What Is Forex? The Very Basics Of Forex Markets
The FOREX (currency) market is the biggest and the most liquid financial market in the world. Its name comes from FOReign EXchange and it’s actually the place where people and institutions from all around the world exchange currencies. It’s so big that more than the worth of $5 000 000 000 000 (5 trillion US dollars) are traded every single day there. This number is huge, having in mind that all the services and goods traded in the United States for a year are around $17 trillion. Just for a little more than 3 days the FOREX market beats the turnover all US companies and people make, buying all kind of stuff for a whole year.
The currency market is actually the place where the market value of all traded currencies is determined by the trades happening there. If the US dollar (USD) is exchanged for 120 JPY (Japanese Yen) at the moment, this means that the price of the dollar is exactly 120 yen. If someone buys dollars at 120.10 yen, this changes the world price of the dollar against the yen to 120.10 . Every single deal on the market determines the current world price of a currency. And because there are hundreds of thousands of deals every single day, the price of a currency constantly changes, sometime several times per second.
The forex market is international and it’s highly decentralized and unregulated. There is no special institution responsible for the trades there. It works 24 hours a day during the work week and it’s closed on Saturday and Sunday.
The FOREX market is decentralized which means that there is no central institution (like the SEC) regulating it. The market constitutes from all the banks and financial institutions exchanging currencies on it. This is why the forex market has no physical location.
How to trade on FOREX?
Practically only banks and other financial institutions have a direct access to the forex market. If you want to trade there you must apply for a forex trading account with a financial broker. Have in mind, that not all brokers offer direct access to the market. The so called retail forex brokers don’t even execute your currency trades, they just register the buy and sell prices of your positions and this way calculate your profit/loss from the position. If you want to be able to really trade on the foreign exchange, you have to explicitly find a broker that offers this and prepare a relatively larger amount of money for this. If you just want to speculate, the retail forex broker are OK enough for this purpose.
The forex market is the perfect market
There are so big volumes on the forex market, there are so many participants there who have equal access to information, that the forex market is the closest to the so called perfect market, or perfect competition.
How are currencies traded?
The currencies on the forex market are traded in currency pairs. If you need to buy a currency, you have to sell another currency and vice versa. EURUSD for example is the most popular currency pair. Each pair is a separate financial instrument. The first currency is called base currency and the second one is called counter currency. The price of a currency pair is calculated by dividing the price of the base currency to the price of the counter currency. For example, if the price of the EURUSD pair is 1.1250 on 01.01.2015, this means that 1 euro is exactly 1.1250 US dollars. For example, if you have $1 000 and you want to exchange it for euro, you have to first sell your $1000 and then buy its equivalent in euro. On the forex market this is represented as a sell at the EURUSD currency pair. This means that you buy euro and sell US dollars at the same time. To calculate the exact amount of euro you will receive, you need to divide your $1 000 to the EURUSD current price:
$1 000 / 1.1250 = 888.889 euro
This is how when you are exchanging your $1 000, you sell $1000 and in the same time buy 888.889 euro.
If you want to sell your euro in a later moment, you have to sell the EURUSD currency pair. On 10.01.2015 the price of EURUSD has changed an it is now 1.1425. To convert you 888.889 euro you have to sell euro and buy dollars in the same time, but this time you will get more than your initial $1000, because the euro has risen in value against the dollar:
888.889 * 1.1425 = $1015.55 – you realize $15.55 profit.
This is how:
- when the price of EURUSD pair rises – the value of euro rises against the dollar = the dollar falls against the euro
- when the price of EURUSD pari falls – the value of the euro falls against the dollar = the dollar rises against the euro
There are many different currency pairs, practically any combination between any two currencies form a currency pair. Other popular pairs are: USDJPY, GBPUSD, AUDUSD, NZDUSD, USDCHF,….. etc.
The following 7 pairs: EURUSD, USDJPY, GBPUSD, USDCHF, AUDUSD, USDCAD, NZDUSD are called ‘The majors’. These are the most heavily traded pairs and they are responsible of more than 85% of the transactions on the forex market. They are also the most liquid currency pairs. The EURUSD pair is currently the absolute leader among them, more than 28% of all transactions are with this pair, according to the Bank for International Settlements (BIS).
Why People And Companies Use Forex?
For example, an European company wants to buy materials from the USA, where payment are made in US dollars. The EU company operates with euro and it has to buy dollars, in order to purchase the required materials from the US.
Another example is when you go on a vacation in a different country. You have to change some of your local currency into the other country’s currency, in order to be able to buy goods and services there.