Forex is a commonly used abbreviation for "foreign exchange," and it is typically used to describe trading in the foreign exchange market by investors and speculators.
For example, imagine a situation where the U.S. dollar is expected to weaken in value relative to the euro. A forex trader in this situation will sell dollars and buy euros. If the euro strengthens, the purchasing power to buy dollars has now increased. The trader can now buy back more dollars than they had to begin with, making a profit.
This is similar to stock trading. A stock trader will buy a stock if they think its price will rise in the future and sell a stock if they think its price will fall in the future. Similarly, a forex trader will buy a currency pair if they expect its exchange rate will rise in the future and sell a currency pair if they expect its exchange rate will fall in the future.
The foreign exchange market is a global decentralized marketplace that determines the relative values of different currencies. Unlike other markets, there is no centralized depository or exchange where transactions are conducted. Instead, these transactions are conducted by several market participants in several locations. It is rare that any two currencies will be identical to one another in value, and it's also rare that any two currencies will maintain the same relative value for more than a short period of time. In forex, the exchange rate between two currencies constantly changes.
For example, on January 3, 2011, one euro was worth about $1.33. By May 3, 2011, one euro was worth about $1.48. The euro increased in value by about 10% relative to the U.S. dollar during this time.
WHY DO EXCHANGE RATES CHANGE?
Currencies trade on an open market, just like stocks, bonds, computers, cars, and many other goods and services. A currency's value fluctuates as its supply and demand fluctuates, just like anything else.
- An increase in supply or a decrease in demand for a currency can cause the value of that currency to fall.
- A decrease in the supply or an increase in demand for a currency can cause the value of that currency to rise.
A big benefit to forex trading is that you can buy or sell any currency pair, at any time subject to available liquidity. So if you think the Eurozone is going to break apart, you can sell the euro and buy the dollar (sell EUR/USD). If you think the price of gold is going to go up, based on historical correlation patterns you can buy the Australian dollar and sell the U.S. dollar (buy AUD/USD).
This also means that there really is no such thing as a "bear market," in the traditional sense. You can make (or lose) money when the market is trending up and down.
OK HERE WE GO IN BRIEF TO THE MARKET
If you’ve ever traveled to another country, you usually had
to find a currency exchange booth at the airport, and then exchange the money
you have in your wallet (if you’re a dude) or purse (if you’re a lady) or man
purse (if you’re a metrosexual) into the currency of the country you are
visiting.
You go up to the counter and notice a screen displaying
different exchange rates for different currencies. You find “Japanese yen” and
think to yourself, “WOW! My one dollar is worth 100 yen?! And I have ten dollars!
I’m going to be rich!!!” (This excitement is quickly killed when you stop by a
shop in the airport afterwards to buy a can of soda and, all of a sudden, half
your money is gone.)
When you do this, you’ve essentially participated in the
forex market! You’ve exchanged one currency for another. Or in forex trading
terms, assuming you’re an American visiting Japan, you’ve sold dollars and
bought yen.
Before you fly back home, you stop by the currency exchange
booth to exchange the yen that you miraculously have left over (Tokyo is
expensive!) and notice the exchange rates have changed. It’s these changes in
the exchanges rates that allow you to make money in the foreign exchange
market.
The foreign exchange market, which is usually known as
“forex” or “FX,” is the largest financial market in the world. Compared to the
measly $22.4 billion a day volume of the New York Stock Exchange, the foreign
exchange market looks absolutely ginormous with its $5 TRILLION a day trade
volume. Forex rocks our socks!
Let’s take a moment to put this into perspective using animations…
The largest stock market in the world, the New York Stock
Exchange (NYSE), trades a volume of about $22.4 billion each day. If we used a mouse to represent NYSE, it would look like this,
You hear about the NYSE in the news every day… on CNBC… on Bloomberg…on BBC… heck, you even probably hear about it at your local gym. “The NYSE is up today, blah, blah”. When people talk about the “market”, they usually mean the stock market. So the NYSE sounds big, it’s loud and likes to make a lot of noise.
But if you actually compare it to the foreign exchange market, it would look like this…
Oooh, the NYSE looks so puny compared to forex! It doesn’t stand a chance!
Check out the graph of the average daily trading volume for the forex market, New York Stock Exchange, Tokyo Stock Exchange, and London Stock Exchange:
The currency market is over 200 times BIGGER! It is HUGE! But hold your horses, there’s a catch!
That huge $5 trillion number covers the entire global foreign exchange market, BUT retail traders (that’s us) trade the spot market and that’s about $1.49 trillion. So you see, the forex market is definitely huge, but not as huge as the media would like you to believe.
Do you feel like you already know what the forex market is all about? We’re just getting started! In the next article we’ll reveal WHAT exactly is traded in the forex market, BYE BYE!
