Introduction to Financial Basics: What is Forex?

If you have ever been on a foreign vacation and exchanged your dollars for the local currency, you have participated in the Forex market. 

Forex is how one currency is exchanged for another

Forex, AKA foreign exchange, FX, or the currency market, is the largest financial market in the world. On average, over $5 trillion of currency transactions occur daily. That’s approximately 100 times the volume of the world’s biggest stock exchange, the New York Stock Exchange (NYSE) -.

Forex is essential for individuals, businesses, financial institutions, central banks, and governments. Forex facilitates international trade and investment, allowing companies to earn money in one currency and pay for goods and services in another.

Who is trading forex?

There are a considerable number of market participants trading forex at any particular time, from individual speculators wishing to make quick profits to central banks attempting to control the amount of currency in circulation.

However, the most significant forex market players are the major international banks. Five banks, Deutsche Bank, UBS, Barclays, Citigroup, RBS, and JPMorgan, account for over half of all global forex trade.

These ten largest players make up about 76% of the total market.

Why trade forex?

There are two reasons Individuals and businesses participate in the forex market:

Speculation

Most forex transactions are simply to make money; the person or institution trading has no plans to take delivery of the currency, only to profit from market movements.

With large financial institutions looking to profit from small changes in forex prices, many large trades generally occur throughout the day resulting in currencies being some of the world’s most consistently volatile financial markets. This volatility provides more opportunities for speculators to profit.

Purchasing international goods or services

For nearly every transaction made between two entities in different regions, a foreign exchange transaction must take place to pay for the goods or services exchanged.

Despite this number of transactions, the amount of currency traded is minimal compared to trades made by large speculators. Therefore commercial trade only has a negligible impact on short-term market rates.

How to trade forex?

Unlike stock trading, forex is an over-the-counter (OTC) market; currencies are exchanged directly between two parties rather than through an exchange.

There is no central forex market, it runs electronically via a global network of banks. Trades can take place anywhere via a forex broker. This means that if a major forex trading center (London, New York, Sydney, and Tokyo) is open, you can trade forex.

Trading Hours EST

This means you can trade most forex pairs from 5 pm Sunday evening, with the Sydney opening, until the close of the New York market on Friday at 5pm. Exact times can vary due to daylight savings time changes in the UK, USA, and Australia.

How does a forex trade work?

Forex prices are quoted in pairs such as USD/EUR, which stands for the US dollar versus the Euro. If you want to purchase Euros, you need to buy them with another currency, most commonly the USD.

Trading forex means simultaneously BUYING one currency while SELLING another.

Each currency has a three-letter currency code. The first two letters generally stand for the country/region, and the last letter represents the currency. So taking EUR/JPY as an example:

EUR stands for the euro, while JPY means the Japanese yen.

Quiz 1

Select the right country for the following currency codes:

  1. AUD?

A Switzerland

B Japan

C South Africa

D Australia

  • CHF?

A Switzerland

B Japan

C South Africa

D Australia

  • JPY?

A Switzerland

B Japan

C South Africa

D Australia

  • ZAR?

A Switzerland

B Japan

C South Africa

D Australia

You can find quiz answers at the end of the lesson.

The first currency in a forex pair is called the base or primary currency. The second is known as the quote or counter currency. A forex price shows how much one unit of the base currency will buy of the quote currency. So, with the following quote:

This means one euro is worth $1.01 dollars.

You will buy this pair if you believe the base currency, the EUR, will strengthen against the quote currency, the USD. This is known as going long. Alternatively, you could sell the pair (go short) if you believe the euro will weaken further.

Quiz 2

Let’s say a news story leads you to believe that the British pound sterling will rise against the Australian dollar. So you decide to buy £1000 of GBP/AUD at 1.78800, which costs you A$1788.00. A few weeks later, you sell at 1.97800. Which one of the following is true (not taking into account commissions or other charges)?

  1.  You made A$190 profit
  1. You made A$12 loss
  2. You made £22 profit
  3. You made A$370 profit

Summary

Forex involves converting one currency to another. Major international banks are the primary players, and speculation is the reason for most transactions. Forex is an over-the-counter market between two parties.

In our next smart Money Club lesson, we will take your trading to the Power of X by looking at the terminology involved in forex trading.

Quiz Answers

Quiz 1

1.D 

2.A  

3.B  

4.C

Quiz 2

A

You sold at 1.998, which meant you would have received A$1998.00, making a A$190 profit (A$1978 – A$1788).

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