How Does The Forex Market Work?

What is Forex?

Forex, short for Foreign Exchange, is the act of converting one currency into another. This is usually done for a variety of reasons and could range from personal such as tourism to large-scale commercial needs or import/export operations.

In 2019, the Forex Market averaged around $5.1 Trillion in terms of daily volume based on statistics performed by the Bank for International Settlements.

The number continues to fluctuate but maintains a similar average as online trading grows, boosted by the Covid-19 pandemic during 2020. The Forex Market is seen as the biggest and most liquid in the world given the multitude of needs that drive people or organizations to participate in exchanging currencies with others


What is the Forex Market?

The Forex Market is where currencies are traded on an ongoing basis. It is a decentralized market, meaning that there is no physical center for it and trades occur around the clock and in an over-the-counter manner. Everything happens through computer networks. Simply put, it is a network of buyers and sellers who are transferring currencies between each other at a set price.

The Forex Market is open 24 hours a day, 5 days per week, and is seen as rather volatile and always in swing across most of the day especially when the bigger centers are operating such as New York, London, and Tokyo. It’s one of the most sought-after markets given its size, liquidity, ease of access, trading hours, and countless opportunities.(Figure 1)


Figure 1 - Hourly EUR/USD Chart
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History Of Forex

The idea of exchanging money dates back to when countries first began minting money thousands of years ago yet the Forex Market as we know it today is a fairly recent culmination of events that led to countries having the choice of how to value their currencies. More specifically, the collapse of the Bretton Woods System which pegged major currencies against the Gold-backed US Dollar led to a new era of foreign exchange where countries are free to let their currency float or peg it against another or a basket of currencies.

One of the oldest and most popular exchanges is the Chicago Board of Trade. The CBOT started in 1848 and allowed for trading on agricultural commodities such as wheat and corn. This helped farmers and consumers manage risk by eliminating uncertainty in prices from the traded products. Today, the CBOT is one of the biggest in the world, offering options and futures on a wide range of products including commodities, interest rates, and equity indices.


Spot, Forwards, And Futures Markets

There are multiple ways that Individuals, Governments, and Institutions can trade on the Foreign Exchange Market. Aside from the traditional spot market which involves a direct exchange of one currency with another, new methods emerged that proved to be beneficial, flexible, and customizable for certain market participants. The spot market is by far the largest and any other derivative to direct exchange is based on that market yet at one point, the futures market was, in fact, the most popular one given that it offered traders the ability to transact long before electronic trading on the spot market became prevalent.

The spot market (Figure 2) is where all currencies are sold and bought according to the current price at the time. This constantly moving and the highly dynamic price is a reflection of a multitude of factors including supply, demand, interest rates, sentiment, economic conditions, geopolitical events, and even the general performance perception of market players, among other reasons. Once the exchange of currencies takes place, the position is closed. In other words, the transaction is cash-settled. Although the spot market is immediate, settling trades takes two days.


Figure 2 - 4-Hour USDJPY Chart
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On the other hand, forwards and futures do not actually exchange currencies. They represent a claim of a certain currency, at a specified price and a future settlement date. The forwards market is made up of contracts that are bought or sold between two parties with a predetermined set of terms between them. This is done over the counter while in the futures market, which is an exchange-based market, contracts are bought or sold using a standardized size and settlement date. Futures contracts include further details such as the delivery date and minimum price movement.


Forex For Hedging Purposes

With globalization and foreign trade comes the risk of currency fluctuation brought upon by companies doing business with others in different countries. This includes buying or selling goods outside of their domestic markets. The Forex market provides a way for those companies to protect themselves and hedge the currency risk by setting and fixing a rate at which the transaction will take place.

To better understand this concept, take a look at the below example:

Imagine a company is planning on selling US-made containers in Europe at a parity exchange rate of 1 Euro = 1 Dollar.
The container costs $100 to build and the company is looking to sell it for 150 Euros, a competitive price compared to other EU-produced containers. If the company succeeds, the profit for each container will be $50 given the exchange rate of 1/1. Suddenly, the US Dollar starts rising in value against the Euro, and the new exchange rate is now 0.80 on the EUR/USD pair. It now costs $0.80 to buy 1 Euro.

Selling the product for 150 Euros will still produce a profit but a smaller one given the stronger Dollar. Previously, 150 Euros would equal $150 but now, 150 x 0.80 = $120. The same container now nets the company $120 on the new exchange rate.

Originally, the company could have protected itself against a stronger Dollar by shorting the Euro and buying the Dollar. If the Dollar rises, the trade itself would be profitable, offsetting the loss on the actual container being sold while if the Dollar drops, the container will net more Dollars after being sold in Europe due to the exchange rate and once again, offsetting the loss from the trade.
For reference, here's a chart showing the exchange rate of the Euro against the Dollar (Figure 1)


Forex As A Speculative Product

The past 10 years witnessed a surge of retail and professional traders speculating on currencies on a daily basis. This was further enhanced during the pandemic of 2020 which saw millions of people stuck at home and seeking a way to supplement their income or create a new one.

Many factors affect the value of one currency against another including supply & demand, interest rates, sentiment, economic conditions, and geopolitical events among others. Some of the mentioned factors are short-term, creating bursts of price changes and volatility while others last over weeks and months as their effect is more pronounced over the long run.
Let’s take a look at an example of a currency trade with an interest rate element to it.

Let’s say a trader is expecting interest rates to rise in the US compared to the rate in Europe. The current rate is 1.20 which means 1 Euro is equal to $1.20. A higher interest rate is positive for the Dollar and could increase demand which means a higher dollar against the Euro and possibly other currencies. Assuming the trader is correct in his judgment and the Euro drops to 1.10 following an interest rate hike in the US, meaning every 1 Euro is equal to $1.10, the trader could make money if he was short the Euro and long the Dollar.

Now let’s look at another example:

Let’s say a trader decides to buy Euro versus the Dollar. The rate stands at $1.20 for every Euro. His rationale is that tourism is booming in Europe and more and more foreigners are likely to visit and exchange their Dollars to Euros. A few weeks later, floods begin to hit mainland Europe and tourism comes to a halt, leading to less tourists and less demand. The Euro drops and the current rate is now $1.15 for every Euro. In this case, a trader who was long the Euro would have lost $5 cents for every Euro in holding.


Currency As An Asset Class

Speculating on price changes of different currency pairs is the common way of making a profit in the Forex market yet there’s another way that is more cyclical and was popular before the financial crisis called “Carry Trading”. Effectively, Carry Trading meant to buy one currency with a high interest rate against another with a much lower interest rate and benefit from the rate differential. Historically, the Japanese Yen always maintained a very low interest rate against other major currencies which made it a favorite for those looking to benefit from the interest rate differential by selling it and buying other currencies.

Nowadays, the interest rate environment is not supportive of such a strategy as most countries are keeping their overnight rates rather low and close to zero for economic reasons


Advantages And Disadvantages Of Forex Trading

Speculating on any market can carry risks that many people may not be ready for. This includes the use of leverage, which could greatly magnify both profits and losses, as well as the idea of going in blind without having done due diligence or proper analysis, thus reducing the probability of making profitable trades.

Using a high leverage can be dangerous to your available capital unless you are knowledgeable enough to know how to properly manage your funds. It can be tempting to enter into big positions with small required margins and attempt to make large sums of money in a short period but given the fact that no one can accurately guess the direction of the market every time, traders risk losing quickly whatever funds they are trading with. Sadly, this is a reality as many brokers offer up to 500 times which means you can control $500 with just $1.

On the other hand, the fact that the Forex market trades 24 hours every day, 5 days per week means countless opportunities on a variety of currency pairs. Traders around the world are speculating at different hours based on their risk appetite and strategy. This creates flexibility not seen in other markets such as the New York Stock Exchange which only trades several hours per day. Another advantage is the fact that liquidity is nearly abundant, meaning you will never struggle to buy or sell at the indicated price as millions are being traded at every increment. This is not the case for other markets that occasionally see intraday gaps and quick movements due to lack of liquidity.


How Is Forex Traded?

There is no right or wrong when it comes to trading Forex in Cyprus. Some traders are very short term (Figure 3), entering and exiting trades within a short period while others focus on the long term, holding positions for weeks, months, and even years. Many factors come into play such as the trader's risk tolerance, their goals, and what makes sense to them. For example, fundamental traders seek news, economic developments, and broader factors that could affect the markets while technical traders may look for specific price patterns that have worked in the past and would expect a similar outcome.

Other traders are hybrid, using a fundamental approach to establish a longer-term view while employing technical analysis to pinpoint entry and maintain low risk per trade. It all comes down to what is comfortable for a trader.


Figure 3 - 5-minute chart on EUR/JPY
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Forex Terminology

Currency pair
Forex is traded in pairs with one currency versus the other. In other words, if you are trading the EUR/USD which is the Euro against the US Dollar, buying the pair means buying the Euro and selling the US Dollar and vice versa when selling the pair.
Major pairs include some of the biggest economies in the world against the US Dollar such as EUR/USD, GBP/USD, AUD/USD, USD/JPY, USD/CHF, USD/CAD, NZD/USD.

Leverage allows you to open a position of considerable size with a smaller amount of money. Leverage is highly popular among Forex traders and different jurisdictions and brokers allow for different leverage settings.

The bid is the price that a trader is willing to sell a pair while the asking price is the price a trader is willing to buy a currency pair. The difference between the two is called the spread.

Popular across the trading world, the terms long and short refer to buying and selling respectively.

Margin is the amount of money needed to open a certain position. This amount depends on the leverage available on the account and the higher the leverage, the lower the amount needed to open a specific position.

PIP stands for percentage in point and is the smallest movement and usually the 4th decimal among many pairs.

A market that is seen as positive with the potential to go up is usually referred to as Bullish while a market pointing downward and seen as weak is referred to as bearish.


Final Thoughts

Trading Forex or any other market carries a high degree of risk and could lead to complete loss of funds in the account. Anyone looking to get started in the markets must learn the basics, read as much as possible, watch the markets for as long as possible and then start learning on a demo account before deciding to trade with real funds.

The learning process can be long and arduous but if done properly, could be rewarding. Most people lose money trading FX, CFDs, and other markets and mostly because they lack the discipline or greed control that is needed to make someone a successful trader.