The exchange where currencies around the world are traded is referred to as the foreign exchange or, in short, forex. Currencies have a key role to play in the lives of people as foreign trade often involves exchange of currencies. Forex trading is the exchange of currencies at an agreed price on the over-the-counter or OTC market. The most traded market in the world is the forex. With the average turnover per day exceeding $5 trillion, it is the world’s biggest financial market. In essence, forex trading involves buying one currency and selling another at the same time, primarily for speculation.
Values of currencies increase or appreciate and fall or depreciate with respect to each other because of several reasons such as economics and geopolitics. The aim of people involving in forex trading is to generate profit out of these variations in the value of one currency with respect to another. Unlike most of the financial markets, there is no central exchange or physical location for the OTC forex market. However, trading is carried out 24-hours in a day and five and a half days in a week by means of a global network of banks, businesses and individuals. As a result of this, forex market offers multiple trading opportunities.
As a central marketplace for forex does not exist, currency trading is carried out electronically. All transactions are conducted through computer networks by traders all over the world. Forex trading happens in all of the major financial centers in the world such as Tokyo, New York, London, Zuric, Frankfurt, Paris, Hong Kong, Singapore and other cities across various time zones. This is to say that when currency trading closes in the US, trading starts in the eastern nations such as Tokyo and Hong Kong.
Forex trading can be done by individuals, institutions and corporations in three different ways. These include the Spot as well as Forwards and Futures Contracts. The major part of forex trading takes place in the Spot market. This is because the Futures and Forwards markets are derivative markets and trades are carried out on the basis of the price movements of the underlying assets in the Spot market. In the past, traders used to frequent the Futures market because it was available to individuals for a longer duration of time. With the advent of electronic trading, however, the activity in the Spot market has surged ahead, surpassed the Futures market and gone on to become the most preferred market of individuals and speculators. People refer to currency trading in the Spot market when they talk about forex trading. On the other hand, the futures and forwards markets are more popular among companies as they help them to hedge their risks related to forex transactions to a specific date in the future.
Forex Spot Market
In the Spot market, traders buy and sell currencies based on their current prices which are determined by their supply as well as demand. The spot price of a currency is a function of many factors such as the local as well as international political sentiments, changes in monetary policies brought about by the central banks in different countries, economic performance of nations, performance of one currency with respect to another in the future, etc. The contracts executed in the Spot market are referred to as spot deals. They are bilateral transactions wherein traders agree to sell specific amounts of one currency and receive specific amounts of another currency in return on the basis of an agreed exchange rate. Settlements are always done in cash after the deal is closed. In the Spot market, transactions are carried out at the current prevailing rate, but settlement of trades are actually executed in about two days’ time.
Unlike the Spot market, trading of actual currencies does not happen in the Forwards/Futures markets. In these markets, currency contracts that represent claims to specific types of currency at specified unit prices at a certain date in the future are dealt with. In the Forwards market, traders buy and sell currency contracts over the counter at the contract terms that are mutually agreed upon between them. However, currency contracts are bought and sold on the basis of standard lot sizes and settlement dates on the Futures market. In the case of Futures contracts, specific details such as the date of delivery/settlement, the minimum price increments and the number of units being traded are clearly laid out prior to the initiation of a trade. These cannot be customized. In this case, the exchange is the second party as far as the customer is concerned. Further, the exchange provides clearance as well as settlement.
The contracts executed by a forex trader in the Futures and Forwards markets are binding and settlement is often done in cash on expiration of the contracts. However, it is possible to buy as well as sell forwards and futures contracts prior to the close of their expiration time. Typically, both the Forwards and Futures markets are made use of by traders to protect themselves against the risks of trading currencies in the Spot market. Though individual speculators execute contracts in these markets, it is the large local as well as international corporations that involve in exports/imports that use the Futures and Forwards markets as a hedge against the fluctuations in forex rates that are likely to occur on a future date.
How Does Forex Trading Work
Forex trades are often executed through either a broker of a market maker. Therefore, you need to choose a forex broker to work with, select the currency pair and then place a trade. Your broker passes on the buy/sell order placed by you to their partner in Interbank Market and fills your position. Your broker closes your position as soon as you decide to close your trade. The profit or loss that you made in this specific trade will get reflected in your account in a matter of a few seconds.