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 , 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.
If you want to start trading forex, check out Forex Basics: Setting Up an Account. Commercial enterprises doing business in foreign countries are at risk due to fluctuation in the currency value when they have to buy goods or services from or sell goods or services to another country. Hence, the foreign exchange markets provide a way to hedge the risk by fixing a rate at which the transaction will be concluded at some time in the future.
To accomplish this, a trader can buy or sell currencies in the forward or swap markets, at which time the bank will lock in a rate so that the trader knows exactly what the exchange rate will be and thus mitigate his or her company's risk.
To some extent, the futures market can also offer a means to hedge currency risk , depending on the size of the trade and the actual currency involved. The futures market is conducted in a centralized exchange and is less liquid than the forward markets, which are decentralized and exist within the interbank system throughout the world.
Since there is constant fluctuation between the currency values of the various countries due to varying supply and demand factors, such as interest rates , trade flows, tourism, economic strength, geopolitical risk and so on, an opportunity exists to bet against these changing values by buying or selling one currency against another in the hopes that the currency you buy will gain in strength or that the currency you sell will weaken against its counterpart.
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. 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. 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. 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! 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. Leverage in the range of 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: 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.
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. This makes it the perfect market for traders that use technical tools. If you want to learn more about technical analysis from one of the world's most widely followed technical analysts, check out Investopedia Academy's technical analysis course.
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.
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. 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. Upon the original publication of this article, the Japanese interest rate is. For more, read The Fundamentals of Forex Fundamentals.
For most traders, especially those with limited funds, day trading or swing trading for a few days at a time can be a good way to play the forex markets. For those with longer-term horizons and larger fund pools, a carry trade can be an appropriate alternative. In both cases, traders must know how to use charts for timing their trades, since good timing is the essence of profitable trading. And in both cases, as in all other trading activities, the trader must know his or her own personality traits well enough so that he or she does not violate good trading habits with bad and impulsive behavior patterns.
Let logic and good common sense prevail. Remember the old French proverb, "Fortune favors the well prepared mind! Dictionary Term Of The Day. Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education.
A celebration of the most influential advisors and their contributions to critical conversations on finance. Become a day trader. Currency as an Asset Class There are two distinct features to this class: You can earn the interest rate differential between two currencies. You can gain value in the exchange rate. Why We Can Trade Currencies Until the advent of the internet, currency trading was really limited to interbank activity on behalf of their clients.
Forex Risk Confusion exists about the risks involved in trading currencies. Bottom Line For most traders, especially those with limited funds, day trading or swing trading for a few days at a time can be a good way to play the forex markets.
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The value of a bond at maturity, or of an asset at a specified, future valuation date, taking into account factors such as No thanks, I prefer not making money. Get Free Newsletters Newsletters.More...