An Introduction to Forex Trading

The foreign exchange market, commonly referred to as the forex market or just the FX market, is the most liquid market in the world. With an average daily turnover exceeding $4.5 trillion, the market is by far the largest in the world.

Trading in the forex market opens up new avenues for traders accustomed to only trading equities: investors can place global, macro-focused trades, can purchase foreign bonds with potentially higher yields, and invest in other foreign assets including equities.

The foreign exchange market has many unique properties that other markets do not posses. These include:

• Its size and liquidity, which represents the largest asset class in the world.


• Its geographical dispersion: forex is traded around the globe.


• The market is rarely closed: except for the weekends, traders can trade from 5:15 pm ET on Sunday to 5:00 pm ET on Friday.


• Low margins of relative profit compared with other fixed income markets.


• The ability to utilize higher amounts of leverage, allowing individual traders with relatively small accounts to make big bets.

There are many participants in the forex market, contributing to its massive liquidity and size. It is important to note for traders that forex markets are not made on exchanges, but are known as interbank markets and are OTC markets. Due to its size and global reach, it would be difficult to trade forex on domestic exchanges, and due to the first-mover advantage that dealers have in market making, the market has remained an interbank market. Other players in the market include:

• Companies looking to hedge out currency risk in overseas businesses.


• Central banks looking to stabilize domestic currencies.


• Hedge funds and other investment management companies.


• Retail traders.


• Non-bank forex dealers.


• Money transfer companies.

Three main factors are thought to determine exchange rates for currencies that are freely traded.

First, there are the set of factors that amass to what is known as international parity conditions. This consists of economic factors such relative purchasing power parity (PPP), interest rate differentials, and inflation effects.

Another set of factors can be classified as the balance of payments, focusing on the flow of goods and services and ignoring factors such as global capital flows.

The last set of factors considers exchange rates less as a result of economic factors and more as a financial asset. This basically assumes that supply and demand determine the rate.

There are other non-economic factors that can affect a currency. For example, political conditions actually play a large role in setting exchange rates. For example, after the Greeks successfully elected a government, the EUR/USD rallied.

Broad market sentiment, too, can play a factor. For example, in "risk-off" times, forex traders tend to shift assets to safe-haven currencies, mainly the U.S. dollar, the Swiss franc, the Japanese yen, and gold. (However, recently, the Swiss franc has been pegged to the euro, and is thus not considered as a safe-haven since it is now dependent on the euro.)

Other factors, including technicals and biases such as anchoring, also play a role in setting rates. For short-term forex traders, technicals are sometimes the most important factor, as short term fluctuations of forex rates are easily explained using technical analysis.

There are multiple different instruments traders can use to express opinions. The first is simply spot market trades, where the trader swaps the currency they have for another at the prevailing exchange rate. These are the simplest forms of transactions.

Another popular type of trade is a forward transaction, in which two traders agree to make a trade at a future date at an agreed-upon exchange rate without exchanging any money now. This allows investors to speculate on, or hedge out, fluctuations in forex rates without posting any collateral. Swaps are the most popular form of forwards in the forex market, a transaction in which two parties agree to swap currencies in the present, and then swap back at a future date.

Futures are another form of forward, however they are traded on exchanges generally reserved for large institutional traders and corporations, since they have large lot sizes.

Lastly, there are FX options which traders can use to speculate on the future value of exchange rates. Traders employ option strategies such as the Double No-Touch, a strategy in which a trader uses options to speculate on a trading range. If the exchange rate stays within the specified range (determined specifically by the strikes of the options involved), then the owner of the strategy is in the money.

One trade that interests lots of traders is the carry trade. The carry trade is a strategy in which a trader borrows currency in a country with low interest rates, exchanges it for a currency whose country has higher interest rates, invests the new currency into a bank account or bond, and earns the difference in interest plus the change in the exchange rate. A common carry trade over the past few years has been for traders to borrow in Japanese yen, where short term borrowing rates are low, and invest the money into an Australian bank account, where rates are higher. The trader pockets the interest rate differential plus/minus the change in the exchange rate.

Forex trading can represent a new, unique opportunity for traders willing to find a new avenue to express global theses. Trading in the most liquid market in the world can provide a different venue for potential profitability. Of course, do note that forex trading carries risks, especially due to the high level of margin associated with trading these assets.