You probably heard about forex trading through ads on social media or from a friend and you are wondering what is it all about?
Basically, forex or foreign exchange is a financial market where currencies are traded. This is one of the most traded markets in the world with a daily average volume of $5 trillion.
In forex trading, traders and investors buy and sell currencies to profit from the difference in the exchange rates.
What is the Forex Market?
Forex, also known as Foreign Exchange, FX, or currency trading, is a global decentralized or over-the-counter (OTC) market where all the world’s currencies trade.
The Forex market is by far the largest, most traded, and most liquid market in the world. With an average daily trading volume of around $5 trillion: 20% is used for real business purposes, and 80% is used for pure speculation mostly by hedge funds, retail traders, and investment banks.
In the forex market, transactions involve exchanging two currencies at the same time. Because currencies don’t have intrinsic values they must be compared to something else to establish value.
For example, if you want to exchange US dollars for Euros, you need to sell the US dollar and buy the Euro at the exchange rate. The exchange rate is the value of the US dollar compared to the value of the Euro. This is why in forex trading currencies are traded in pairs.
Forex is a Decentralized Market
Unlike stocks or commodities, forex trading doesn’t take place on a physical location or exchange but directly in an over-the-counter (OTC) or a decentralized market.
A decentralized market is a market structure that consists of a network of banks that enable investors to trade currencies across four major sessions in different time zones: London, New York, Sydney and Tokyo. This allows buyers and sellers of securities to deal directly with each other instead of meeting in a traditional exchange.
In a decentralized market, technology provides investors with access to various bid (the price that a buyer is willing to pay) and ask (the price that a seller is willing to accept) prices. These prices are usually provided by retail brokers or dealers online. Their job is to connect traders online rather than in centralized exchanges.
In forex trading, traders and investors use the Internet to get access to market quotes from different brokers. This type of market structure can allow for transparency between market participants (buyers and sellers).
A Brief History of Forex Trading
In the ancient world, coins were important elements of trade between different parts of the world. They were often introduced as a convenient method of payment for goods such as food, pottery, and essential materials.
If a Roman coin held more gold than a Greek coin due to its size or content, then a merchant could barter fewer Roman gold coins for more Greek ones, or more food and materials. This is why, at some point in their history, most world currencies in circulation today had a value fixed to a specific quantity of precious metals like gold and silver.
In the early modern times, “Alex. Brown & Sons” was the first investment bank to trade foreign currencies around 1850 in the USA.
1. The Gold Standard Monetary System
The inception of the gold standard is one of the most important events in the history of the modern forex market. The system simply allowed governments to hold a certain amount of gold in reserve to back their currencies to meet the demand for currency exchanges.
Before the gold standard was created, countries around the world had a major issue with commodities like gold and silver as international payment methods, because the value of these metals is affected by global supply and demand. For example, when a new gold mine is discovered it would drive gold prices down due to a high supply of gold.
During the late 19th century, most of the countries had fixed their currencies to an ounce of gold. The difference in the price of an ounce of gold between two currencies established the exchange rate for those two currencies. This represented the first official means of the currency exchange rate in history.
The gold standard broke down twice during the beginning of World War I and by the onset of World War II. The major European powers needed to complete large military projects, which forced governments to print more money. They ended up with more money than the gold reserves to exchange for extra currency to sustain the financial burden of completing these projects. However, gold never stopped being the ultimate form of monetary value and is generally regarded as a safe haven for those seeking stability.
2. The Bretton Woods Accord
At the end of World War II, and after abandoning the gold standard monetary system, the United States, Great Britain, and France met at the United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire to come up with a new economic order.
In July 1944, the Bretton Woods Accord was established to restore global economies by replacing the gold standard with the U.S. dollar to become a primary reserve currency, and creating three international agencies to oversee economic activity:
– General Agreement on Tariffs and Trade (GATT).
Unfortunately, the Bretton Woods Accord was a failure and was terminated on August 15, 1971, by U.S. President Richard Nixon, primarily because the U.S. dollar became the only currency in the world that was backed by gold.
3. The Beginning of the Free-Floating System
In 1972, the European community established the European Joint Float agreement by West Germany, Italy, France, Belgium, the Netherlands, and Luxemburg for an attempt to escape the dependency on the U.S. dollar.
This attempt was also a failure and the agreement was canceled in 1973.
4. Establishment of the Euro
The Maastricht treaty was signed in 1992 and established the European Union (EU), the creation of the Euro currency, and included initiatives on foreign policy and security.
5. Internet Forex Trading
With the advent of technology, the currency markets grew faster and became accessible to everyone around the world. Now with just one click of the mouse, you can get the most accurate price on any asset in a few seconds.
Since the end of WWII, the history of the Forex market presents a classic example of a free market in action. Now the Forex market is one of the most liquid and heavily traded markets in the world.
The 3 different Types of Forex Market
There are three different types of forex markets:
- Spot Forex market: this is an over-the-counter market where physical exchange of currency pairs happens. The transactions take place immediately – on the spot – or within two day period of time after the trade date. This type of market is reserved to institutions because they trade in large quantities and have the power to move prices in the forex market.
- Forex CFD market: CFD means “contract for difference” which is a financial derivative instrument that tracks the currency pair’s price on the spot market. This is an agreement between the broker and the trader. Both parties agree to pay the other the difference in asset’s value if they win the bet on whether the asset is going up or down in value.
- Future Forex market: futures are contracts between buyers and sellers where the price at which currencies are bought or sold on a future date are specified. This type of trading contracts are well-regulated and traded in a centralized exchange.
Most retail traders trade the CFD market as they speculate on whether the asset’s value is going up or down to profit from price movements in the market.
Remember, all of these types of forex markets work the same way as we explained in this article; a forex trade consists of buying a currency by selling another currency at the same time.
Also read How do you start trading Forex!
Market participants from different background trade forex for various reasons:
For investors, forex trading is used to protect their portfolios against currency depreciation and to diversify their investments.
For businesses and corporations, they trade forex to complete business transactions overseas to buy and sell products.
For traders, they use it for pure speculation to profit from price movements. They use an arsenal of tools and knowledge to speculate on whether a currency will appreciate or depreciate against another currency to generate profits.