WHAT IS FOREX?
The foreign exchange market is the largest and fastest growing market in the world. Traditionally, it is the platform through which governments, businesses, investors, travelers, and other interested parties convert or ‘‘exchange’’ currency. At its most fundamental level, the foreign exchange market is an over-the-counter (OTC) market with no central exchange and clearing house where orders are matched. FX dealers and market makers around the world are linked to each other around-the-clock via telephone, computer, and fax, creating one cohesive market. Through the years, this has changed with many institutions offering exchange traded FX instruments, but all of the prices are still derived from the underlying or spot forex market.
Comparing the FX Market with Futures and Equities
The foreign exchange market has not always been a popular market to trade because for many decades, it was restricted to hedge funds, commodity trading advisers who manage large amounts of capital, major corporations, and institutional investors due to regulation, capital requirements, and technology. Yet it was the market of choice for many of these large players because the risk was fully customizable. Trader A could use a 50 times leverage, and Trader B could trade cash on cash. When the market opened up to retail traders, many brokerage firms swept in to provide leveraged trading along with free instantaneous execution platforms, charts, and real-time news. This access to low-cost information helped foreign exchange trading surge in popularity, increasing its attractiveness as an alternative asset class to trade.
Many equity and futures traders also turned to currencies, adding the asset class to their trading portfolios. Before you choose to do so, however, it is important to understand some of the key differences between the forex and equity markets.
Characteristics of FX Markets
- It is the largest market in the world with growing liquidity.
- The market is open 24 hours, 5.5 days a week for trading.
- Profits can be made in both bull and bear markets.
- There are no trading curbs, and short selling is permitted without an uptick.
- Instant executable trading platform minimizes slippage and errors.
- Leverage can be extremely high, which can magnify profits as well as losses.
Characteristics of Equities Market
- There is decent market liquidity, but that can depend on a stock’s daily volume.
- The market is only available for trading 9:30am to 5pm NY Time, with limited after-hours trading.
- The existence of exchange fees results in higher costs and commissions.
- There is an uptick rule to short stocks, which many day traders find frustrating.
- The number of steps involved in completing a trade can increase slippage and error.
The foreign exchange market, or forex (FX) for short, is a decentralized market place that facilitates the buying and selling of different currencies. This takes place over the counter (OTC) instead of on a centralized exchange.
Without knowing it, you have probably already participated in the foreign exchange market by ordering imported products such as clothing or shoes, or more obviously, buying foreign currency when on vacation. Traders may be drawn to forex for several reasons, including:
- The size of the FX market
- A wide variety of currencies to trade
- Differing levels of volatility
- Low transaction costs
- 24 hours a day trading during the week.
Trading forex has many advantages over other markets as explained below:
- Low transaction costs: Typically, forex brokers make their money on the spread provided the trade is opened and closed before any overnight funding charges are applied. Therefore, forex trading is cost effective when weighed up against a market like equities, which attracts a commission charge.
- Low spreads: Bid/Ask spreads are extremely low for major FX pairs due to their liquidity. When trading, the spread is the initial hurdle that needs to be overcome when the market moves in your favor. Any additional pips that move in your favor is pure profit.
- More opportunities to profit: Forex trading allows traders to take speculative positions on currencies going up (appreciating) and going down (depreciating). Furthermore, there are many different forex pairs for traders to spot profitable trades.
- Leverage trading: Trading forex involves the use of leverage. This means that a trader need not pay the full cost of the trade but instead only put down a fraction of the cost. This has the potential to magnify your profits but also your losses. At DailyFX we suggest a disciplined approach to risk management by restricting your effective leverage to 10 to one or less.