Foreign Exchange Markets

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Written by Justin Grossbard

Edited by David Levy

Fact Checked by Robert Payne

Edited by David Levy

Fact Checked by Robert Payne

Our Guide to the Foreign Exchange Markets covers everything you need to know about the development of forex trading. Learn about market players, key segments, leverage and important trading tools.

CONTENTS

The foreign exchange market is one of the largest, most dynamic markets in the world, with a daily turnover of billions of dollars. It’s also one of the most popular markets to trade, with over 10 million active traders from every populated continent. In this guide, we’ll learn more about the history of the forex market, its key players and foundational trading concepts.

Key Takeaways

  • The foreign exchange market is a complex global network for trading currencies between participants.
  • It facilitates international trade, enables entities to currency risk, and provides a platform for traders to speculate on the price of currencies.
  • Leverage in forex trading enables traders to control larger positions with a smaller amount of capital, which can mean bigger profits but also bigger losses.

the basics of the foreign exchange market

What Is The Foreign Exchange Market?

The foreign exchange marketplace, or the forex market as it is more commonly known, is a network of banks, brokerages, dealers, and exchanges all over the world that are engaged in trading currencies.

Dealers across the globe transact trillions of dollars worth of foreign currencies 24 hours per day, five days per week. With participants such as central banks, hedge funds, international corporations, investment banks, and retail speculators, the buying and selling pressures determine the value of each currency.

Movements in global currency markets can have huge effects on the economies of countries around the world. A large positive move in a currency like the British Pound (GBP) could have a number of major effects on the UK economy. For instance, it could damage UK exports, causing them to be more expensive to the rest of the world. This could cause a chain reaction of events, such as the UK economy taking a hit, the Bank of England lowering interest rates, and much more.

Forex trading isn’t strictly a domain for banks, hedge funds, and corporations. Individual traders are also highly active in the forex market, using it as an opportunity to profit from the movements of currency prices.

Why Trade Forex?

Most capital markets, such as the stock market, bond markets and cryptocurrency ecosystem, offer individuals the ability to openly trade its financial products.

Each asset class has distinct advantages, but for an individual trader sitting in front of their computer or on their smartphone, the forex market may be the very best financial market to trade.

Some of the main reasons why retail investors opt to trade forex include:

  • Round-the-clock, 24-hour-a-day trading allows you to find plenty of trading opportunities even if you have a busy day job.
  • The ease of going long and short allows you to profit from a currency price going either upwards or downwards.
  • The huge market liquidity of several trillion dollars cuts transaction costs.
  • The ease of leverage allows a trader to deposit a small amount of capital at a forex broker and then trade a large position size, allowing for magnified profits and losses.
  • The ease of using forex trading platforms, such as MetaTrader 4 and cTrader, enables even a rank beginner the ability to get started in under an hour.

There are a lot of great things about forex trading, but trading currencies isn’t always easy.

At the end of the day, you need to understand that you’re competing against some very well-financed and highly intelligent participants. Let’s take a look at who they are…

Major Participants in the Forex Market

The foreign exchange market is a multi-trillion-dollar-per-day, global ecosystem, operating 24 hours per day. Here are some of the forex world’s major players:

  • Central Banks, such as the American Federal Reserve and the Bank of England. These government-aligned entities underpin the modern global economy, setting interest rates and monetary policy with the aim of maximising financial stability in the global economy.
  • Commercial Banks, such as Barclays and Lloyds, which move money across the globe, offer money market instruments and help their clients hedge exposure to exchange rate risk in currency price movements.
  • Hedge funds, which are sophisticated investment funds, that buy and sell currencies, often in huge volume, looking to profit from exchange rate movements and interest rate differentials.
  • Brokers and foreign exchange dealers act as agents for companies and individuals who’d like to buy and sell currencies.
  • Proprietary trading firms, which are sophisticated companies, often well-capitalized and with complex trading strategies, making fx transactions with a view to making profits on their capital.

What are market makers

These participants are the liquidity providers. Without them, there would not be the mass scale of trade that occurs every second during Forex market hours. The liquidity providers are the counterparty to your trades and, in some cases, set the prices to play the role of market maker.

What we see today is an advanced, global foreign exchange marketplace. But things weren’t always so sophisticated.

The History of the Foreign Exchange Market

We don’t want to bore you with a long lesson in the history of trading foreign currency and financial markets. Instead, here are a few short things you need to know about the history of foreign exchange markets:

1. Early Beginnings

The foreign exchange market has a long and intricate history dating back to the days when people would exchange value using the barter system. That is, before the advent of currency, people would trade one commodity for another, such as wheat for rum.

The actual formation of a centralised currency dates back to ancient times with roots in Babylonian culture. The first genuine, organised exchange market emerged in Amsterdam when it was a global trading hub. The foreign exchange market now consists of a global network of financial institutions taking part in dealing with enormous amounts of up to 5 trillion dollars per day on average.

early beginnings

2. Gold Standard Era

A noteworthy period in this field is from the 19th century until the early 20th known as the Gold Standard Era, where gold acted as the primary medium of exchange for trade. The Gold Standard Era saw gold being widely used as an international currency where the value of each nation’s money was linked to a set price for the precious metal. This arrangement caused exchange rates between countries to remain static, granting businesses more assurance when trading abroad due to consistent values for currencies in circulation.

Throughout the 20th century, the world moved away from tying currency values to gold as a way to induce value creation through the free trade of capital. This has largely worked but has also enabled some huge, oftentimes economically damaging moves in currencies.

Different Forex Market Segments

The foreign exchange market involves several different products and avenues for traders to hedge and speculate on currency rates.

different forex market segments

1. Spot Market

The spot market is a place for the direct exchange of currencies at the current rate. This is the most active and liquid market in terms of daily trading volume. For speculators, the spot market can enable traders to take advantage of price fluctuations to make profits.

The spot market also allows commercial users, such as companies that sell products across the globe, to quickly and efficiently get access to foreign currencies needed to pay international suppliers.

2. Forward and Futures Markets

The forward and futures markets are used by hedgers to protect against currency fluctuations as well as by traders as a way to speculate on currency prices. Currency futures are a type of regulated financial contract traded on futures exchanges, allowing traders to agree on a future price.

Forward contracts are similar to futures contracts, but they are traded over-the-counter (OTC), allowing for a more unique and personalised trading contract.

3. Forex Options

Another way that traders can participate in the currency markets is with the use of forex options.

Purchasing an options contract gives a trader the right, but not the obligation, to purchase a currency at a particular price on a particular date in the future. On the flip side, the seller of the options contract holds the obligation to fulfil the terms of the contract in the future.

Whether you trade spot forex, futures, forwards, or options, before you get involved, you should understand how leverage works.

Leverage in Forex Trading

When it comes to forex trading, leverage is a powerful tool that allows traders to control larger positions using much smaller amounts of capital. This amplifies the potential profits on their trades but also increases any losses should the market move against them.

How Leverage Works

Leverage in forex trading means using borrowed capital to increase the size of a position that a trader can hold. With a leverage ratio of 100:1, an individual can open a $100,000 currency position with just $1,000 in their account.

In this situation, if the currency position gains just 1% in value, the trader will have a 100% return on their capital. Conversely, if the position loses 1% of its value, the trader’s capital will be wiped out. For this reason, some regulators limit the leverage brokers can allow retail clients to trade with.

If you’re just starting out in forex trading, be cautious with leverage. Less is better until you have an advanced skillset and strategy. Make sure you compare forex brokers to ensure the one you select is appropriate for your trading needs.

How Foreign Exchange Markets Function

By now, you’ve probably got a good idea of who’s active in the foreign exchange markets and the products they’re using to hedge and speculate on currencies.

Now, let’s have a look in simple terms, exactly why these players are involved in the foreign exchange market.

1. Facilitating Global Trade

We live in a highly globalised world.

You might purchase an iPhone from a shop in London. The iPhone was designed in the USA, but it was made in China, Vietnam, and India. The materials used to make the iPhone are from numerous countries, from Asia and Africa to the Americas.

facilitating global trade

This is a simple snapshot of foreign trade. At every point of the production process, one entity had to pay another a certain amount of currency. This is essentially what global trade is and why trillions of dollars worth of currencies are traded around the globe each day.

2. Managing Currency Risk

The currency markets also enable companies, banks and people to hedge exposure to currency price movements while transacting in the global market.

For example, imagine a commodity trading company that wants to purchase iron ore from Australia 6 months from now. The firm enters into a contractual agreement to purchase the iron ore from a supplier for $10 million Australian dollars.

In the coming six months, the price of the Australian dollar could rise by 10%, meaning that the commodity firm needs to spend 10% more to purchase the iron ore, potentially causing the company to take a loss on the deal.

So, what can the commodity firm do to protect itself from a change in currency prices? One risk management strategy is to use a hedge. Hedging can be done by using a futures or forward contract to lock in the price of Australian dollars that they’ll need to pay in 6 months.

3. Speculative Trading

With prices of currencies fluctuating 24 hours per day, sometimes by large amounts, many traders, banks, and funds look to make profits by buying and selling currencies for a profit. By using insight into economic data, price charts, market sentiment, or algorithmic software, countless traders are active across the globe, trying to make a profit each day.

Just note that in most cases, there will be a spread between the ask and sell price determined by the market or forex broker. This means that forex trading is not exactly a 50/50 scenario. The same applies to spread betting trading platforms in the UK, where the main fee is the spread (after overnight fees).

Frequently Asked Questions

What Is a Foreign Exchange Market?

The foreign exchange market, otherwise known as forex or the FX Market, is a financial network where international currencies are exchanged and traded. It provides global traders with opportunities to buy, sell speculate, and hedge the value of various currency pairs.

Forex is the largest and most liquid of all trading markets globally. Trillions of dollars worth of currencies are traded every business day.

What Are The Major Types Of Forex Market Products?

You can trade on the forex market via the spot market or using contracts for difference (CFDs). In spot trading you directly buy and sell currencies through a broker or bank. With CFDs, you speculate on the FX market movement without buying the underlying currency pairs.

Futures or options contracts create a right or an obligation to buy or sell a currency at a specific price on a specific date in the future.

How Can A Retail Trader Compete In The Foreign Exchange Market?

Retail traders can compete in the forex market by taking advantage of their size. Smaller and more nimble, a retail trader can get in and out of the market at the drop of a hat without having to consult anyone. They just need an advanced forex trading platform.

About the author:

Justin Grossbard

Having traded since 1998, Justin is the CEO and Co-Founded CompareForexBrokers in 2004. Justin has published over 100 finance articles from Forbes, Kiplinger to Finance Magnates. He has a Masters and Commerce degree and has an active role in the fintech community. He has also published a book in 2023 on on investing and trading.

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