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Forex is the world's largest market in terms of trading volume and liquidity. Brokers, businesses, governments and other economic agents trade currencies and derivatives in foreign exchange and international trade.
Traders can also use the market for speculative purposes. The market provides many arbitrage opportunities with exchange rates and interest rates, making it attractive for trading in large volumes or using leverage.
The Forex market consists of fiat currency pairs and their market prices. These pairs are usually bought and sold in lots. A standard lot contains 100,000 units of the pair's base currency, but smaller sizes are available - up to 100 units.
Typically, traders use leverage to increase investment amounts. Risks can also be offset by using forwards and swaps to trade a currency pair at a specific price in the future. Combining these two tools with other trading strategies and products creates a wealth of investment opportunities for Forex traders.
Introduction
Even if you don't trade Forex yourself, the international foreign exchange market can play an important role in your daily life. Although the effects of a stock market decline are not always so obvious, changes in the value of a currency can significantly affect the prices of goods and services. If you have been abroad, then you probably had to exchange currency at the current rate, which always depends on current quotes and exchange rates on Forex.
Forex is a unique asset class that is different from stocks, commodities or bonds. If you understand what makes Forex unique, it will become clear why there is such a need in the global market.
What is Forex?
Forex trading, or FX (from the English foreign exchange - currency exchange), is the purchase and sale of currencies, as well as other Forex products. The rate at which currencies are exchanged at a bank or exchange office directly depends on what is happening on the Forex currency market.
Exchange rate fluctuations are affected by economic conditions, world events, interest rates, politics and many other factors. Therefore, Forex is extremely liquid and has the highest trading volume compared to other financial markets.
The Forex market combines two types of activities: trading with economic transactions and speculative trading. For companies and other entities operating in international markets, buying and selling foreign currency is an integral part of the job. Most often, Forex is used specifically to return funds or purchase goods abroad.
Forex trading also has a negative aspect – speculation. Short-term trading with large volumes of fluctuating exchange rates is common. The many arbitrage opportunities for speculators are to some extent responsible for the large volume of trading in the market.
Traders also tend to use long-term strategies related, for example, to fluctuations in interest rates. Events related to geopolitics and the global economy also cause significant fluctuations in foreign exchange markets. By buying a currency and holding it, you can make a profit in the long term. Finally, you can plan exchange rates years in advance using futures contracts, betting on or against the market.
Forex trading can be challenging for inexperienced users. Without loans or a large amount of capital to begin with, it can be very difficult to engage in arbitrage or short-term trading, which is why most trading volume in the foreign exchange market is generated by international banks and financial institutions.
What is a Forex pair?
At a basic level, the Forex market contains pairs of currencies that describe the relative price between them. If you have already traded cryptocurrencies, you should be familiar with how the FX market works. The first currency in the pair is the base currency. The second is the quoted currency, sometimes called the counter currency. Quote currency expresses the value of one unit of the base currency.
GBP/USD expresses 1 pound sterling in US dollars. This ratio is shown as a number, for example 1.3809 means that £1 is worth $1.3809. GBP/USD is one of the most popular pairs, known as the “cable”. The name comes from slang for the pound, as transactions between the London and New York exchanges were carried out via transatlantic cable in the 19th century.
In Forex you can find many liquid markets. The largest trading volume is for the USD/JPY, GBP/USD, USD/CHF and EUR/USD pairs. They are also called major pairs and consist of the US dollar, Japanese yen, British pound, Swiss franc and euro.
Why do people trade Forex?
The Forex market is not just speculation. Banks, businesses and other parties that need access to foreign cash participate in currency trading to facilitate cross-border transactions. Additionally, they agree to FX rates in advance to control future exchange costs. This process is called hedging. For governments, Forex trading provides an opportunity to build up reserves and achieve their economic goals, including currency peg or increased imports/exports.
For individual traders, the Forex market is also extremely attractive:
Small traders can take advantage of the leverage feature, which allows them to invest large amounts of capital even if they do not have direct access to it.
To start working on Forex, you don’t need huge sums of money – it’s enough to buy a small amount of currency. Buying a share of the stock market can cost thousands of dollars, while entering the foreign exchange market can cost as little as $100.
Forex trading can be carried out at any convenient time, combining it with any daily routine.
There is high liquidity in the market, as well as a low spread between supply and demand.
Options and futures are standard Forex products. For traders who don't want to simply buy and sell at the current market price, a shorting option is available.
Where does Forex trading take place?
While stocks are primarily traded on centralized exchanges such as the NYSE or NASDAQ, FX trading is widespread throughout the world. Participants can interact with each other directly through over-the-counter (OTC) trades or enter the vast network of banks and brokers in the interbank market.
Managing such a market can be difficult due to the different regulations governing each currency. And although many states have special services that control trade on the domestic market, their international coverage is limited. Forex trading may require purchasing a license or using an accredited broker, but this does not prevent traders from trading in other, less regulated markets.
Most trading volume in the foreign exchange market occurs in four main zones: New York, London, Tokyo and Sydney. The foreign exchange market is decentralized and has no real central location, you can always find a brokerage company that will help you trade currencies around the world.
Brokerage services are widely available online and are usually free. You don't have to pay a commission - Forex brokers make profits through price spreads. To start, it is best to choose microlot trading. This is the most affordable option to start trading Forex. Next we will look at it in more detail.
What is unique about Forex trading?
Forex differs from other financial markets in many ways:
Forex covers many regions: there are 180 recognized currencies around the world, and, accordingly, markets for them in each country.
Forex is extremely liquid and has a huge trading volume.
Forex market prices depend on many global factors: politics, economic conditions, speculation, transfers, etc.
Forex is available for trading almost 24 hours a day, five days a week. Because the market is decentralized, the exchange or brokerage service is almost always open to you. Markets are closed on weekends, but some platforms offer trading even after business hours.
Unless you trade in large volumes, the margins will be quite low. However, even a small difference in the exchange rate can be profitable when making large transactions.
How to trade Forex?
In Forex, individual traders have several options to choose from. The easiest way is to buy a currency pair on the spot market and hold it. For example, you buy euros in the USD/EUR pair. If the counter currency rises, it can be sold for the base currency and make a profit.
You can also use the funds to increase your available capital. In this case, you will be able to trade using leveraged funds if you cover your losses yourself. Additionally, you should consider Forex options. They will allow you to buy or sell a pair at a set price on a specific date. Futures contracts are also popular because they allow you to enter into future transactions at a pre-agreed price.
One of the main aspects of Forex trading is the opportunity to profit from differences in interest rates. Central banks around the world set different interest rates, which opens up countless investment opportunities for traders. By exchanging currency and storing funds in a foreign bank, you can significantly increase your income.
However, there are additional costs: transfer fees, bank fees and tax fees in different countries. All this needs to be taken into account for your strategy to work. Arbitrage opportunities and profits are often minimal, so margins will be low, and fees you didn't know about could wipe out any benefit.
What are pips?
A pip (short for “percentage” and “point”) is a percentage point that represents the minimum variation in the price of a currency pair. Let's take another look at the GBP/USD pair:
A move up or down of 0.0001 would be the minimum change in the price of the pair (a value of 1 pip). However, not all currencies reflect price changes in such detail. Any pair with the Japanese Yen as the quote currency will typically have 0.01 pips due to the lack of currency decimalization.
Pipette
Sometimes brokers and exchanges break the standard and offer pairs that expand the number of decimal places. GBP/USD, for example, has five decimal places, while USD/JPY usually has two, but can go up to three. This extra fifth decimal place is called a pipette.
What is a lot in Forex?
When trading Forex, currencies are bought and sold in certain quantities - lots. Unlike stock markets, lots of foreign currencies are traded at set prices. Typically a lot is 100,000 units of the base currency in a pair, but there are also smaller amounts: mini, micro and nano lots.
When working with lots, calculating your profits and losses from pip changes is quite easy. Let's take the USD/CHF pair as an example:
When you purchase one standard EUR/USD lot, you purchase 100,000 euros for $119,380. If a pair increases its price by one pip and you sell that lot, this will equate to a change in the quoted currency of 10 units. In other words, you will sell your 100,000 euros for $119,390 and make a profit of $10. If the price increases by ten pips, the profit will be $100.
As trading becomes increasingly digitized, the popularity of standard lots is declining in favor of more flexible options. On the other hand, large banks increase their standard lot sizes to 1 million to accommodate the high trading volume.
How does leverage work when trading Forex?
Forex stands out from other markets due to its relatively small margins. To increase profits, you will have to increase your trading volume. While banks can easily do this, ordinary people do not always have sufficient capital and resort to leverage instead.
Leverage allows you to borrow money from a broker against a small collateral. Leverage can be 10 or 20 times your funds - meaning $10,000 with 10x leverage would give you $100,000 to trade.
The trader borrows this money against a margin that the broker can use to cover possible losses. A 10% margin is 10x, a 5% margin is 20x, and a 1% margin is 100x. When you use leverage, you will also receive losses or gains on your investment in proportion to the total amount of leverage. In other words, leverage magnifies both your profits and losses.
Let's take EUR/USD as an example. To purchase one lot of this pair (100,000 euros) you will need approximately $120,000 at the current rate. Small traders who do not have access to such funds are better off considering using fifty times leverage (2% margin). In this case, you would only need to provide $2,400 to access $120,000 in the forex market.
If the pair falls by 240 pips ($2,400), your position will be closed and your account will be liquidated, meaning you will lose all your funds. When using leverage, even small price movements can lead to sudden losses or profits. Many brokers will give you the ability to increase the margin on your account and top it up as needed.
How is Forex hedging done?
Any floating currency allows for changes in the exchange rate. For speculators, volatility is an opportunity to profit. But there are also those who value stability. Thus, a company planning to expand internationally is interested in a fixed exchange rate to better plan its expenses, and this is possible through hedging.
Speculators may also sometimes benefit from fixing the exchange rate to protect against an economic shock or financial crisis. You can start hedging your exchange rates using various financial instruments. The most popular of them are futures or options contracts. With futures contracts, the investor or trader agrees to trade at a specific rate and amount in the future.
Futures contracts
Let's say you enter into a futures contract to buy one lot of USD/EUR at a price of 0.8400 (buying $100,000 for €84,000). Perhaps you will sell in the Eurozone and after a year you will want to take back your profits. A futures contract will eliminate the risk of a possible appreciation of the US dollar against the euro and help you better plan your finances. In this case, if the US dollar strengthens, each euro will buy fewer dollars when the funds are repatriated.
If the US dollar appreciates and is 10,000 per year against the euro, then without a futures contract the spot rate would be 100,000 dollars per 100,000 euros. However, instead, it is better to enter into a futures contract for one lot of USD/EUR at 0.8400 ($100,000 for 84,000 EUR) in advance and save EUR 16,000 per lot before commissions.
Optional
Options offer a similar way of reducing risk through hedging, but unlike futures, they give you the opportunity to buy or sell an asset at a predetermined price on or before a specific date. After paying the purchase price (premium), an options contract can protect you from unwanted increases or decreases in the value of a currency pair.
For example, if a UK company sells goods and services to the US, they may purchase a GBP/USD call option. This instrument will allow you to purchase GBP/USD in the future at a predetermined price. If the value of the pound rises or remains at its current level at the time of payment in US dollars, the company will only lose the funds paid for the option contract. If the pound depreciates against the dollar, the company's exchange rate will already be hedged and they will be able to get a better price than what is offered on the market.
More information about futures and options contracts can be found in the sections What are forward and futures contracts? and What are options contracts?.
Arbitrage with interest coverage
Since interest rates around the world are constantly changing, traders can manage these differences by offsetting the risks associated with exchange rate changes. One of the most common ways to do this is through covered interest arbitrage. This strategy allows you to hedge future price movements of a currency pair to reduce risk.
Step 1: Finding an Arbitrage Opportunity
As an example, let's take the EUR/USD pair with a rate of 1,400. The interest rate on deposits in the Eurozone is 1%, while in the US it is 2%. That is, 100,000 euros invested in the Eurozone will return you 1,000 euros in profit after a year. If you had invested in the US, you would have made a profit of €2,000, assuming the same exchange rate. However, this simplified example does not take into account commissions, banking and other expenses.
Step 2: Hedge Your Exchange Rate
By using a one-year EUR/USD futures contract with a forward rate of 1.4100, you can take advantage of better US interest rates and secure a fixed income. The forward rate is the agreed exchange rate used in the contract.
The bank or broker calculates this rate using a mathematical formula that takes into account various interest rates and the current spot price. The forward rate adds a premium or discount based on the spot rate and depending on market conditions. In preparation for arbitration, we enter into a futures contract to sell one lot of EUR/USD at 1.41 per year.
Step 3: Completing Arbitration
With this strategy, you sell one lot of EUR/USD at 1,400 on the spot market to get 100,000 euros for $140,000. Once you make money on spot trading, you can open a deposit in the US for a year at 2% per annum, and by the end of the year you will have $142,800.
You will then need to convert that $142,800 back into euros. With the futures contract, you will buy back $142,800 at the agreed rate of 1.4100, giving you a profit of €101,276.60.
Step 4: Profit Comparison
Let's compare the profit you get with and without bet hedging. After executing the interest covered arbitrage strategy in the US, you will have €101,276.60. As stated earlier, if you had gone without hedging, you would have €102,000. So why hedge if it reduces profits?
Traders primarily hedge to protect against exchange rate fluctuations. A currency pair rarely remains stable throughout the year. Thus, although the profit decreased by 723.40 euros, by using hedging we were able to guarantee ourselves at least 1,276.60 euros. It's also important to consider that we expect the central bank to maintain its current interest rate throughout the year, which is unlikely.
Summary
For anyone interested in international economics, trading and global events, the Forex market provides a unique alternative to stocks. Forex trading may seem less accessible to smaller investors than trading cryptocurrencies or stocks, but with the increase in the number of online brokers and increasing competition in the provision of financial services, the prospects of working in Forex are becoming more realistic. Many Forex traders rely on leverage to make profits. These strategies involve a high risk of liquidation, so make sure you have a good understanding of the market before taking risks.