What is Foreign Exchange?
If you have ever purchased an item online and the seller wanted to receive payment in their form of currency, then you would have to check the exchange rate and adjust your money accordingly to pay for the goods sold. You would have just participated in the foreign exchange market.
You have exchanged one currency in place for another. No matter the reason, this transaction is one of millions that occur every day. The foreign exchange market which is usually known as “FX” or “forex” is the largest financial market in the world, outpacing any stock or commodities exchange in the history of the world. To put things in perspective, the New York Stock Exchange (NYSE) publicly trades an estimated $22.4 billion of volume daily. The foreign exchange market turns over $5 trillion a day in volume.
That means the foreign exchange markets are over 220 times larger than the NYSE. Retail traders trade the spot market and that’s only about $1.5 trillion but this is the significance of money exchanging hands every second of every day, five days a week.
What is traded?
The simple answer is money. You aren’t buying anything physical; you are investing in a currency as if you were buying a stock. Think of buying a currency like putting your money into a company. If you choose to buy the U.S. dollar, you are betting that the U.S. markets will fare well and are expecting the exchange rates to appreciate. You are essentially investing in the state of the economy for which you have chosen to put your money in.
The exchange rate of a currency against other currencies around the world is a direct reflection of the political, social, and financial conditions of that country’s economy compared to other countries’ economies.
Here are some examples of the many acronyms and nicknames of forex jargon. These symbols are used every day in trading, they do not change.
- USD is characterized for the U.S. Dollar, EUR is characterized for the euro,
- CAD is for the Canadian dollar. Then there are nicknames for each currency.
- NZD (the New Zealand dollar) takes the nickname “kiwi”, which is derived from the native flightless birds that inhabit New Zealand.
- The “Pound” is the nickname for the GBP (Great British Pound).
Market Size and Liquidity
Unlike other financial markets like the New York Stock Exchange or the Nasdaq Composite Index, the forex spot market has no central location. This market can be traded anywhere since it is run electronically within a number of large banks over a 24-hour period.
The dollar is the most actively traded currency. Approximately 85% of all currency pairs traded include the dollar. This 85% is out of 200% to reflect two currency pairs in each transaction. The sum of the percentage of shares of individual currencies totals 200% instead of only 100%.
Most trading and liquidity comes from speculation. The majority of all trades are comprised of buyers and seller based on intraday price movements. The trading volume brought about by speculation is estimated to be over 90%.
This creates a large pool of liquid markets and allows traders to enter and exit trades with ease while keeping huge trading volumes from greatly affecting price. While these markets may be very liquid, the market’s depth may change significantly due to the time of day. Trading a euro currency pair after the close of the London trading session would result in less liquidity and less volume.
How to Trade Forex
There a number of different ways to trade forex. We will begin with the spot market, which is an over-the-counter market, meaning there is no supervision of an exchange. Currencies are traded instantly here using the current market price. It is very easy to participate in the spot market since there are round the clock operations and some brokers only call for $25 to open an account.
Futures are another way to invest in forex, where the buyer agrees to buy the currency at a predetermined price but at a future date. On the flip side of things, a seller can enter into a futures contract to sell an underlying currency at a predetermined price at a future date.
An option is a financial instrument used to give a buyer or a seller the right but not the obligation to buy or sell the underlying currency at a specified price by the options expiration date. There are many variations and complexities with options but on the simplest level, this is what occurs.
Exchange-traded funds are created by financial institutions and can contain a variety of different financial instruments used to invest with. An ETF can reflect the price of a certain currency or be combined with several stocks. This is yet another way you can invest in forex without directly buying up the currency.