What is FX (Forex)?
FX stands for Foreign Exchange, and is also commonly referred to as Forex. It’s the name given to the swapping or exchanging of one country’s currency for the currency of another country. Without realising it, you have likely experienced this whenever you have travelled to a different country and swapped your home country’s currency for that of the country you are travelling to, so you are able to buy things while you are there.
A country’s foreign currency, like any other commodity, is subject to changes in demand and supply. The more a country’s currency is in demand, or in less supply, the more it rises in value against another currency. For example, if more people wanted Euros than they did US Dollars, then the Euro price would rise against the US Dollar, meaning you would have to give up more US Dollars for every Euro you received in exchange.
If the price of Euros (EUR) in US Dollars (USD) is 1.2100, this means that to receive 1 Euro, you must give up 1.2100 US Dollars. If the demand for Euros increases and causes the price to increase to 1.2500 US Dollars, it means that to obtain 1 Euro you now must give up 1.2500 US Dollars. As the value of the Euro increased, and the US Dollar decreased, it has meant that to obtain 1 Euro, it has cost you an additional 4 cents. 1.2500 – 1.2100 = 0.04 US Dollars, or 4 cents.
The FX Market
FX is the largest and most liquid traded market in the world, with an estimated volume of over $5 trillion worth traded globally every single day. It is unique in that the majority of FX volume is traded OTC (Over the Counter) on what is called the Spot Market, where there is no centralised exchange and banks and financial institutions all over the globe exchange these currencies between themselves electronically.
The FX market was largely ignored by individual investors until around 20 years ago, when thanks to the Internet, Brokers were able to provide much better access to the currency markets for retail customers, causing its popularity to suddenly explode!
*Scalping and Hedging are forbidden when trading with Plus500
Why exchange currency?
There are four main reasons for transacting in the FX Market. They are:
- Foreign Trade
One of the most well know reasons for exchanging currencies is to buy good or services from a foreign country. Anyone who lives in the UK and wants to travel to the USA will know that in order to pay for food and accommodation, they need to convert their UK Pounds into US Dollars, as restaurants and hotels in the USA will not accept their UK Pounds.
The same situation occurs for businesses who want to buy components from overseas, they will need to convert their local currency to that of the seller to make the purchase. International Trade is vast and so the need to buy and sell currency is also very large.
The second popular reason for exchanging currency is for the purpose of Investment. As an individual investor, you may wish to invest in shares, bonds, commodities etc from a different country to where you live.
If you live in Germany and wish to invest in Apple stock, then you need to exchange your Euros into US Dollars so that you can actually pay for those shares. Companies face the same requirements if they wish to acquire an overseas company, they must also exchange their local currency to that of the country of the company they wish to acquire.
Hedging is the third main reason for transacting FX. Hedging is the financial strategy of transacting to mitigate the risk of future adverse price movements. The best way to think about this is to consider it as a form of Insurance against the price or value moving unfavourably against you.
For example, say you wish to buy a property in Florida at a cost of $400,000, but all your money is currently held in British Pounds, and the current pound equivalent of $400,000 is £250,000 (GBPUSD of 1.6000). However, by the time comes to actually pay for the property, the Pound has weakened to 1.3333 US Dollars, which means the amount in Pounds you must give up to exchange for US Dollars has changed to £300,000, an increase of £50,000. If you had hedged and bought the US Dollars at the original time, then you would have mitigated the risk of the Pound dropping in value and saved yourself £50,000.
Another reason for hedging may be to diversify exposure away from a holding too much of a particular currency. Macro factors such as Inflation, Interest rates or Political instability, can cause big changes in a country’s currency, affecting the value of what you hold. If you held the currency of Venezuela, the Bolivar, in February 2018, then 7 Bolivar would buy you 1 US Dollar. However due to hyperinflation, in February 2021 to buy 1 US Dollar you now needed 1.88 million Bolivar. That means that the Bolivar currency is now worth 250,000 times less than it was just 3 years previously!
The final major reason to exchange currency is for the purpose of speculating in an attempt to make financial gains. As mentioned previously, there are many factors that can affect the valuation of a currency and impact its price, and we cover these factors in greater detail later in this article.
As the FX market is so large with many participants, it causes frequent, and sometimes large, price changes or volatility. These rapid price changes attract those looking to anticipate what those future movements will be and benefit from buying and selling at the most opportune time to make a gain. You should also take into consideration the possibility of capital losses due to extremely volatile markets. Changes occur within seconds, and traders could lose their capital as quickly as they could gain from it. These speculators transactions also help increase liquidity so that other market participants have opportunities to trade.
What moves the FX Market?
The currency markets can be tricky to trade, there can be large price movements even though there has been little apparent news to cause them. FX Markets are notoriously fickle and news that would normally cause the market to move in one direction can actually make it move the other way. This occurs because market participants interpret information and data differently and draw different conclusions as to its impact.
The factors widely considered to have the greatest impact on FX markets are:
- Interest Rates
- Economic Indicators
- Politics News
- Technical Indicators
A country’s interest rate plays a huge factor in the demand for their currency. An increase in rate normally attracts what is referred to as ‘hot money’, where demand increases as investors and speculators look to earn a higher return on deposits held in that currency. A currency returns 6% is more attractive to depositors than one that is only at 1%, encouraging investors to sell the lower Interest Rate rate currency and buy the currency of the higher rate.
However, rising Interest rates could be interpreted as an indication that a country’s currency could be subject to future inflation. This would be a negative effect and cause the demand for the currency to drop significantly.
Country’s regularly release data to the market in the form of Economic Indicators. These give the public a good insight into the performance of their economy. The more growth an economy experiences the more attractive it is to investors looking to increase returns on their capital, and in turn the more demand there is for that country’s currency.
The most important indicators with the highest impact on the FX markets can be found on our page The top 5 data releases.
Similar to Economic Indicators, wider Political news can have a significant impact on currency demand. Political instability, such as a war or domestic unrest, will lead to a greater risk to any capital that is held in that country. Such events can cause a drop in return on capital invested, make it very difficult to repatriate overseas funds, and impact a business’s supply chain. All such instability will reduce demand for the currency as investors seek the currency of safer countries, and businesses find alternative suppliers in more stable environments.
Technical indicators involve the analysis of past market events and behaviour to try and predict the future behaviour and prices of a market. This examination of historical events, normally through the use of charts and statistical tools, are used to predict where other market participants are likely to enter the market and buy or sell. Common indicators used include support and resistance lines, Moving Average (MACD), Bollinger Bands etc.
Technical Indicators are typically used by market speculators, and normally have the biggest impact when the markets are a little quieter than normal. Their significance should not be underestimated though as the same buy or sell signal can be determined by large numbers of analysts simultaneously, resulting in a mass of activity that causes significant price movements.
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Ways to Trade FX
There are a number of different mechanisms with which to trade FX. The most popular are:
- CFDs & Spread Bets
The primary difference between most of these methods is the time frame in which you have exposure to the fluctuations in currency.
Spot trading a currency is for very short delivery, typically so exchange takes place in only one or two days. If you buy Euros and sell US Dollars on the Spot market, then you will be required to supply the US Dollars, and so receive your Euros, in two business days.
Forward trading allows you to set a specific date for when you want the exchange of currency to take place. This time frame may be very short, such as a few days ahead, or could be much longer such as 4 or 5 years.
FX Futures are very similar to Forwards, except that the date the exchange of currencies take place is the same for everyone, and is defined by the Futures contract, and not custom a custom date. Futures are normally also traded on an exchange rather than OTC.
Swap trading is one party agreeing to lend the currency they hold to another party for an agreed period of time, thus receiving it back again at the end of the loan or ‘swap’ period.
Options provide the facility to buy or sell a currency if it reaches a certain price point in the future. There is normally a cost or premium involved to place the transaction. Options are considerably more complex products, we provide more detail on them in a separate article.
Due to the size of the FX market, many financial institutions are willing to offer very customised solutions to market participants. These hybrids can involve a combination of Forward, Swap and Option to facilitate the customers requirement.
CFDs & Spread Bets
CFDs and Spread Bets are alternative ways to speculate on the FX Market without having to actually exchange the currency itself. These products allow you to buy and sell currency and just receive the difference between the price when you buy it and the price when you sell it.
*Scalping and Hedging are forbidden when trading with Plus500
The Pros and Cons of Trading FX
Low Transaction Costs – the most commonly traded currencies are very liquid, meaning that the spreads (difference between buy and sell price) is normally low reducing trading costs
Liquidity – excellent liquidity also means that there are plenty of buyers and sellers in the market so you can always enter and exit your trades
Accessibility – the market trades 24 hours a day 5 days a week, giving you access to trade when market moving global events occur
Leverage – FX markets are normally traded on leverage, requiring you to only put down a small amount of funds as a deposit compared to your exposure to the market
Volatility – many market participants and sensitivity to macro and micro events mean that Currency markets can have significant movements creating
Volatility – although volatility is a positive, it can also be a negative as the FX markets are prone to sharp price movements causing your trade to move quickly as significantly against you
Leverage – similar to volatility, trading on leverage is also a negative as well as a positive. Because you only need a small deposit to trade much bigger exposure, your losses can quickly be far greater than the initial capital you invested.
*Scalping and Hedging are forbidden when trading with Plus500
If you’re ready to start trading the FX markets, please click here to open your account today.