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Forex Trading: A Basic Guide

Forex, or foreign exchange market, can be understood as a network of buyers and sellers, who exchange currency among themselves at a predetermined price. Through forex, individuals, companies, and central banks are able to convert one currency into another. You may have carried out a forex transaction if you have traveled outside your country. 

Of course, a lot of foreign exchange activities are done for practical purposes, a major chunk of currency conversion happens with the ultimate goal of earning profit. The amount of currency that gets converted every day can make price movements of certain currencies very volatile. Since this volatile nature brings many profit-making opportunities, traders are attracted to forex. But do bear in mind that volatility is also a major factor that contributes to increasing the associated risks with forex trading. 

Let’s now look at forex like a beginner and understand what makes it so attractive for traders.

What Is Forex?

An exchange rate is basically the price you pay for one currency in exchange for another. The forex market is steered by such currency exchanges. 

Overall, a forex trader would come across 180 different kinds of official currencies in the world. However, a majority of international forex trades and payments are carried out using the U.S. dollar, British pound, Japanese Yen, and Euro. Other than these the Australian dollar, Swiss franc, Canadian dollar, and New Zealand dollar are also popular. 

Currency can be traded wherever the underlying instrument is yet another fiat currency. This can be done via spot transactions, forwards, swaps, and option contracts. Currency trading takes place round the clock around the world, 24 hours a day, five days a week.

How are currencies traded?

Similar to the ticker symbol in the stock market, all currencies have a three-letter code. As we discussed above, there are a number of currencies around the world but the U.S. dollar is involved in most forex trades, so you should remember its code, i.e: USD. Second to USD is the Euro which is accepted in 19 countries in the European Union and is denoted by EUR in the forex market. 

Some other codes that will be helpful to know are the Japanese yen (JPY), the British pound (GBP), the Australian dollar (AUD), the Canadian dollar (CAD), the Swiss franc (CHF), and the New Zealand dollar (NZD).

Forex trading takes place in currency pairs that are expressed as a combination of the two currencies being exchanged. The seven currency pairs below are referred to as the majors and they account for about 75% of trading in the forex market:

  • EUR/USD
  • USD/JPY
  • GBP/USD
  • AUD/USD
  • USD/CAD
  • USD/CHF
  • NZD/USD

Who trades Forex?

While it is true that the forex market has many players, it also has several different types of players. Let’s take a look at some of the major types of institutions and traders in forex markets:

Commercial & Investment Banks

The interbank market witnesses a large volume of currency trades. Different banks, irrespective of their sizes, trade currencies with one another through this market using electronic networks. Needless to mention, it is the big banks that make up a large chunk of total currency volume trades. Banks are the ones that carry out forex transactions for their customers and also conduct speculative trades from their own trading desks.

When banks step into the shoes of a dealer for their own customers, the bid-ask spread is a reflection of the bank’s profits. 

Central Banks

The role of central banks in the forex market cannot be underplayed as they in a way operate on behalf of the nation’s government. Open market operations and interest rate policies of central banks can have a significant impact on currency rates.

It is the central bank’s duty to take care of the price of its native currency on forex. This refers to the exchange rate regime as per which the currency will begin to trade in the open market. Exchange rate regimes are further classified into three types: floating, fixed, and pegged. 

A central bank acts in the forex market to stabilize a country’s economy or to make it more competitive. Central banks along with speculators may participate in currency interventions in order to make their currency value increase or decrease. For instance, a central bank may choose to weaken its own currency by boosting supplies during the time when the market is slow and then use it to buy foreign currency. This strategy weakens the domestic currency which contributes in promoting competition in terms of exports in the global market.

Central banks typically take up such a strategy to control inflation. 

Investment Managers and Hedge Funds

Portfolio managers, pooled funds, and hedge funds are the ones that follow banks in terms of their forex market share. Investment managers trade currencies on behalf of major accounts such as pension funds, foundations, and endowments.

An investment manager who has an international portfolio will have to buy and sell currencies to be able to trade foreign securities. Investment managers might even go ahead and make speculative forex trades. Though there are some hedge funds that carry out speculative currency trades under the umbrella of their investment strategies.

Multinational Corporations

There are firms that are involved in imports and exports. They tend to execute forex transactions so they can pay for the various goods and services they use or trade. Companies trade forex so that they can cut down the risk which comes with foreign currency transactions. The same firm may buy American dollars in the spot market, or get into a currency swap agreement to get their hands on the dollars prior to buying the components required from the American company. This brings down their risk exposure. 

Individual Investors

The forex market has opened to retail investors recently and thus retail investors have a rather small share in the market in terms of trade as compared to financial institutions and companies. However, the number of retail investors in the forex market is growing steadily now. 

The Bottom Line

The forex market is empowering for all investors and that is probably why it is the largest financial market in the world. Everyone can see the profit potential in the market that comes from the fluctuation in the global economy.