Résumé
Forex is the world's largest market by trading volume and liquidity. Brokers, companies, governments and other economic agents trade currencies and forex derivatives to enable international trade.
Traders also use the market for speculative purposes. There are various arbitrage opportunities with exchange rates and interest rates, making it a popular market to trade in large volume or with leverage.
The forex market consists of fiat currency pairs and their respective markets. These pairs are usually bought and sold in sets. A standard lot contains 100,000 units of the base currency of the pair, but other smaller sizes are available, up to 100 units.
Traders commonly use leverage to increase the amounts they can invest with their capital. You can also offset risk by using Futures contracts and swaps to trade a currency pair at a specific price in the future. Combining these two instruments with other trading strategies and products creates a variety of investment opportunities for forex traders.
Introduction
Even if you don't trade currencies yourself, the international currency market often plays an important role in your daily life. While the effects of a decline in the stock market are not always so obvious, a change in the value of your currency can affect the price of goods and services. If you have been abroad, you have also probably had to exchange your currency and pay a rate that depends on current forex rates.
Forex is a unique asset class that differs from stocks, commodities and bonds. When we look at what makes it different, it's easy to see why there is a need for such a global and large-volume forex market.
What is forex ?
Forex or FX trading (from foreign exchange) is the buying and selling of sovereign currencies and other forex products. When exchanging currencies at a bank or currency exchange, the rates you find are determined directly by what is happening in the forex market.
Exchange rate movements are based on a combination of economic conditions, world events, interest rates, politics and other factors. Therefore, forex is highly liquid and has the largest trading volume compared to other financial markets.
The forex market includes two main activities: trading to facilitate transactions in the economy and speculative trading. For businesses and other entities operating in international markets, buying and selling foreign currencies is a necessity. Collecting your funds at home or purchasing goods abroad is a key use case in the forex market.
Speculators are the other face of FX trading. Short-term, high-volume trading, which takes advantage of very small fluctuations in currency prices, is common. Forex is a market full of arbitrage opportunities for speculators, which partly explains the vast volume in this market.
Traders also look to make money with long-term opportunities such as fluctuating interest rates. Economic events and geopolitics also cause significant long-term fluctuations in these markets. By buying a currency now and holding it, you can make long-term gains. You can also agree exchange rates years in advance with Futures contracts in a bet with or against the market.
Forex trading can be difficult for small users. Without borrowing or having a lot of initial capital, arbitrage trading and short-term trading become much more difficult. This aspect has led to banks and international financial institutions providing most of the volume we see in the foreign exchange market today.
What is a forex pair?
At the most basic level, the forex market contains currency pairs describing the relative price between them. If you have ever traded cryptocurrencies, you know a little about how the forex market works. The first currency listed in a pair is the base currency. The second is the currency being traded or quoted. We express the quote currency as a value linked to a single unit of the base currency.
GBP/USD shows the price of £1 in USD. This ratio is stated as a number, such as 1.3809, indicating that £1 is worth $1.3809. The GBP/USD pair is one of the most frequently traded pairs and is known as the cable. This nickname comes from a 19th century transatlantic cable which relayed this rate between the London and New York stock exchanges.
When it comes to forex trading, there are many liquid markets present. Some of the pairs with the highest trading volume include USD/JPY, GB/USD, USD/CHF, and EUR/USD. These pairs are known as the "majors" and include the US dollar, Japanese yen, British pound sterling, Swiss franc and euro.
Why do people trade forex?
The forex market is not just about speculation. Banks, businesses and other parties that need access to foreign liquidity participate in foreign exchange trading to facilitate international transactions. Companies also agree in advance on exchange rates to hedge. Another use case is for governments to build reserves and achieve economic goals, including maintaining currency value or boosting imports/exports.
For individual traders, there are also attractive features in the forex market:
Leverage allows even small traders to invest with larger amounts of capital than they have access to in equity.
Entry costs are low because it is possible to purchase small amounts of currency. Buying a stock on the stock market can cost you thousands of dollars, while you can enter the forex market for $100.
You can trade at almost any time, making forex suitable for any schedule.
There is high liquidity in the market, as well as a low Bid-Ask spread.
Options and futures are standard products. Shorting the market is possible for traders who don't just want to buy and sell spot at the current market price.
Where do people trade forex?
Unlike stocks that trade primarily on centralized exchanges like the NYSE or NASDAQ, currency trading occurs in hubs around the world. Participants can deal directly with each other through the over-the-counter (OTC) market or use a huge network of banks and brokers in the interbank market.
Supervising this international trade can be complicated due to the different regulations of each currency. While many jurisdictions have agencies that oversee domestic market trading, their international reach is limited. Although they may need to acquire a license or go through an accredited broker for foreign exchange trading, this does not prevent traders from simply using other, less regulated markets for their activities.
Four major areas have the highest volume of currency trading: New York, London, Tokyo and Sydney. As the FX market has no central location, you should be able to find a broker who can help you trade currencies worldwide.
There are a wide variety of options available for online brokerage services that are generally free. You won't pay a direct commission, but currency brokers maintain a spread between the price they quote and the actual market price. If you're just starting out, choose a broker that allows you to trade micro lots. We'll cover this further, but this is by far the most accessible way for you to start trading forex.
What makes forex trading unique?
Forex has many aspects that make it different from other financial markets:
It offers considerable geographic coverage. 180 foreign currencies are recognized worldwide, creating markets for them in almost every country.
It is extremely liquid and has massive trading volume.
Its market prices are affected by many macroeconomic factors. This includes politics, economic conditions, speculation, remittances, etc.
It is open for trading almost 24 hours a day and five days a week. Since the market is not completely centralized, an exchange or broker is almost always open for you. Markets are closed on weekends, but it is still possible to trade after hours on some platforms.
Its profit margins can be low unless you trade with significant volume. Small differences in the exchange rate can be made profitable through a large trade.
Comment les gens tradent-ils sur le forex ?
There are several forex choices that individual traders can opt for. The easiest way is to buy a currency on the Spot Market and hold it. For example, you buy EUR with the USD/EUR pair. If the exchange currency appreciates, you can sell it for your base currency and make a profit.
You can also use leverage to increase the amount of usable capital. In this case, you can trade using borrowed funds as long as you are able to cover unrealized losses. You can also consider Forex options, which allow you to buy or sell a pair at a set price and on a specific date. Futures contracts are also popular, requiring you to enter into a transaction at an agreed price at a future date.
One of the exciting aspects of forex trading is the opportunity to make a profit through interest rate differences. Central banks around the world have set different interest rates that provide investment opportunities for forex traders. By exchanging your cash and depositing it in a foreign bank you can earn more interest than in your country.
However, there are additional costs, including transfer fees, bank fees and different tax regimes. You need to consider all possible additional costs to make your strategies work. Arbitrage opportunities and winnings are often minimal, so your margins will be narrow. Unexpected fees can wipe out the entire expected winnings.
What is a pdb?
A pdb (basis point) is the smallest possible increment for a forex pair. If we look at GBP/USD again:
An upward or downward movement of 0.0001 would be the minimum step (1 bps). However, not all currencies trade to four decimal places. Any pair incorporating the Japanese Yen as a quote normally has a PWB of 0.01 due to the currency's lack of decimalization.
Pipettes
Some brokers and exchanges deviate from the norm and offer pairs that extend the number of decimal places. GBP/USD, for example, will move to five decimal places rather than four. USD/JPY is usually two decimal places, but can go up to three. This extra decimal place is called a pipette.
What is a lot in Forex trading?
In Forex trading, currencies are bought and sold in specific quantities called lots. Unlike stock markets, these currency lots are traded at fixed values. A lot is typically 100,000 units of the base currency in a pair, but there are also smaller quantities you can purchase, including mini, micro, and nano lots.
When working with lots, it's easy to calculate your wins and losses with changes in pdb (pips). Let's look at the EUR/USD pair for example:
If you buy a standard lot of EUR/USD, you have purchased €100,000 for $119,380. If the pair's price increases by one bps and you sell your lot, this amounts to an increase of 10 units in the quote currency. This means you will sell your €100,000 for $119,390 and you made $10. If the price increases by ten bps, the profit will be $100.
As trading has become increasingly digital, standard lot sizes have decreased in favor of greater flexibility. On the other side of the spectrum, major banks have even increased their standard batch sizes up to 1 million to accommodate the large volume encountered.
How Does Leverage Work in Forex Trading?
One of the unique features of the forex market is relatively low profit margins. To improve your earnings, you will need to increase the volumes you trade. Banks can do this easily, but individuals may not have access to enough capital and may instead use leverage.
Leverage allows you to borrow money from a broker with relatively little collateral. Brokers present leverage as a multiplication of the capital provided, for example, 10x or 20x being equal to 10x or 20x your funds. $10,000 combined with 10x leverage is like trading $100,000.
To borrow this money, traders maintain a margin amount that a broker uses to cover possible losses. 10% margin is 10x, 5% margin is 20x, and 1% margin is 100x. With leverage, you see the total losses or gains of an investment based on the total amount invested. In other words, leverage magnifies your wins and losses.
Let's take a look at the EUR/USD pair as an example. If you want to buy a lot of this pair (€100,000), you'll need around $120,000 at current prices. If you are a small trader without access to these funds, you may want to consider getting 50x leverage (2% margin). In this case, you only need to provide $2,400 to access $120,000 in the forex market.
If the pair falls by 240 bps ($2,400), your position will be closed and your account liquidated (you will lose all your funds). When using leverage, small price movements can cause large gains or losses. Most brokers will allow you to increase the margin on your account and top it up if necessary.
How to hedge in the Forex market?
With any floating currency, it is always possible for the exchange rate to fluctuate. While speculators attempt to make gains from volatility, others value stability. For example, a company planning to expand internationally may want to lock in an exchange rate to better plan its expenses. She can do this quite easily through a process called “hedging.”
Even speculators may want to lock in a specific exchange rate to protect against an economic shock or financial crisis. You can start hedging your exchange rates using various financial instruments. The most common methods are the use of Futures contracts or options. With a Futures contract, an investor or trader is obligated to exchange a given amount at a specified rate at a future date.
Futures Contracts
Let's say you enter into a Futures contract to buy a lot of EUR/USD at 0.8400 (buying $100,000 for €84,000) per year. You may, perhaps, sell in the Euro zone and wish to repatriate your gains. A Futures contract removes the risk of an appreciation of the US dollar against the euro and helps predict your finances. In this case, if the US dollar appreciates, each euro will buy fewer dollars when repatriating funds.
If the US dollar appreciates and the EUR/USD pair is at 1.0000 in a year, without a Futures contract, the spot rate would be $100,000 for €100,000. However, instead of this rate, you would take a contract for one lot of EUR/USD at 0.8400 ($100,000 for €84,000). In this simple example, you will have saved a cost of €16,000 per batch, excluding fees.
Options
Options provide a hedge-like way to reduce risk. But unlike Futures contracts, options give you the choice to buy or sell an asset at a predetermined price on or before a specific date. After paying a purchase price (the premium), an option contract can protect you against unwanted appreciation or depreciation of a currency pair.
For example, if a British company sells goods and services in the United States, it can purchase a GBP/USD call option. This instrument allows them to purchase GBP/USD at a future date at a predetermined price. If the pound has appreciated or held steady at the time of payment in US dollars, the company has only lost the price paid for the option contract. If the pound depreciates against the dollar, the company will have successfully hedged against the depreciation and will benefit from a better than market price.
To learn more about Futures contracts and options contracts, see the articles What are forward contracts and futures contracts? and What are options contracts?.
Covered interest arbitrage
With differing interest rates around the world, forex traders can arbitrage these differences while offsetting the risk of a movement in exchange rates. One of the most common ways to do this is through covered interest rate arbitrage. This trading strategy hedges future price movements of currency pairs to reduce risk.
Step 1: Find an arbitrage opportunity
Take, for example, the EUR/USD pair with a rate of 1,400. The deposit interest rate in the Eurozone is 1%, while that in the United States is 2%. Thus, 100,000 euros invested in the euro zone will bring you 1,000 euros in earnings after one year. However, if you could invest the money in the United States, it would give you a gain of €2,000 if the exchange rate remains the same. However, this simplified example does not take into account fees, bank costs and other expenses that you also need to take into account.
Step 2: Hedge your exchange rate
Using a 1-year EUR/USD Futures contract with a Futures interest rate of 1.4100, you can take advantage of the improved interest rate in the USA and guarantee a fixed return. The forward rate is the agreed exchange rate used in the contract.
A bank or broker calculates this rate with a mathematical formula that takes into account different interest rates and the current cash price. The Futures rate adds a premium or discount to the spot rate depending on market conditions. To prepare for arbitrage, we enter into a futures contract to buy a lot of EUR/USD at a rate of 1.41 one year from now.
Step 3: Reread the arbitration
In this strategy, you sell a lot of EUR/USD at 1,400 on the Spot Market to get $140,000 at a cost of €100,000. Once you receive the funds from the trade, deposit them in the United States for one year with an interest rate of 2%. At the end of the year, you will have a total of $142,800.
Then you can convert the $142,800 into euros. With the Futures contract, you sell the $142,800 back at the agreed rate of 1.4100, giving you approximately €101,276.60.
Step 4: Compare the gains made
Compare the gains you make with and without rate hedging, assuming all else is equal. After reviewing the US interest covered arbitrage strategy, you will get €101,276.60. If you didn't have coverage, you would have €102,000, as mentioned previously. So why do people hedge if it results in lower earnings?
Traders hedge primarily to avoid the risk of exchange rate fluctuations. A currency pair rarely remains stable over a year. So even if the winnings are less than €723.40, we have managed to guarantee a winning of at least €1,276.60. Another factor: we assume that the central bank will not change the interest rate during the year, which is not always true.
To conclude
For anyone interested in the international economy, trade and global business, the forex market provides a unique alternative to stocks. Forex trading may seem less accessible than crypto or stocks for small investors. But with the rise of online brokers and increasing competition in providing financial services to the public, forex is no longer so out of reach. Many forex traders rely on leverage to generate decent gains. These strategies carry a high risk of liquidation. So make sure you understand the mechanics before taking risks.