Foreign Exchange (FOREX) Explained

Investments » Foreign Exchange

What is Foreign Exchange (FOREX) Trading?

Types of Investments

Foreign exchange trading – also known as "FX", or "Forex" trading – is essentially exchanging one currency for another, simultaneously buying say British Pounds and selling say US Dollars.

Currencies are quoted in pairs – the US Dollar and Japanese Yen, or the Euro and the US Dollar, are other popular pairings – and as one of the pair strengthens, or increases in value, so the other weakens, or decreases in value. Despite being the largest financial market in the world – with a total transaction value estimated at $1,200 billion daily – the foreign exchange market is not based in any fixed, geographical location, such as a stock exchange; trading is conducted, instead, through a network of banks, companies and individuals.

Foreign Exchange Features, Benefits & Considerations

Foreign exchange trading can take place via a "spot" deal, where the exchange takes place immediately – or, at least, within 2 business days – at the current exchange rate or a "future" deal, where the exchange takes place, at an agreed rate, on a future date. Forward dealing is often employed by companies involved in international trade as protection against currency fluctuations which may otherwise affect payments and receipts to, and from, overseas customers.

Foreign exchange trading takes place around the clock, 24 hours a day, and the market has no opening or closing times. In this respect, at least, foreign exchange trading can be seen as a less risky proposition than stock market trading, which may be susceptible to a "gap" – that is, a change in price levels up or down – between opening and closing on consecutive days. Foreign exchange rates are, however, highly susceptible – far more so than say equity markets – to currency fluctuations caused by political and social events, as well as economic influences. It is important for foreign exchange traders to be aware of and monitor these macroeconomic indicators, but the nature of foreign exchange trading means that it is possible to react to events as they happen.

One definite advantage of foreign exchange trading is "trading on margin", and the amount of "leverage" made available to investors. Trading on margin essentially allows investors to establish foreign exchange positions without having to put up the entire amount of capital required. This is largely due to the reduced volatility in currency pairs, when compared to other markets, such as futures or equities; leverage allows investors to magnify gains derived from smaller moves in the market, although if the market moves in the wrong direction, losses incurred may be similarly magnified. Depending upon the experience of individual investors and the margin required by individual brokers, a position of up to 200 times the original investment – that is, leverage of 2,000% – may be permissible; in simple terms, this means that an investment of £1,000 can allow up to £200,000 worth of foreign exchange trading.

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