The forex market, fx, or foreign exchange, is the market for currencies.
Unlike the New York Stock Exchange (NYSE), there isn’t one place where the forex market exists.
Currencies are traded over the counter, which means you have to go to a broker who will facilitate trade.
Since technology has enabled people to trade currencies from the comfort of their homes, many online brokerage services have emerged to serve anyone and everyone who wants to trade currencies.
To really understand what the forex market is, we have to dig a little deeper:
Most international transactions require the exchange of two different currencies.
For example, let’s say you are an American traveling to France. In order to buy the stuff you want, you have to change dollars to euros.
In this case, you exchanged your domestic currency (dollars) for a foreign currency (euros). Hence, the name Foreign Exchange.
Moreover, we can say you sold your dollars in order to buy euros.
But wait, you didn’t just change $100 dollars for $100 euros.
No, the exchange only gave you $90.9 euros. Why the difference?
In another page, I'll explain in depth how exchange rates are determined, but for our purposes here, the short answer is:
In the global economy, a euro is worth more than a dollar
That’s why the man at the exchange booth quoted an exchange rate of 1.1 dollars per euro.
This quote is the price of a euro in dollars.
At that point in time, every euro bought from that exchange cost you a dollar with 10 cents.
Now, let’s think about all the other tourists, businessmen, and multinational corporations whom, like you, had to sell dollars for euros in order to purchase goods and services in the Eurozone.
You can easily imagine hundreds of thousands of similar transactions occurring all over the world at all times of the day.
So, if we think of your dollar as a stock: what happens to a stock price when everyone sells the stock?
That’s right, the price plummets.
The same happens with currencies, their price, which is the exchange rate goes down (or up, if being bought much and sold little).
In our example, if everyone sold dollars for euros, the dollar would lose value and people would ask for more dollars per euro.
Our exchange rate would increase from 1.1 dollars per euro to 1.2 dollars per euro.
Notice how loss of value in the dollar made the euro more pricey if you want to buy it with your dollars.
This happens because people with euros would demand more dollars to make the exchange worthwhile for them.
Because there are also millions of individuals and corporations doing the exact opposite:
converting euros to dollars
And all of their transactions amount to one thing: selling euros and buying American dollars.
Thus, not everyone is selling your stock, many people are buying it too!
However, unlike stocks, currency doesn’t just sit in your account.
In the United States people will always need to spend dollars to live and do business.
While the same can be said for the necessity of euros in the Eurozone.
This is how we get a fairly stable exchange rate that while varying, isn’t all over the place.
Both currencies are always very well demanded.
Which brings us to:
1. The trading volume of currencies is huge. According to the International Bank of Settlements (BIS), we are talking about several trillion dollars per day.
2. Exchange rate fluctuations tend to be small. Usually in the order of a fourth decimal place (which we call pips)
What does this mean for you, the trader?
First, the substantial trading volume means the market is highly liquid, you won’t have trouble entering or exiting a position.
Your buy (or sell) order will always find a counterparty to execute the trade.
Hence, it’s unlikely you will find yourself with a truckload of foreign currency with no one to sell them to (unless you buy less traded currencies).
Secondly, the small price movements make it difficult to make significant profits or losses unless a trade is conducted with tens or hundreds of thousands of dollars.
On that last point, you don’t have to rob a bank before you trade forex.
Most brokers will allow you to trade with leverage often in the realm of 100:1. With an investment of $1,000 you can trade a block of $100,000.
This brings us full circle.
Also, you might like to know what happens when there's too much risk in the markets and investors move to safe haven currencies.
See you there,
The Forex EconomistHome › What is Forex?
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