How many times have you seen headlines about the dollar going up or the euro going down? Have you ever wondered why some analysts spill thousands of words over every half-penny fluctuation of the yen or the pound?
Well, part of the answer is Forex.
What Is Forex?
The Forex, or "Foreign Exchange," market is for buying and selling currencies. There's no central Forex marketplace in the way that the New York Stock Exchange or the CME have physical floors. Instead, when traders talk about the Forex market, they mean a worldwide network of traders, banks and investment houses which collectively make up this enormous market.
Forex trades happen over the counter, or OTC. This means that all trades are done between investors and institutions directly rather than through a central exchange. (The Forex futures market can be an exception to this, as we'll discuss below, but it's an unusual one.)
How Does Forex Trading Work?
It is not too far to say that Forex markets finance global trade.
When you travel to Thailand and trade dollars into baht, the local bank needs a reason to give you its spendable money in exchange for a currency it can't use to pay the rent. When a U.S. car dealership wants to sell Volkswagen (VLKAF Jettas, it needs to buy those cars with euros that it doesn't have. These businesses depend on the ability of money to cross borders.
This is where Forex comes in. This market plays an essential role in global trading by giving currencies value against each other.
The goal of a currency trader is to profit off the movements of one currency against another. A trader who feels, for example, that the euro will gain strength against the dollar would trade these two currencies, while another might do the same with the pound and the Turkish lira. These are called currency pairs, and they are the building blocks of the Forex market.
Currency appreciation happens based on perceived or actual strength of an economy. As the demand for a given currency increases, its price rises. This demand is driven by a wide variety of factors, including supply of notes in circulation, exports, imports, interest rates, government debt, and political/criminal stability.
Appreciation can happen worldwide, or demand for a given currency can increase within isolated economies. For this reason currencies are tracked against each other, not against an objective market.
Forex Trading Example
David is a Forex trader who pairs the U.S. dollar against the European Union euro. The euro is currently trading at $1 U.S. to 0.88 euros/1 euro to $1.14 U.S., and he believes the euro will get stronger against the dollar. He buys 10,000 euros. This costs him $11,409.47 U.S.
The following day the euro appreciates. It now trades at $1 U.S. to 0.869 euros/1 euro to $1.15 U.S. (approximately). He converts his euros back to dollars and collects $11,500, a profit of almost $100.
David's profit came from holding euros until they increased in value against the dollar, then trading them back.
How Is Forex Notated?
You will often see Forex notation in the format of Base/Quote/Bid/Ask. This is not the only format. Formal trading screens typically include much more data, but this is the essential information you need in order to understand a position.
- Base: the currency against which the bid and ask prices are set.
- Quote: the currency in which the bid and ask prices are set.
- Bid: the price for which you can sell 1 Unit of the base currency, set in units of the quote currency. (It is the price at which the broker will buy the base currency.)
- Ask: the price for which you can buy 1 Unit of the base currency, set in units of the quote currency. (It is the price at which the broker will sell the base currency.)
- Spread: the difference between the ask and the bid prices. It is almost always positive because the ask is almost always higher than the bid. This reflects the cost of trading; an institution will always sell its local currency for more than it buys that currency.
This can be confusing, as sometimes the local currency in which an institution operates or the currency in which a trader intends to close his position may be referred to as the base currency as well. That format is disfavored.
Example of Forex Notation
Below, is an example using this typical Forex notation:
- The base currency here is the euro. This trade will be structured around the euro.
- The quote currency is the dollar. The price for this trade will be set in dollars.
- The bid price is $1.1396, this trader will buy 1 euro from you for $1.1396 U.S.
- The ask price is $1.1397, this trader will sell you 1 euro for $1.1397 U.S.
- The spread is $0.0001, this is the difference between the ask and bid prices. It is the profit that the trader anticipates from trading euros in dollars.
Long and Short Positions in Forex
In Forex you are always simultaneously long and short at the same time based on which currency you have bought and sold.
In a long Forex position you buy the base currency in the anticipation that it will increase in value. In doing so you take a short position against the quote currency, anticipating that it will decline in value against the base.
In a short Forex position you sell the base currency in the anticipation that it will decrease in value. In doing so you take a long position against the quote currency, anticipating that it will gain value against the base.
• Example: Long EUR/USD
In this trade you have purchased euros with dollars, anticipating that the euro will appreciate against the dollar. You will close your position in dollars.
• Example: Short EUR/USD
In this trade you have sold euros and received dollars, anticipating that the euro will lose value against the dollar. You will close your position in euros.
Readers will note that these two positions are mirror images of each other. At all times when you are long in one currency you are short in another.
Three Forex Contract Formats
There are three main types of Forex trades: spot, forward and futures.
1. Spot Market
Spot trades are the real-time selling and purchasing of currencies. In a spot transaction you buy or sell a currency according to its current price as listed.
This is by far the largest Forex market.
2. Futures Market
A futures trade is a standard futures contract sold on a commodities and futures exchange. In this contract you agree to buy or sell a currency at a set price on a set date.
This is the only significant form of Forex transaction that is not handled privately.
3. Forward Market
This is a futures contract that is not conducted on an exchange. Instead, it is dealt with over the counter (OTC), meaning that two parties make the contract between themselves.
While structurally no different from a futures contract it comes with the risk of default if the other party does not fulfill their end of the bargain.
Should You Trade Forex?
Forex is a difficult market for the retail investor.
While online trading has made this an increasingly easy market to get into, the small margins of currency fluctuation can make it a very difficult one in which to make any meaningful gains. Typical Forex traders will manage single trades worth millions of dollars, as this is the scope required for realistic profit margins in a market where prices move by pennies (or fractions thereof).
As a result this can also be a highly dangerous market. The scope of Forex trading lends itself to aggressive leveraging. It is common for traders to make their deals while putting up only a fraction of the actual cash in their transaction. They pay for their initial investment with the money they make after closing out their position. Closing out a position which has lost money requires them to cover the difference from their portfolio (or even personal) assets.
Under virtually no circumstances should you adopt a leveraged position.
However, if you are comfortable with small gains and potentially high paced trading, there is little harm in the Forex market as long as you stake your own capital. It is a market with little relationship to stock movement and can provide some slow and steady diversity to your portfolio.