What is the forex market?
The forex or currency market is the biggest financial market in the world, with over $5 trillion in daily turnover. Every transaction made globally which converts one currency into another contributes towards that staggering total, such as when a British company buys goods or services from an American or European supplier, or a tourist buys the foreign currency needed for their holiday abroad.
In 1971, President Nixon’s decision to drop the ‘gold standard’, which pegged the value of the dollar to physical gold, was the birth of the modern forex market. The major world currencies became ‘free floating’, with their value against one another determined by supply and demand dynamics. When there is more demand for the U.S dollar around the world it becomes more expensive compared to other currencies.
The British pound lost significant value against the dollar and other major currencies in the wake of the Brexit vote due the uncertainty the result provoked. A feeling of less certainty on what the future held for the UK economy meant that holders of cash pounds or pound-denominated assets sold some of them off to hedge risk, reducing demand for the pound and subsequently its comparative value against other currencies.
As well as transactions in the ‘real economy’ eg. Volkswagen, a business denominated in euros, buying steel for its cars in dollars, there are also speculative currency exchanges. These speculative currency transactions are what is known as forex trading. A forex trader would, for example, buy dollars with their pounds if they believed the value of the dollar would rise against the pound, subsequently making a profit in pounds when those dollars are converted back into pounds. Forex traders can also take ‘short’ positions if they want to speculate that a currency will lose value against another.
Why trade forex?
The basic reason for trading forex is the same as trading any financial market from equities to bonds: to profit from rising and falling prices through buying and selling at the right time. However, there are some specific advantages that make forex the most popular financial market to trade.
1) Forex market impossible to manipulate
The sheer scale of international forex markets mean that no individual or organisation have the resources to significantly effect price movements. Even central banks cannot significantly influence the value of a currency over an extended period of time.
2) High Liquidity
Another consequence of the size of the forex market is that it is also the most liquid of markets. Traders are never ‘stuck’ in a trade and can always buy and sell currencies at the current ‘spot’ price instantaneously. This means that profits can be taken or losses stopped instantaneously at any given moment.
3) Over-the-Counter Market
Forex is not traded on an exchange so does not feature middle men setting prices or taking a commission. The price of one currency against another is controlled purely by the free principles of supply and demand. This also means transaction costs of forex trading are lower than for any other financial instrument. Forex trading platforms take a tiny ‘spread’, which is usually around 0.1%, though can be even lower.
4) 24-Hour Market
Because the forex market is not tied to an exchange it operates 24-hours a day, while most financial instruments can only be traded during the exchange’s business hours.
Forex traders can take advantage of leverage offered by brokers to multiply their exposure compared to the cash deposit they must put down on a trading position. Retail forex traders can usually access leverage of up to 50:1, so a $10 position would allow them to buy up to $500 dollars. This means that profits can be greatly increased, though also means that losses can exceed the initial investment.
6) Minimum Barrier to Entry
The low transaction costs of forex trades and complete flexibility in trade position size means that forex traders can theoretically start trading with an account size in double or low triple figures. While the smallest possible account value would make hedging and spreading risk problematic, taking very small positions allows beginners to learn the ropes and gain experience with minimal financial exposure.
There are also many educational resources and aids, such as forex signals, available on the market. This means that beginner forex traders can experiment and learn cheaply how to trade forex and gain confidence and skill before scaling their financial exposure to positions they take.