Forex Trading

Forex trading, which is short for foreign exchange trading, is the act of swapping one sovereign currency (such as the U.S. dollar) for another (such as the Japanese yen). The process of trading foreign currency is conducted for many reasons, but it is most commonly done to facilitate international trade, tourism and capital flows and for investors to engage in speculation or hedging strategies to offset the risks associated with investing.

Generally, any currency can be exchanged for another, and when two currencies are quoted for an exchange, they are referred to as a currency pair. The quoting process results in a forex rate — an expression of the value of the first currency in relation to the second.

Suppose you operate a small business in the United States and want to buy $10,000.00 of computing equipment from a company in South Korea. In this scenario, you must buy the equipment with South Korean won (SKW), not United States dollars (USD). This means you must exchange $10,000 into the equivalent amount of won to execute the transaction.

In this example, if the current exchange rate for 1.00 USD were 1,260.00 SKW, you would need to exchange $10,000.00 for 12,600,000.00 SKW to facilitate the deal.

With an estimated daily trading volume of more than $6 trillion and nearly 14 million total traders, the foreign exchange market is the largest, most liquid market in the financial world. Operating on a decentralized basis 24 hours a day, five-and-a-half days a week, the market consists of a massive electronic network of banks, brokers and traders. The foreign exchange market covers a wide range of currencies, including the United States dollar, the British pound sterling, the Canadian dollar, the Japanese yen and the eurozone euro, to name a few.

Note: The majority of forex trading is conducted virtually, but many physical exchange points do exist. They are most common in densely populated areas of developed and emerging markets.

As the largest and most liquid financial market in the world, the forex market is a vital venue for institutional and retail investors who are focused on generating wealth and hedging currency risk. That said, the forex market is complicated, with many pros and cons. The chart below highlights the most important considerations about forex trading.

The forex market is influenced by many macroeconomic factors and is highly sensitive to technical imbalances of supply and demand. As a result, currencies, especially the currencies of emerging markets, can demonstrate a high degree of volatility.

If you are considering getting into forex trading, the first step is to educate yourself on the market and its operations. You should begin with a basic understanding of key forex terminology. To accelerate your education, check out one of the many online courses designed to teach beginners the basics of forex trading.

Next, you need to open a brokerage account. Opening an account is relatively simple and can be done online in less than 15 minutes. Funding a new account can take a bit longer, but you can be ready to trade in a matter of days. One important consideration when opening an account is the lot size (the standardized size of a trade) at which you intend to trade. Basically, there are three types of forex accounts, which can be summarized as follows.

1. A standard forex account allows you to trade 100,000 units of a currency in one lot.
2. A mini forex account allows you to trade 10,000 units of a currency in one lot.
3. A micro forex account allows you to trade 1,000 units of a currency in one lot.

For beginners, the micro account is usually the best option, given its relatively low lot size.

Once you’ve established a brokerage account, you need to develop a trading strategy. This involves establishing some qualitative principles and quantitative rules to guide your day-to-day behavior. The strategy should be based on your financial position and your tolerance for risk. This means looking at your personal finance situation and identifying the amount of cash you are willing and able to risk, the extent to which you intend to utilize financial leverage and the points at which you are committed to realizing your gains and losses.

Ultimately, a forex trade is characterized as either a long trade or a short trade. With a long trade, there is an expectation that a purchased currency will increase in price, which will generate an economic gain for the buyer.

With a short trade, a sold currency is expected to experience a price decline, which generates a gain for the seller. Essentially, a short trade involves the following steps:

Currencies can be traded in three venues: the spot market, the forward market and the futures market. The spot market is the largest of the three. It’s where currencies are bought and sold immediately, based on their current, on-the-spot prices.

The forward and futures markets consist of contracts that are based on the spot market. Because the buy- and sell-side values of the contracts are derived from the spot market, the forward and futures markets are known as derivatives.

A forward contract is a private, customized agreement between two parties to exchange currencies at a future date at a predetermined price. A futures contract is a standardized agreement between two parties to exchange currencies at a future date at a predetermined price.

Forward contracts are traded over-the-counter, while futures contracts are traded on exchanges. Forwards are largely unregulated, uniquely structured and subject to a high degree of counterparty credit risk. Conversely, futures are highly regulated, at least in developed nations, standardized (in terms of their position size, delivery and settlement dates) and protected from counterparty credit risk.

Note: The spot market reflects the exchange rate at which a foreign currency can be bought or sold today. The forward and futures markets, which are often used to hedge foreign currency risk, reflect the exchange rate at which a foreign currency can be bought or sold in the future.