If you have ever traveled overseas or noticed that some magazines list a price in both US and Canadian dollars, you are likely familiar with the concept of exchange rates. Forex markets allow traders to exchange one currency for another. These exchange rates are not set in stone and are always changing as one currency increases in value and another declines.
This provides an opportunity for speculators to make money by converting a large sum of money into the currency they expect to increase in value. All they are doing is changing one form of money for another, but if and when that currency becomes more valuable, they can pocket the difference in profit. It’s not unlike buying a stock or a bond at a lower price and selling it at a higher price for a profit, except in this case the asset is currency.
Forex is global. While Wall Street’s official hours are 9:30 am to 4 pm EST, forex markets don’t ever go to sleep. Until the very recent advent of some cryptocurrenciesglobal forex trading was the only continuous, nonstop market in the world.
Additionally, forex markets don’t depend on an individual sponsor running the operation, such as the New York Stock Exchange. Currencies are instead traded”over the counter“based on an electronic network of banks, commercial enterprises, forex brokers, large institutions and individual traders. This decentralized approach has some advantages, like 24/7 trading hours, but also some drawbacks, as certain disclosures are not mandatory as they are in other assets where oversight and operations are centralized.
Investors can’t think of forex investing in terms of just one currency. Trading strategies include “pairs” where one currency is priced in another. The value of just one kind of money is irrelevant because, as the name implies, the purpose of these trading venues is to ultimately make an exchange from one currency to another.
That means you’re not just researching one part of a trade, but two parts. For example, currency A may go up in value generally, but ultimately not make any money on your forex trade because currency B goes up in value even more.
Forex investing is all about leverage where you are investing at a multiplier of the actual money you put forward. After all, forex market changes are normally discussed in terms of “pips” – or, one one-hundredth of one percent. That means a one pip change on an investment of $10,000 is only moving the value by $1. Unless you have a massive amount of money involved in any forex investment, the pips simply won’t add up.
That’s why many platforms allow you to trade at up to 100 to 1 leverage or even greater under certain circumstances. This leverage comes with significant risk, of course, as you are effectively trading with borrowed money and can find yourself in the hole significantly if you’re not careful.
One added bit of complication worth mentioning is that there is an active futures market for currencies as well as a “spot” market based on day-to-day price movements.
If you’re unfamiliar with future, they are contractual agreements for one party to buy or sell a specific asset at a specific price and a specific date in the future. Futures markets are common for many different commodities or financial instruments, in part because they have a real application for hedging price risk. And just as a farmer can use futures to guarantee the right to sell corn at a favorable amount regardless of market prices, multinational companies can use forex futures to lock in an exchange rate for a currency.
Forex investors can speculate in either spot or futures markets. However, the added complexity of future markets demands research for any strategy. It’s hard enough to predict where currency prices will be tomorrow, let alone at a date in the distant future.
Forex markets are downright biblical in their age, occurring in ancient texts via the mention of money-changers who often got a bad name for overcharging people who wanted to exchange one coin for another. While modern markets are much more high-tech, the basic idea is the same, as investors try to be the intermediary who makes a quick buck – or pound, euro or yen as the case may be.
Forex markets are incredibly “liquid,” with global forex trading collectively averaging $5 trillion to $6 trillion worth of total assets daily. That alone makes them worth paying attention to, as small movements in forex can often trickle down into other areas of the economy or your investment portfolio.
FAQ’s
Forex trading is fairly easy and not much harder than trading stocks. The first stop is a forex broker. Most stockbrokers don’t offer this level of service, or if they do, they require you to opt in separately. After you have a broker, then you can book trades – assuming you have the cash and know-how.
As with any investment, there’s a combination of research and gut instinct required. Most currencies move thanks to big-picture economic news such as inflation, unemployment or plain old politics. You need to know what’s going on in the issuing country of a given currency, and then do your best to make an informed bet on what happens next.
All investments carry some amount of risk. But forex is particularly risky because of two unique factors: Forex is over-the-counter and decentralized without as much oversight as other assets, and it involves leverage, which is effectively investing with borrowed money. The rewards can be significant if you make the right moves, but the unique circumstances of forex markets create real risks.
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