Put simply, the foreign exchange or forex market provides a decentralized system where currencies trade against each other in pairs. Any forex trade involves an exchange of one currency for another, and those two currencies make up a currency pair. The forex market is the most liquid and largest financial market in the world, with its average daily trading volume exceeding $5 trillion. This is greater than the daily volume typically traded on all of the world’s stock markets combined.
Who Trades Forex?
Several types of trader routinely operate in the forex market. The more common are described below.
Large financial institutions, including commercial and investment banks, often trade forex for their own account in the Interbank forex market, as well as acting as market makers when asked to execute currency transactions for clients. When businesses want to buy or sell products or services with companies in other countries, they rely on major banks and other financial institutions to help them complete the necessary foreign exchange transaction.
Corporations and Commodity Producers
Companies and producers of desirable commodities, like barrels of oil, often sell their products to buyers in other countries. Unless a sale contract specifies payment in their local currency, the transaction involves the seller taking a foreign exchange risk. They can then choose to receive and hold the foreign currency or sell it and buy their local currency.
For example, if a U.S. based farmer wants to sell their soybean crop to China, the farmer will receive Chinese yuan from the buyer. They might then call their bank and ask to sell that amount of yuan and buy U.S. dollars. A dealer at the bank then quotes the farmer the offer side of the spot exchange rate for USD/CNY, which is forex market shorthand for the U.S. dollar or USD quoted in terms of the Chinese yuan or CNY. Unless another delivery date is specified, a spot transaction will settle in 2 business days.
Investment and Hedge Funds
Fund and portfolio managers also trade in the forex market. Some might trade currencies speculatively for their fund’s account, while others might exchange currencies when they make a foreign stock transaction or want to hedge their holdings of foreign stock.
High Net Worth Individuals and Retail Traders
Many individuals speculate on exchange rate movements based on their analysis of the currency market. Some might also make forex transactions to offset the risk of foreign stock holdings. High net worth individuals can usually trade currencies directly with major financial institutions using credit lines, while retail traders typically must operate on margin through online forex brokers.
Pros and Cons of Forex Trading
Trading foreign currencies presents its own unique sets of benefits and drawbacks.
- Leverage: Currency markets allow traders to control large amounts of money with very little capital. This allows traders to make or lose money from small currency pair movements.
- Liquidity: The forex market provides the highest liquidity of any financial market. If you trade the major currency pairs, you are virtually guaranteed a counterparty for your trades.
- Continuous trading: The forex market operates 24 hours a day except when it is closed from 5 p.m. ET on Friday until 5 p.m. ET on Sunday. Since it’s a global market, it also operates through most major U.S. holidays, although liquidity might be reduced somewhat during New York trading hours.
- No volume shown: Unlike exchange traded financial markets, the largely unregulated over the counter forex market does not show accurate volume traded numbers. Unless the volume of currency futures traded or tick counts from online brokers can be used instead, this limits some forms of technical analysis that traders might want to use, such as point of control (POC), on balance volume (OBV) and other types of volume-related technical indicators.
- Volatility from events: Just like when a company’s stock moves rapidly during earnings reports, currencies may also move sharply due to benchmark interest rate announcements, major economic data releases or geopolitical events.
- Less regulatory protection: Unlike the stock market, the forex market operates over-the-counter, and online forex brokers may be subject to less regulation depending on where they are based. This leads to more problems with forex brokers than are typically seen with stock brokers.
- Fewer investment return options: Outside of certain strategies, such as carry trading where the interest rate differential between 2 currencies is exploited, the forex market doesn’t provide for investor returns in the same way that stock dividends and share buybacks can.
How to Analyze the Forex Market
Do a quick search in Google, and you’ll see there’s no shortage of gurus and guides that will claim to show you how to profit from forex trading. If you browse through enough material you’ll notice that most forex traders fall into 2 camps:
Fundamental analysts: Analysts who study the fundamentals of the foreign exchange market review economic and geopolitical factors to forecast future exchange rate movements. They might look to central banks for interest rate guidance, to governments for spending policy decisions, and to economic and trade data to assess the strength of a country’s economy. Fundamental analysts focus on how these factors interact with one another and what their influence on the supply and demand for one currency relative to another might be.
Technical analysts: Technical analysts often rely on using chart depictions of a currency pair’s movement over time to predict where its exchange rate will go based on the premise that past movements can help them forecast future movements. They might also compute technical indicators from past exchange rate levels, such as moving averages, which can provide useful trading signals.
Traders don’t need to stick with one type of analysis exclusively. Many traders use both fundamental and technical analysis to develop their own trading styles.
The stock market and forex market are fundamentally very different. If success eludes you when you trade stocks, you may do better trading forex. Conversely, don’t assume you’ll be successful trading forex just because you trade stocks well.
Becoming a profitable forex trader requires study, practice and discipline. Even if you start out by copying a more experienced trader, spending more time operating in the forex market will help you discover and improve your own trading style.
If you want to start trading forex now, check out some of Benzinga’s picks for the Best Forex Brokers in the USA.
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