falls under this category. Large multinationals, investment banks and individuals are all active at this level.

How does it work?
Currencies are traded in crosses and pairs such as EURUSD, GBPUSD and USDJPY. This means that every time you trade a currency pair you are simultaneously buying one currency and selling another. For example, if you were to buy the EURUSD at 1.2700 then you are buying the Euro and selling the Dollar, or buying the Euro against the Dollar.

The most commonly traded currencies are those of the Worlds largest economies. It is estimated that 85% of currency trading takes place involving the U.S. Dollar, the Euro, the Japanese Yen, the British Pound Sterling, the Swiss Franc, the Canadian Dollar, the Australian Dollar and the New Zealand Dollar. These currencies are popular because of the stable political environments in their respective countries as well as respected central banks and sound monetary policy.

USD: US Dollar
EUR: Euro
JPY: Japanese Yen
GBP: Great British Pound
CHF: Swiss Franc
CAD: Canadian Dollar
AUD: Australian Dollar
NZD: New Zealand Dollar

Currency rates are displayed as follows:

EUR/USD 1.2723/ 1.2725
EURUSD 1.2723/ 1.2725

A quote is read as follows: For our EURUSD example earlier of 1.2700, 1 Euro (the first currency in the quote) is worth 1.2700 U.S. Dollars. The first currency is known as the base currency. It is always the case that the base currency is assumed to have the value of 1 unit. So if the EURUSD is currently quoted at 1.2700, 1 Euro is worth 1.8870 Dollars. This means it will take 1.8870 Dollars to buy 1 unit of the Euro.

Therefore if the quoted value is higher than 1, it means that one unit of the base currency has a higher value than one unit of the second currency in the quote (quote currency, counter currency or terms currency). This is not always the case; for example, the AUDUSD quote currently reads 0.7490. This means that 1 Australian Dollar currently has a market value of slightly less than 0.75 US Dollars (or 75 cents).

You will also notice that a quote is listed as 1.2700/ 1.2702. The difference between the first price (bid) and the second price (offer) is known as the spread.

Foreign exchange currency is traded in something known as lots. There are three type of lots, standard or maxi (100 000 units of currency), mini (10 000 units of currency) or micro (1 000 units of currency). You are free to trade in as many multiples of these lot sizes as your account balance will allow. However, not all brokerage firms offer all of the different lot sizes and you should check before opening your account. In each case you are trading in units of base currency.

Advantages of currency speculation
The fact that the Forex market is so large is significant for the following reasons:

All of this money changing hands creates massive liquidity (the degree to which a currency can be bought or sold without affecting its price). Therefore as your account grows you have no worries about ever moving the market or having an order only partially filled (however the reliability of your broker may have something to say about this). In effect you can remain completely anonymous within the market place.
The fact that the foreign exchange market is so large is partly due to the fact that big banks (both commercial and federal) are active participants. By following their money you can, in theory, eliminate a lot of risk from your trading.
As we have already established, there are smaller costs associated with Forex trading when compared to trading stocks or futures. Forex brokers also offer a higher rate of leverage. Typically this figure stands at 1:100, which means that you can command a $100 000 position with a balance of $1 000.

David Thorpe is a senior contributor for http://www.passion-trading.munbuns.com a free educational resource centre for traders and investors. The site has a dedicated forex trading and currency trading portal and its goal is to stimulate the minds of its users, enabling them to achieve a greater understanding the forex market, thus helping them to become more profitable.