Forex is short for foreign exchange, but the actual asset class we are referring to is currencies. Foreign exchange is the act of changing one country's currency into another country's currency for a variety of reasons, usually for tourism or commerce. Due to the fact that business is global, there is a need to transact with other countries in their own particular currency.
After the accord at Bretton Woods in 1971, when currencies were allowed to float freely against one another, the values of individual currencies have varied, which has given rise to the need for foreign exchange services. This service has been taken up by commercial and investment banks on behalf of their clients, but it has simultaneously provided a speculative environment for trading one currency against another using the internet. (If you want to start trading forex, check out Forex Basics: Setting Up an Account.)
Why We Can Trade Currencies
Until the advent of the internet, currency trading was really limited to interbank activity on behalf of their clients. Gradually, the banks themselves set up proprietary desks to trade for their own accounts, and this was followed by large multinational corporations, hedge funds and high net worth individuals.
With the proliferation of the internet, a retail market aimed at individual traders has sprung up that provides easy access to the foreign exchange markets, either through the banks themselves or brokers making a secondary market. (For more on the basics of forex, check out 8 Basic Forex Market Concepts.)
Forex Risk
Confusion exists about the risks involved in trading currencies. Much has been said about the interbank market being unregulated and therefore very risky due to a lack of oversight. This perception is not entirely true, though. A better approach to the discussion of risk would be to understand the differences between a decentralized market versus a centralized market and then determine where regulation would be appropriate.
The interbank market is made up of many banks trading with each other around the world. The banks themselves have to determine and accept sovereign risk and credit risk, and for this they have many internal auditing processes to keep them as safe as possible. The regulations are industry imposed for the sake and protection of each participating bank.
Since the market is made by each of the participating banks providing offers and bids for a particular currency, the market pricing mechanism is arrived at through supply and demand. Due to the huge flows within the system, it is almost impossible for any one rogue trader to influence the price of a currency. Indeed, in today's high-volume market, with between $2 trillion and $3 trillion being traded per day, even the central banks cannot move the market for any length of time without the full coordination and cooperation of other central banks. (For more on the interbank system, read The Foreign Exchange Interbank Market.)
Attempts are being made to create an Electronic Communication Network (ECN) to bring buyers and sellers into a centralized exchange so that pricing can be more transparent. This is a positive move for retail traders who will gain a benefit by seeing more competitive pricing and centralized liquidity. Banks of course do not have this issue and can, therefore, remain decentralized. Traders with direct access to the forex banks are also less exposed than those retail traders who deal with relatively small and unregulated forex brokers, which can and sometimes do re-quote prices and even trade against their own customers. It seems that the discussion of regulation has arisen because of the need to protect the unsophisticated retail trader who has been led to believe that trading forex is a surefire profit-making scheme. (See also: Why It's Important to Regulate Foreign Exchange.)
For the serious and somewhat educated retail trader, there is now the opportunity to open accounts at many of the major banks or the larger, more liquid brokers. As with any financial investment, it pays to remember the caveat emptor rule – "buyer beware!" (For more on the ECN and other exchanges, check out Getting to Know the Stock Exchanges.)
Pros and Cons of Trading Forex
If you intend to trade currencies, in addition to the previous comments regarding broker risk, the pros and cons of trading forex are laid out as follows:
The forex markets are the largest in terms of volume traded in the world and therefore offer the most liquidity, thus making it easy to enter and exit a position in any of the major currencies within a fraction of a second.
As a result of the liquidity and ease with which a trader can enter or exit a trade, banks and/or brokers offer large leverage, which means that a trader can control quite large positions with relatively little money of their own. Leverage in the range of 100:1 is not uncommon. Of course, a trader must understand the use of leverage and the risks that leverage can impose on an account. Leverage has to be used judiciously and cautiously if it is to provide any benefits. A lack of understanding or wisdom in this regard can easily wipe out a trader's account. (For more on leverage, check out Forex Leverage: A Double-Edged Sword.)
Another advantage of the forex markets is the fact that they trade 24 hours around the clock, starting each day in Australia and ending in New York. The major centers are Sydney, Hong Kong, Singapore, Tokyo, Frankfurt, Paris, London and New York.
Trading currencies is a "macroeconomic" endeavor. A currency trader needs to have a big-picture understanding of the economies of the various countries and their inter-connectedness in order to grasp the fundamentals that drive currency values. For some, it is easier to focus on economic activity to make trading decisions than to understand the nuances and often closed environments that exist in the stock and futures markets where microeconomic activities need to be understood. Questions about a company's management skills, financial strengths, market opportunities and industry-specific knowledge are not necessary in forex trading. (Take a look at Economic Factors That Affect the Forex Market to learn more.)
Two Ways to Approach the Forex Markets
For most investors or traders with stock market experience, there has to be a shift in attitude to transition into or to add currencies as a further opportunity for diversification.
Currency trading has been promoted as an "active trader's" opportunity. This suits the brokers because it means they earn more spread when the trader is more active.
Currency trading is also promoted as leveraged trading, and therefore, it is easier for a trader to open an account with a small amount of money than is necessary for stock market trading.
Besides trading for a profit or yield, currency trading can be used to hedge a stock portfolio. If, for example, one builds a stock portfolio in a country where there is potential for the stock to increase value but there is downside risk in terms of the currency, for example in the U.S. in recent history, then a trader could own the stock portfolio and sell short the dollar against the Swiss franc or euro. In this way, the portfolio value will increase, and the negative effect of the declining dollar will be offset. This is true for those investors outside the U.S. who will eventually repatriate profits back to their own currencies. (For a better understanding of risk, read Understanding Forex Risk Management.)
With this profile in mind, opening a forex account and day trading or swing trading is most common. Traders can attempt to make extra cash utilizing the methods and approaches elucidated in many of the articles found elsewhere on this site and at brokers' or banks' websites.
A second approach to trading currencies is to understand the fundamentals and the longer-term benefits, when a currency is trending in a specific direction and is offering a positive interest differential that provides a return on the investment plus an appreciation in currency value. This type of trade is known as a "carry trade." For example, a trader can buy the Australian dollar against the Japanese yen. Upon the original publication of this article, the Japanese interest rate is .05% and the Australian interest rate last reported is 4.75%, so a trader can earn 4% on this trade. (For more, read The Fundamentals of Forex Fundamentals.)
However, such a positive interest needs to be seen in the context of the actual exchange rate of the AUD/JPY before an interest decision can be made. If the Australian dollar is strengthening against the yen, then it is appropriate to buy the AUD/JPY and to hold it in order to gain in both the currency appreciation and the interest yield.
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