Introduction to Forex Trading

Definition of a Foreign Exchange Market

Forex trading, or trading in Foreign Exchange involves trading in international currencies. The forex market is an OTC or over the counter market where the buyers and sellers trade in foreign currencies/exchange by viable and affordable means of communication (phone, internet etc.). It is the market where one currency is traded for another, with the approximate U.S. Dollar equivalent of a whopping $2 trillion worth of currency changing hands every single day.

Forex trading is also known as the 24-hour Interbank market. The Interbank market is the bank to bank currency market that literally follows the sun around the world, moving from one major banking center to another.

A Brief History

The history of forex trading can be traced back to ancient times, when traders exchanged coins from different empires. However, those trading were primarily barter systems, with gold being the standardizing parameter. Foreign exchange, as we know it today, started in the early part of the 20th century. 1944 marked the pegging of currencies to the dollar which was in turn pegged to gold. This process was initiated in the Bretton Woods Agreement, and it marked the birth of the IMF, or the International Monitory Fund. With the collapse of Bretton Woods in 1971 and the US dollar no longer convertible to gold, currency became more volatile and trading opportunities in the currency market started to arise. This was the start of the era of the modern foreign exchange market.

Today, the central banking system of each country is the controlling authority for stabilizing the movements in currency of that respective country in the forex market. The free floating exchange system that propels the forex market was introduced after the 1973 Smithsonian & European joint Float agreements, and foreign exchange trading has never looked back since.

Why does it exist?

The existence of forex trading is critical to the international trade of goods, products, and services. Given the fact that all countries, apart from members of the EU, have their own currency that is not universally accepted in any other country, exporters as well as importers need foreign currencies to complete trade transactions. Apart from trade, inter-country financial transactions like grants, aids and loans often also require third-country currencies. These needs are all met by the forex markets.

Bulk forex trading is done by major international banks, though the last couple of years has witnessed an increasing number of individual investors getting involved in the forex markets as well.

At present the forex market actually guides the sale of goods and services globally. Created by the necessity of traders, investors, speculators, importers and exporters, the forex market is a diverse zone for hedging risks and speculation for profit. The market is controlled not by individual forex traders but by multinational corporations and institutional investors.

The only scenario where foreign exchange trading may be abolished is when all countries accept a common currency, as the Euro was accepted in the EU. However, given the diverse nature of countries, fragmented political systems and their economic scenarios, it is highly unlikely that a worldwide currency will arise, at least in our lifetimes.

Distinctive features of Forex Trading

The Forex market has no regulation on daily price fluctuation and speculative positions. Transactions are mainly negotiated and done on an individual, one to one basis. Spot trading in currencies and forward cash are the main transaction features that have little or no regulatory control.

The brokerage firms and banks i.e. the forex traders in the forex market are linked through an electronic exchange network that allows conversion of world currencies. Previously forex trading was limited to central, commercial, and investment banks only. With more and more enthusiasts taking an interest, though, the market has now became accessible to private investors via internet.

The forex market is the financial market that observes the heaviest volume of transactions and highest level of participation from the traders. At the same time traders do not have to deal with gaps and price movements that are common in other lower markets. The forex market is open five and a half days per week and transactions are held 24/7 throughout the world from west to east and vice versa.

US Dollar, Euro, British Pound Sterling, Japanese Yen, Euro, Canadian Dollar, and Australian Dollar are the most commonly traded currencies in the market. The market provides maximum flexibility as a trader can trade with leverage and low margins.

The global forex trading market also features commission free trading. The spread is negligible and you do not have to pay anything more if you secure a profit or suffer a loss. Spot currency trading offers the advantage of the margin rate or leverage that clients are given. The margin rate is applicable for 24 hours within the same trading day. Margin rates are between 1 to 5 percent depending on the size of transactions. This rate is unique and uniform so a trader can manage transactions efficiently throughout.

Potential for Profit

Forex trading is considered to be one of the most profitable trading activities, and not without reason. Due to its inherent volatility and huge trade volumes, the Forex market offers the potential of extremely large earnings if proper trading strategies are followed. One of the most important factors that makes forex trading particularly lucrative is the concept of margins. The broker with which a trader opens an account, forwards a loan to the trader on the basis of the margin. So, if the trader has ten thousand dollars in his account with the brokerage firm, and has a margin of 2%, then he gets a leverage ratio of 50:1, and can trade up to five hundred thousand dollars worth of currency.

Another factors that makes Forex trading attractive is the 24/7 liquidity that the market provides. Because forex markets are active 24 hours a day for all five business days per week, there is no lock in period for any invested position.

Having said that, it is critical to understand that Forex trading also requires both a sound trading strategy and the discipline to follow the chosen strategy. There are many methods that can bring order out of the apparent madness, but a trader can be continuously successful over a long period of time only if trading decisions are marked by discipline, and not by emotion.