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What is Forex Trading?

Your capital may be at risk. This material is not investment advice.

The trading in currencies has its roots back to the ancient times when the practice of exchanging money was actually very common. There were money-changers who used to help people in changing money and charge a commission or fee for exchange.

Today, Forex or foreign exchange is a marketplace where trading of currencies takes place. Whether people from anywhere in the world realize this fact or not, the currencies are vital to most of them. This is because all foreign businesses and trades are possible when a currency is exchanged. For example, if someone living in the US wants to purchase cheese from London, then that person or the company from which cheese is purchased will have to pay the cheese supplier from London in pounds (GBP). It means that the US importer should exchange equivalent US dollars (USD) into pounds (GBP).

The same is true while traveling to another country. An American tourist when traveling in China can’t pay in dollars because the American currency is not locally accepted in China. The tourist should exchange the dollars for local currency for covering expenses in China.

It is the need for exchanging currencies which makes the Forex market the biggest and most liquid market in the world. The total volume of Forex market is around US $2,000 billion every day and these numbers make every other financial market in the world tiny. (The traded volume is not consistent all the time and in August 2012, BIS reported that the Forex market had a trading volume of more than US $4.9 trillion every day).

A unique feature of the Forex market is the absence of any central marketplace where the foreign exchange can take place. Trading in currencies takes place electronically OTC (over-the-counter), which implies that all the transactions occur through computer networks amongst the different traders all over the world. A single centralized exchange is absent. The market is open for 24 hours on all weekdays except for Friday because on Friday, the Forex market is active for half day only and on weekends, it remains closed. The major financial centers for currency trading are New York, London, Zurich, Tokyo, Frankfurt, Singapore, Paris, Hong Kong and Sydney. Trading in the Forex market can be done anytime of the day because when the trading session in US ends, the Forex market starts anew in Hong Kong and Tokyo. This is why this market remains very active in any time of the day.

Spot Market, Futures Market and Forwards Market

The individuals, corporations, and the institutions do Forex trading through three markets – spot market, forwards market and futures market. Forex in the spot market is always the largest since it is the real “underlying” asset on which futures and forwards market is based upon. In the past, the most preferred and famous place for traders was futures market because its availability to individual investors was maximum. However, the arrival of electronic trading and emergence of numerous brokers has brought a huge increase in activity of the spot market and it has now surpassed futures market as the most preferred trading platform for individuals. Today, when people talk about the Forex market, they mean the spot market. Futures and Forwards are more preferred by companies that hedge their risks of foreign exchange in future.

Spot Market

In the Spot market, the currencies are purchased and sold on the basis of their current price. This price is determined by the demand and supply. This price is also impacted by many things, like economic performance, interest rates, sentiments towards current political situations (both local and international), and the perception of the upcoming performance of a currency over another. When finalized, a deal called “spot deal” takes place. The transaction is bilateral where one party gives an agreed-upon amount in a currency to other party and receives a specific amount in other currency. This transaction occurs at an exchange rate value which was previously agreed-upon. After the closing of position, the settlement happens in cash. The spot market is usually known as the market which deals with the transactions occurring in present (instead of future), the trades actually settle in two days.

Futures and Forwards Market

Unlike spot markets, the futures and forwards market don’t trade in real currencies. The dealing is in contracts which represent claims of a certain type of currency, a particular price, and a future settlement date.

In forwards market, the buying and selling of contracts happen OTC in between two individuals or parties who themselves finalize the agreement terms.

In futures market, the buying and selling of contracts happen depending on the settlement date and standard size on the public commodity markets, like CME (Chicago Mercantile Exchange). In the US, the Futures market is regulated by the National Futures Association. The specific details of Futures contract, like number of units traded, delivery date, settlement date, and minimum price increment can’t be customized. The exchange behaves like a counterpart to the trader and provides clearance as well as settlement.

Both kinds of contracts are irrevocable and are usually matured for cash at the time of expiry. A notable thing is that the contracts can be sold and brought before the expiry as well. The futures and forwards markets offer protection against the risk while trading currencies. These contracts are often used by big corporations that want to hedge against the future fluctuations of the exchange rate.

When trading in currencies, you will find that they are traded in pairs. The prime currency in pair is always the directional one on the price chart. For example, on a chart of EUR/USD, if the price movement is upwards then it signifies EUR is going higher in comparison to USD.

The best guide to learning forex is seeing the price movement in the actual time. You should register with some demo account and practice forex trading with artificial money. This will surely improve your forex trading skills.

A better understanding of Forex market will help you quickly comprehend the happenings of the Forex market.

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