The Forex Market has always been considered mysterious with famous stories of fortunes being made and lost. We have all heard a lot about the Foreign Exchange market and indirectly everyone has been a trader in the trillion dollar market. Yes, every time you tried to convert the currency of your home country to another, you were trading in the Forex market. Though the above is very different from Forex trading, in essence foreign exchange market takes into account the profit or loss made while converting one currency into a different currency.
What is the Forex Market?
Forex Market is a global market where currencies are bought and sold, exchanged and speculated on and thus is called the Forex market by traders. It involves trading one currency in terms of the other and the trading activity is carried out Over the Counter. This Forex market happens to be the largest and the most traded financial market in the world.
Now, we know that no market can function without there being those who demand and those who supply products or services in the market. The participants in the market at first were primarily central banks, multinational firms, and big financial institutions. Over time, technology has made it possible for individual retail traders to join the league. The market operates 24 hours a day and all throughout the week and the market has no particular physical location.
There is a purpose behind the existence of the Forex Market. Let us understand the functions that it plays:
FUNCTIONS OF FOREX MARKET:
The Interbank Market and the Over-the-Counter Market
Now, we have two major divisions of the Forex Market: Interbank Market and the Over-the-Counter Market. The Interbank Market refers to the market where the buying and selling activities take place and a network is established between the biggest banks in order to exchange currencies. The banks interact with each other continuously, trying to maintain the uniformity in the exchange rates.
Other transactions and trading activities carried out between the individuals and the companies take place in the Over-the-Counter market. The Over-the-Counter Market lacks a centralized system for trading and there is no clearing house. This market has become popular with more and more companies initiating the trading activities online.
The Spot Market and the Forward Market
Further, depending on the time of the transaction, there is the spot market and the forward market. The spot market takes into consideration the currency price at the time of the trade while the forward market involves an agreement to exchange the currencies on a certain future date at an agreed-upon price.
Basically, the spot market deals with transactions that are of an everyday nature and such transactions are current transactions. While the forward market follows a futuristic approach and deals with transactions which shall occur on a future date in order to mitigate the future loss for the trader.
The Features of the Forex Market
Let us find out about the features of the Forex Market:
- Liquidity
The Forex market is characterized by being highly liquid and it changes rapidly. It is considered as the most liquid market in the world. Again, there are two sides to this liquidity, the positive and the negative; the positive side of a liquid market is that there is no room for manipulation while the negative side is that it creates a high degree of uncertainty in the market.
- All-Encompassing and Dynamic
The Forex market acts as a great investment opportunity for all and all it takes is the right investment strategy to understand the size and extent of the investment. Therefore, if the traders are able to understand the dynamics of the market it can prove to be the most fruitful investment opportunity for them.
The Forex Market is the biggest in the world of finance and includes currencies across the globe.
- Transparency and All-time operation
The Forex market is transparent in the sense that it enables trading activities directly with the market makers, eliminating the role of middlemen and therefore any price discrepancies. Also, the Forex market operates for 24 hours of the day all 7 days of the week providing easy trading access to the users across different geographies, thereby indulging in trading of a huge volume of transactions.
Major, Minor & Exotic Currency Pairs in Forex:
As Forex Trading involves the conversion of one currency in terms of the other, the Forex market usually considers the currencies in pairs.
The major currency pairs refer to those pairs which make a comparison with the US Dollar on one side against another currency. These pairs are highly liquid and are the most traded.
The minor currency pairs, also called the cross-currency pairs can simply be understood as those pairs which do not include the US dollars. Initially, there was no comparison medium available for drawing the exchange rates between two non-US dollar currencies. So, the currencies would be converted in terms of the US dollar and the exchange rate would be calculated accordingly. In course of time, currency crosses were introduced and the problem has been eliminated.
Exotic currency pairs comprise of a combination of a major currency along with an emerging or smaller currency.
Why can currencies be traded?
We have come far in understanding how the Foreign Exchange markets work, but one major question that may be going on in our minds would be as to why currencies can be traded and what would be the benefit of trading currencies. So, operating in the Forex market can help the traders to earn the difference between the interest rates and also gain value in the exchange rate.
Also, currencies are traded by a variety of institutions from banks, central banks, investment managers, corporations, hedge funds and individual investors. Each trader in the Forex Market has a different role to play in increasing the competitiveness, trading foreign securities, hedging risk to bringing a stability in the economy.
The Forex movements play an important role in impacting the level of inflation and the maintenance of Balance of Payments (BOP) in the economy. Therefore, the Forex Market empowers the economy and helps in improving the profitability of the economy.
Long Term vs. Short Term Forex Trading
There are different schools of thought on whether traders participating in the market should opt for long-term trading or short-term trading. It is the discretion of the trader whether to invest for the long term or the shorter term.
A short-term trade is the one that lasts for less than a week. Short-term traders may also be involved in the trading activity for a few seconds, minutes or a few days. However, one disadvantage of short-term trade is that these traders trade more and hence, are forced to overcome the spread more often.
A long-term trade may simply be classified as something that is not a short-term trade. However, a long-term trade is also considered on the basis of how the trader is able to manage the position during the holding period.
It is believed that short-term trading is less flexible as against long-term trading as the long-term traders find enough time to manage and adjust the transactions in the longer run. Long-term trading, therefore, has the potential to be more profitable and it is possible to control risk better in the longer run. However, there are many traders who find it tempting to operate in the shorter term in the Forex market. They are happy with the gains they make in the short term and wish to exit the market soon after.
Participation in the Forex Market – Who is Affected?
Even you may have been a participant in the Forex Market when you tried to exchange the US Dollars in Euros or Pounds for your international trip. Apart from you, there are a wide range of participants in the Forex Market.
The major participants include:
- Central Banks
constitute the most powerful segment among the participants of the Forex Market. The Central Bank could be independent of the Government of the Country or may work in close liaison with the Government.
- Commercial Banks & Other Financial Institutions
are the next category in the tier and happen to constitute the broadest segment of participants among all since there are highest number of large banks and institutions in the market.
- Non-Bank Corporations (Multi-National Corporations)
are another major participant in the Foreign Exchange market for the reason that they operate in more than one geographies. This category may also include exporters/ importers as foreign currency is centric to their day-to-day activities.
- Brokers
are also considered as the market makers and facilitate a huge volume of transactions in the Forex market. Brokers operate on behalf of individuals or banks and have enough experience in the Forex market and understand exactly what the client wants and which opportunity would prove to be the most rewarding investment for the client.
- Currency Speculators and Traders (Individuals or Small Businesses)
are those who are looking to make money by the fluctuations in the rates of exchange. The degree at which they are operating and what they are seeking in the market may differ for each and this shall determine their tenure and extent of the trading amount in the market.
- Travelers
are another party affected by the fluctuations in the exchange rate. Although they comprise the smallest segment of those who are affected by the exchange rate and perhaps, the most insignificant one but it is extremely important to consider them talking about participation in the market.
The Forex Market Instruments
Before we think of trading in the market, we must know the instruments that are available for striking the right kind of trading deal. There are 2 major instruments traded in the Forex market which facilitate the trading transactions in these markets, namely Currency Agreements and Derivatives. Depending on the goals of traders and their requirements and whims to trade in the market for a shorter or longer duration they will help them in making the right choice of the instrument to be traded in the market.
Agreements
Agreements or Currency Agreements are the first types of instruments traded in the Forex market. Currency agreements deal with Spots, Forwards, and Currency Swaps. Spot transactions, also termed as cash transactions, refer to those which are made on the spot (currently) i.e. not later than the next day on which the agreement is made. Forwards deal with an agreed upon ‘forward’ rate for exchanging the currencies especially at the time of fluctuating rates of exchange. Currency swaps refer to the purchase and sale of currencies simultaneously on different exchange rates on different dates. The swap price is the difference between the exchange rates.
Derivatives
An underlying asset or ‘underlying’ determines the value of the instrument in case of Derivatives. Common derivative instruments are Currency Futures, Currency Options, and Interest rate swaps. Currency Futures refer to an agreement to purchase or sell the currency on a future date on a pre-decided price. Currency Options set a certain option date and the trader is free to exchange the currency at the pre-established rate before the expiry of the date of the option. Depending on whether the currency is to be sold or bought, options are called a put option and call option. Interest Rate Swaps are an agreement of the contractual nature, between two parties for making an exchange of payments.
Another derivative is SAFE i.e. Synthetic Agreement for Foreign Exchange which aims to protect the agreement of the rate of interest established for the future.
Forex Hedging
We all understand that risk is an important element of the Forex Market. Hedging is the way out to steer clear of this risk and protect the trader from incurring a big loss due to unfavorable market conditions. What a Forex Hedge basically does is to protect the traders looking to exchange the currency on a certain future date, from the fluctuations and the possible losses in the exchange rate in the future. The trader is therefore guarded against the downside risk.
The Forex Hedge is usually done through the spots contracts or options. While spots are short-term tools, they are ideal for hedging. However, options are also, another effective tool used for currency hedging which gives the trader the right to place an option to secure a future trade.
Moving towards Forex Trading
There is an art to trade in the Foreign Exchange Market and you cannot succeed in the market unless you understand the approach to trade. Whoever is approaching Forex trading, needs to be aware of the market conditions, the rules to trade, their personal targets, the period in which they are looking to trade, etc. to be able, to begin with it in the right way.
A few important considerations before actually beginning with Forex Trading are provided below:
- The right time to trade:
Traders must evaluate the market trends before beginning with their trading activity. A look at the previous weekly or monthly charts would give a fair idea about the growth or decline of the commodity. The trader must be aware of the risk that they will be taking in the Forex market and must plan out accordingly.
- Trading Instruments:
The next consideration is to decide on the trading instruments depending on the requirement and vision of the trader. There are a variety of instruments available in the market and it is the discretion of the trader to select a stable and lucrative trading instrument.
- The Approach to Trading:
The kind of approach the trader has towards the trading activity has a big role to play in its success. Therefore, the trader must be very alert, hold very practical expectations and maintain a level of discipline if they want to end up getting the best bet of the trading transaction.
- The Advanced Technical Analysis:
The method of evaluating the future price on the basis of past figures along with some analysis of the current changes is what is termed as Advanced Technical Analysis. The Technical Analysis is instrumental in helping the trader devise the trading strategy. The techniques that are a part of the Technical Analysis in Forex Trading include charting analysis done by drawing candlestick charts, bar charts, line charts, etc. apart from other technical indicators and patterns.
- The Trading Strategy:
Following the right strategy is crucial to trading in the Forex market. Although there is no specific fool-proof strategy for attaining success in the trading transactions, the trader will be able to identify the ideal strategy with experience and learning more and more about the trade and the market conditions.
How does Forex Trading work?
Using Forex Trading to make money is something every person would want. But how the process of trading goes on in the market and how one can make money by trading in the market is something that we are not exposed to currently. The phenomenon of making money by trading currencies is attractive and there is a lot that the traders can gain provided they put to use the right strategies to benefit from the trading deals. Forex trading gives the traders the option to participate in the trading activity either by seeking help from brokers or to invest as private individuals. The exchange rate is established by the equilibrium of the buying and selling bids i.e. the demand and supply in the market. However, in a few scenarios, the rate of exchange is pegged or fixed by the Government, in such scenarios this rate will be valid.
The traders must be able to ascertain whether the currency that they are looking to trade in will rise in value in the future. Foreign Exchange has been a major support for the functioning of Central Banks for the past many years. Factors like economic and political instability have a major bearing on the work of financial markets.
The trading sessions determine the working of the Foreign Exchange Market which means that each zone has its own currency and its own trading session timings. But, the closure of the trading session in its zone is not the end of the trading activity for that particular currency simply because, the currency is traded across different time zones and geographies, thereafter.
Forex trading does not work in a centralized platform but across several communication networks all across the globe.
Forex Trading Sessions
Do you know when the right time to trade is? We will help you to solve this puzzle. An important consideration for successful trading is making the choice of the time to trade. Though the Forex market remains operational all throughout the day, there are certain times reserved and specific to the different geographies when the foreign exchange market remains most active.
The participants of the trading activity must be aware of the appropriate timings to trade in order to make the most of the available opportunities and be able to make the maximum amount of profits in the trading sessions.
The three major sessions in the Forex Market are called the Tokyo, London and New York sessions respectively considering that the names are given after the major financial Centers of the world. Apart from this, there is also a Pacific Session where Sydney is the major financial Centre.
- The Asian Session or the Tokyo Session is held from 11 p.m. to 8 a.m. GMT
- The European Session or the London Session is held from 7 a.m. to 4 p.m. GMT
- The North American Session or the New York Session is held from 12 noon to 8 p.m. GMT
The trader now has to decide on making the choice of the right trading session by aiming at the level of volatility which is favorable for the individual. Also, past analysis and experience reveal that the ideal trading time is when most of the countries open their trading sessions in order to enable the trader to leverage the opportunity for maximum returns.
The Risks and Rewards of the Forex Market:
If there is a profitable activity, there is certainly a high degree of risk involved. Initially, the intention is not to try and grow the capital but to minimize the degree of risk in the transactions.
A few types of risks are:
Interest Rate Risk:
The interest rates on borrowings impact the exchange rates of the economy. With the increase in interest rates, the road to higher foreign investment is opened which leads to an increased demand for the value of the home currency.
Leverage Risk:
Leverage is an important aspect for making an investment or borrowing money can either prove to be profitable for the business but at the same time, it can rip the business apart by causing a loss of the same magnitude.
Political Risk:
Political risk can influence the economy for the good or bad depending on the policies and the situation. The spot market is the most affected by the political conditions prevailing in the country. There can be a lot of uncertainty and fluctuations in the exchange rate at the time of elections.
Credit Risk:
The risk of default in payment due in a Forex settlement is defined as a credit risk. This risk may arise on account of bankruptcy, insolvency or any such event that may cause the counterparty to fail in paying the amount in exchange of the currency. Various measures are taken to reduce the potential credit risk in the trading transactions.
Operational & Broker Risk:
Failure in internal systems, processes, gaps in communication, etc. can prove to be risky for the Forex market as it could lead to a delay in the processes. Also, the interaction with an unregulated broker can lead to a negative impact on the trading activity. It is, therefore, extremely important that the right broker is chosen after making sufficient research.
Common Mistakes in Forex Trading
As a beginner who is not well aware of the market, one is expected to make mistakes while trading. In due course, it will not be very difficult for the traders to grab knowledge about the market and trade with perfection.
- Risk Management: often those who are not well-aware of the market may falter in ascertaining the degree of risk that they should take in the trading activity.
The traders must be able to manage their daily losses so that they are able to secure the gains in the future.
- Getting carried away with the gains & over-trading: it is human nature to be overwhelmed by increasing gains. However, one must understand where to put a stop and not take the risk of losses by investing further.
- Estimating by the Averages: Foreign Exchange rates vary unexpectedly and mostly rampantly, so the rate at which the rate may finally settle down cannot be estimated by taking the averages according to the prevailing conditions or the previous day conditions.
- Lack of discipline: discipline is an important and indispensable principle of the Foreign Exchange market. Trading is not about doing about whatever comes to one’s mind and it cannot be random guess-work. There has to be an intensity of discipline and a proper plan so that the trader is able to mitigate losses. However, it is also important that the trader switches between various strategies so that, he is able to find out the best strategy that could be used specifically in different situations.
- Going by the Flock Mentality: for those who lack knowledge, it is natural to do as the others in the crowd are doing but, this can cost the trader if the strategy that he follows goes against him. Therefore, each trader should evaluate the situation and devise the strategy specific to the scenario.
The Advantages and the Disadvantages of the Forex Market:
Trading in the Foreign Exchange market has its own pros and cons. Apart from the rewards and the risks that surround the trading transactions, there is a lot more to the Forex market. By this time, you may have been able to judge its advantages and disadvantages. Let us have a look at the major advantages and disadvantages.
The Advantages:
- Easy Entry & Exit: One of the most attractive features of the Forex Market is that it allows the traders to enter the market and exit the market according to their will.
Entering the market is not a very complex process and it does not require much from the traders and the same remains for exiting the market. Traders may exit the market depending on their goals and whether they have achieved what they had set out for in the market. They also have the option to enter the market for a very brief trading period in the market.
- 24 Hour Trading: The availability of the Forex market all throughout the 24 hours and 7 days of the entire week enables users to trade according to their convenience and especially for those who participate in the trading phenomenon as a side activity and not a full-time activity. Also, the fluctuating changes in the pricing can be monitored all around the clock bringing a high degree of flexibility in the processes.
- Transparency: Though the volume of transactions that take place in the market is big, the Forex market does allow the information to be accessible for the all, therefore, ensuring the market operates in a transparent manner.
- Elimination of Middlemen: Trading in the Forex market has reformed in the sense that there is no need for individuals to trade through the broker. Traders may partake the trading activity privately and not have to pay any commission to the brokers.
The Disadvantages:
- Unregulated: There is no central authority to control the Forex market which leads to an increased chance of fraud and unethical activities, therefore, deterring the Forex market from operating at its full capacity. Therefore, the lack of a central regulatory body costs the traders when such activities take place.
- Leverage: One drawback accompanied by liquidity in the Foreign Exchange market is leverage, which can act as a negative aspect if not used in the right manner. Leverage allows traders to trade uncontrolled amounts after contributing a smaller portion of the money. Therefore, the trader must understand the thoughtful and right use of leverage so that it is fruitful for the trader and do not incur major losses.
- Lack of Knowledge & Operational Risk: Traders who are beginners in the market may not have complete knowledge of the market and the direction of change in the market. Therefore, lack of a complete understanding of the market may lead to a negative factor in the growth of the trader’s earnings. Therefore, it is important for traders to understand the proper working of the Forex market to avoid making significant losses.
Forex Trading Important Terms:
- Spread: The difference between the buying price (bid) and the selling price (ask) is called as the spread in the Forex transaction.
- Leverage: Leverage or Margin determines the difference which the traders can use in the currency movements for trading. However, the trader must understand the right way to use leverage to their advantage lest they incur a loss.
- Hedging: Hedging involves securing the position in the Forex market in the opposite direction so that in the event of an untoward activity the same existing position can be retained.
- Swaps: When the currency bought by the trader sees an increase or decline in the interest rate, it is called as a swap. Swaps may be positive or negative and are also called positive rollovers and negative rollovers.
- Pip: Pip or Point in Percentage is the minimum movement in the price of a currency. It could lead to a profit or a loss.
Is it Right for You?
After finding out so much about the Forex Market, whether the Forex Market is really the right choice for your investment is certainly an important question.
- If you can understand the right use of leverage and know when to stretch the leverage and to what extent, the Forex is the right place for you.
- If you follow a disciplined action system for the market, the Forex market will help you make the big shot earnings, so yes then it is the right place for you.
- If you are looking to trade in currency on a fundamental or technical basis and you are ready to study and work hard, the Forex market is the right investment.
- If you keep a track of the news related to the Forex market and can analyze the financial jargon associated with currency investments, you will be able to perform in the Forex Market.
- If you are able to handle risk, the Forex markets will certainly reward you handsomely.
