What is Forex Trading and How Does it Work ?

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Keeping my series of articles continued on Online Financial topics, after eBay Frauds HowTo and Credit Cards Fraud and Prevention article, this is about Forex Trading. I am only covering the basics of it like what is forex trading and how does it works. May be in the future, I will write a more detailed article on how you can do forex trading.

Forex (Foreign Exchange Currency) trading is a very exciting market, where you can quickly gain or lose a lot of money in a blink of an eye. In this market you are trading one currency for a different currency. The forex market is open 24 hours a day because there is no physical structure (such as the NY Stock Exchange) but significant trading hour’s center around normal business hours in Tokyo, London and New York. It’s the largest financial market in the world with daily trades totaling over $2 trillion USD.

It’s an important trading facility for central banks, multinational corporations, banks governments and currency speculators. You can trade spots, which means you must deliver the currency right away or forwards where there is a specific future settlement date and an agreed upon price. Cash doesn’t change hands until the settlement date. These trades are also referred to as futures contracts.

Forex rates are based on a pair of currencies, whereby you exchange currency A for currency B. For example, there will be a forex rate for the US Dollar (USD) vs. Japanese Yen (JPY) or the Euro (EUR) vs. Hong Kong Dollar (HKD). The foreign exchange market works on a spread basis, with a bid and ask price. The “bid” is the price a customer is willing to pay to purchase the currency. The ‘ask” is the price the seller wants to receive in order to trade the currency. The difference between the rates is the spread, which is the profit for the forex trader, very similar rate to a commission in a stock.
Forex trading is extremely important to multinational corporations.

Usually there is a currency mismatch between their revenues and expenses. The major expenses for multinationals are go to salaries, buildings and raw materials. They will have to pay these expenses in the currencies where their factories are and local currency where the natural resources are obtained. Their revenues will be paid in the currencies where they sell their products or services. In order to minimize there risk of currency fluctuations, these companies buy or sell currencies in the future (hedging).

Central Banks (government entity) use the forex market to help stabilize or prop up their local currencies. They will buy or sell depending on the current monetary policy. Central Banks also purchase stable currencies (such as the USD or Euro) to ensure investors they can meet their financial obligations. Large banks and other financial institutions use the forex markets to facilitate their customer’s international trading activity, payments for their customers in different countries, help import and export firms execute their business and service multinational currency needs. The three largest currency trading banks (Deutsche Bank, UBS and Citigroup) account for almost 40% of the trading volume.

When many people think of forex trading, they picture speculators in their minds. Speculators take positions in a particular currency, basically making a bet that that currency will either increase or decrease in value vs. other currencies. It’s very risky because unlike corporate treasurers, speculators do not own, or want to own the currencies. The typically make a lot of money fast or lose a bundle if they are on the wrong side of the market.

To add to the profit but also the risk of speculation, a typical trader will buy on margin, which means they borrow most of the purchase price of the contract. This is also referred to as leverage because you do not have to provide the full value of the trade. Some brokers will lend as much as 250% of the value of the traders account. This is much higher ratio than allowed in other financial markets. While this can greatly increase your profits, it could also cause huge losses if the markets shift dramatically. You also need to be concerned about margin calls (when the value of your account goes below the leverage rate, you would have to provide your broker with additional cash or they will liquidate your portfolio).

The number of hedge funds has soared in popularity as people find the forex markets exciting, but lack the expertise or capital to participate. Growing quickly from about 300 hedge funds in 1990, there are now over 8,000 hedge funds today. Experts estimate these funds control a trillion dollar and with leveraging can overwhelm central bank intervention. As an investor, you need to be aware hedge funds charge very high management fees (1% - 2%) along with performance incentives.

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