Understanding the Forex Market

Forex Market

The term Forex is short for Foreign Exchange and is the global trading market for currencies. As compared to other financial markets, this one is the behemoth, reaching $5.3 trillion in volume on an average day. For comparison, the world’s largest stock trading exchange, the New York Stock Exchange, would need a full month of trading volume to equal one day of Forex. For most of its history, the Forex was limited to currency swaps between governments, large banks, international corporations, and the occasional super-wealthy individual. As the Internet grew, trading opportunities opened up to small traders looking to speculate on intra-day price action.

How Forex Works

If one were to peel back the curtain and examine the mechanics of a Forex transaction, it would reveal a multi-level market inhabited by banks of all sizes and other types of financial institutions. Behind the scenes, banks, governments, corporations, and individual traders engage in transactions with a fewer number of larger banks known as dealers. The dealers create the market by posting a running total of how much one currency is worth when measured against another. This becomes critical when, for instance, business between two countries is conducted. Dealers serve primarily as a means of converting one currency to another.

Characteristics of a Trade

When you make a trade on the Forex market, you essentially buy one currency while simultaneously selling another. While governments and corporations are not unduly concerned with creating profit through the Forex process, many small speculators and institutional traders are. Due to the size and liquidity of the market, there is the potential for fortunes to be made and lost in moments. Movement in the market is measured through the means of what is called a Price Interest Point, or pip, in currency parlance. You enter a trade at a certain point and exit at another. The difference covered equals a certain number of pips, which are easily convertible to money in whatever currency you’re trading in.

A Unique Market

As the most decentralized financial market on the planet, the Forex is often pointed at as being as close to the capitalistic notion of “perfect competition” as exists on earth. The global nature of the Forex market makes it difficult to regulate. The only real form of outside influence comes when central banks try to intervene to prop up failing currencies. Other special characteristics of the Forex include:

* 24 hour trading schedule and closed only on weekends
* High leverage can create exponential profits (and losses) from a modest investment
* Global dispersion

What Drives Price?

Since currency and trade between nations is the lifeblood of the currency market, it should be no surprise that price action is driven by national economic and political events. The healthier an economy is perceived to be, along with political stability, has a lot to do with the relative strength or weakness of an individual currency. Some factors that have a negative effect on a currency: budget and trade deficits, high inflation, GDP, high unemployment. On the flip side: budget and trade surpluses, controlled inflation, high employment, and a healthy economy. As the holder of the world’s reserve currency, the release of United States government reports related to these factors can have a strong effect on the Forex as a whole. Any time the US Federal Reserve meets to discuss interest rates is a time for high excitement, and sometimes dread, in the stomachs of Forex traders around the world. When meeting notes are released, every word is parsed for hidden meaning that might offer a clue as to possible future rate changes.

The need to exchange currency has been with us since Biblical times and before. Remember when Jesus through the money-changers out of the temple? They were the ancient equivalent of today’s dealers. No comparison intended. Just an historical observation. The Forex market used to be an exclusive club accessed by only those with big money. These days, an individual trader can open an account for as little as $50 and jump into the electronic trading pit with the big boys. Whether or not he or she finds success in wheeling and dealing currencies is a whole other question.

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