What is Forex Trading?

What is Forex Trading?

What Is Forex?
The
foreign exchange market is the "place" where currencies are traded.
Currencies are important to most people around the world, whether they
realize it or not, because currencies need to be exchanged in order to
conduct foreign trade and business. If you are living in the U.S. and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French for the cheese in euros (EUR). This means that the U.S.
importer would have to exchange the equivalent value of U.S. dollars
(USD) into euros. The same goes for traveling. A French tourist in Egypt
can't pay in euros to see the pyramids because it's not the locally
accepted currency. As such, the tourist has to exchange the euros for
the local currency, in this case the Egyptian pound, at the current
exchange rate.

The need to exchange currencies is the
primary reason why the forex market is the largest, most liquid
financial market in the world. It dwarfs other markets in size, even
the stock market, with an average traded value of around U.S. $2,000
billion per day. (The total volume changes all the time, but as of
April 2004, the Bank for International Settlements (BIS) reported that the forex market traded U.S. $1,900 billion per day.)

One
unique aspect of this international market is that there is no central
marketplace for foreign exchange. Rather, currency trading is conducted
electronically over-the-counter
(OTC), which means that all transactions occur via computer networks
between traders around the world, rather than on one centralized
exchange. The market is open 24 hours a day, five and a half days a
week, and currencies are traded worldwide in the major financial
centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong,
Singapore, Paris and Sydney - across almost every time zone. This means
that when the trading day in the U.S. ends, the forex market begins
anew in Tokyo and Hong Kong. As such, the forex market can be extremely active any time of the day, with price quotes changing constantly.

Spot Market and the Forwards and Futures Markets
There are actually three ways that institutions, corporations and individuals trade forex: the spot market, the forwards market and the futures market.
The forex trading in the spot market always has been the largest market
because it is the "underlying" real asset that the forwards and futures
markets are based on. In the past, the futures market was the most
popular venue for traders because it was available to individual
investors for a longer period of time. However, with the advent of
electronic trading, the spot market has witnessed a huge surge in
activity and now surpasses the futures market as the preferred trading
market for individual investors and speculators. When people refer to
the forex market, they usually are referring to the spot market. The
forwards and futures markets tend to be more popular with companies
that need to hedge their foreign exchange risks out to a specific date
in the future.

What is the spot market?
More
specifically, the spot market is where currencies are bought and sold
according to the current price. That price, determined by supply and
demand, is a reflection of many things, including current interest rates,
economic performance, sentiment towards ongoing political situations
(both locally and internationally), as well as the perception of the
future performance of one currency against another. When a deal is
finalized, this is known as a "spot deal". It is a bilateral
transaction by which one party delivers an agreed-upon currency amount
to the counter party and receives a specified amount of another
currency at the agreed-upon exchange rate value. After a position
is closed, the settlement is in cash. Although the spot market is
commonly known as one that deals with transactions in the present
(rather than the future), these trades actually take two days for
settlement.

What are the forwards and futures markets?
Unlike
the spot market, the forwards and futures markets do not trade actual
currencies. Instead they deal in contracts that represent claims to a
certain currency type, a specific price per unit and a future date for
settlement.

In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves.

In the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange. In the U.S., the National Futures Association
regulates the futures market. Futures contracts have specific details,
including the number of units being traded, delivery and settlement
dates, and minimum price increments that cannot be customized. The
exchange acts as a counterpart to the trader, providing clearance and
settlement.

Both types of contracts are binding and are
typically settled for cash for the exchange in question upon expiry,
although contracts can also be bought and sold before they expire. The
forwards and futures markets can offer protection against risk when
trading currencies. Usually, big international corporations use these
markets in order to hedge against future exchange rate fluctuations,
but speculators take part in these markets as well. (For a more in-depth introduction to futures, see Futures Fundamentals.)

Note
that you'll see the terms: FX, forex, foreign-exchange market and
currency market. These terms are synonymous and all refer to the forex
market.


Next: Forex Tutorial: Reading a Forex Quote and Understanding the Jargon


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