Forex Trading Basics
The foreign exchange or Forex market is the largest and most liquid financial market in the world. As of April 2004, the Forex market experienced average daily turnover of approximately $1.88 trillion, which was a 57% increase (at current exchange rates) from 2001 daily averages. For more information regarding this surge in Forex trading activity, we refer you to the Bank of International Settlements, Triennial Central Bank Survey, Foreign Exchange and Derivative Market Activity in 2004 (March 2005).
The Forex market is predominantly an over-the-counter ("OTC") market, with no fixed location and it operates 24 hours a day, starting each business day in Sydney, and moving around the globe as the business day begins in each financial center, first to Tokyo, London, and New York.
London, New York City and Tokyo are the principal geographic centers of the world-wide foreign exchange market, with approximately 58% of all foreign exchange business executed in the U.K., U.S. and Japan. Other, smaller markets include Singapore, Zurich and Frankfurt. Approximately 89% of foreign exchange transactions involve the U.S. dollar ("USD"), and approximately 37% involve the Euro ("EUR").
An over-the-counter market is a market which lacks a centralized exchange. An example of a centralized exchange would be an exchange such as the New York Stock Exchange or the Chicago Mercantile Exchange. You will hear the phrase "inter-bank" from time to time. This refers to the foreign currency trading which occurs between banks. Historically, most of this trading had been conducted over the phone. However, the electronic brokering system was created in September of 1993 to permit electronic trading of foreign currencies between banks and other financial institutions. Now, much of the Forex trading that takes place occurs over various electronic systems.
The USD/EUR pair is by far the most-traded currency pair and in recent years has comprised approximately 28% of the global turnover in foreign exchange. There are three major kinds of transactions in the traditional foreign exchange markets: spot Forex transactions, outright Forex forwards and foreign exchange swaps. "Spot" Forex trades are foreign exchange transactions that settle typically within two business days with the counterparty to the trade. Spot transactions account for approximately 35% of reported daily volume in the traditional foreign exchange markets. "Forward" trades, which are transactions that settle on a date beyond spot, account for 12% of the reported daily volume, and "swap" transactions, in which two parties exchange two currencies on one or more specified dates over an agreed period and exchange them again when the period ends, account for the remaining 53% of volume. There also are transactions in currency options, which trade both over-the-counter and, in the U.S., on the Philadelphia Stock Exchange.
All of the transactions which are executed with a spot forex firm as a counterparty to a client are ""spot" Forex trades which settle in two business days. In practice, however, these Forex trades never settle because they are rolled over on a daily basis.
Currency futures are transactions in which an institution buys or sells a standardized amount of foreign currency on an organized exchange for delivery on one of several specified dates. Currency futures are traded in a number of regulated markets, including the Chicago Mercantile Exchange, the New York Board of Trade, the Singapore Exchange Derivatives Trading Limited and the London International Financial Futures Exchange (LIFFE). Over 85% of currency derivative products (swaps, options and futures) are traded over the counter. Participants in the foreign exchange market have various reasons for participating. Multinational corporations and importers need foreign currency to acquire materials or goods from abroad. Banks and multinational corporations sometimes require specific wholesale funding for their commercial loan or other foreign investment portfolios. Some participants hedge open currency exposure through off-balance-sheet products. The primary market participants in foreign exchange are banks (including government-controlled central banks), investment banks, money managers, multinational corporations and institutional investors. The most significant participants are the major international commercial banks that act both as brokers and as dealers. In their dealer role, these banks maintain long or short positions in a currency and seek to profit from changes in exchange rates. In their broker role, the banks handle buy and sell orders from commercial customers, such as multinational corporations. The banks earn commissions when acting as broker. They profit from the spread between the rates at which they buy and sell currency for customers when they act as a dealer.
Typically, banks engage in transactions ranging from $5 million to $50 million in amount. Although banks will engage in smaller transactions, the fees that they charge have made the foreign currency markets relatively inaccessible to individual investors. Some banks allow individual investors to engage in spot trades without paying traditional commissions on the trades. Instead, the banks charge the investor the spread between the bid and the ask price maintained by the bank on all purchases and sales.