The Foreign Exchange market (known as Forex or the FX market for short) is the largest financial market in the world and paradoxically one of the least well-known among individual investors. No goods or services are traded on Forex; instead investors are buying and selling money with profit taking place based on the difference between currencies. As the most liquid market in the world, transactions on FX market easily total four trillion daily and it’s rare for an investor to be stuck with assets they don’t want.
Forex’s main purpose is to make currency exchange easier for companies that need to manage a lot of international transactions, such as payroll, foreign suppliers and clients, or global mergers and acquisitions. Yet in the last few years, FX has moved well beyond its utilitarian role and 80 percent of the trades are currently essentially ‘speculative’. Many professional traders need to combine both aspects of the FX market. Ashay Mervyn manages Emerging Market Assets in various parts of the world, so working in different currencies is necessary as well as profitable.
Previously, the FX market was the domain of large multinational organisations, massive hedge funds, and corporations with a lot of financial weight. This has changed recently to allow more space for individual investors who want to try their hand at a different market.
Read on for the answers to four important FAQ’s about Forex.
What makes Forex different from other markets? – One of the major differences is that there is no regulatory body to oversee exchanges and handle disputes. Unlike structured stock exchanges, deals on the FX market take places based on a ‘credit agreement’, a virtual ‘handshake’ so to speak. There is no ‘uptick rule’ so investors are free make profitable investments on dropping currencies. There is also no penalty for insider trading; investors can gamble as much they are able to afford on a reliable tip that a certain currency will drop. This freedom increases the ease with which currency is traded on Forex. There are few gaps or dead spots and large amounts of profit can be gained through smart negotiation.
Another difference is that the FX market does not work on a commission basis. Firms that trade in foreign currency are not brokers; rather they are dealers working in a ‘principals-only market’. They act as ‘counterparty’ to the trade and assume market risk. Since they don’t charge commission, dealers on Forex make money through the ‘bid-ask-spread’, the difference between the seller’s asking price and the buyer’s bid. As the most liquid asset in the world, currency has the lowest bid-ask-spread.
How is Forex regulated? – The lack of traditional regulatory structures doesn’t make the FX market a free for all. To survive, Forex traders have to work both with and against each other. Shady dealing and dishonest transactions will initiate an investor’s downfall, so the system of ‘self-regulation’ works fairly well. Reputable Forex traders also become members of independent regulatory organisations, like the National Futures Association (NFA) in the US. Funded exclusively by member dues, the NFA handles disputes through ‘binding arbitration’ and helps to ensure that currency traders are held to the same ethical standards as other markets.
How does trading work on Forex? – Currencies are traded in pairs. In any transaction, the investor will always be ‘short’ one currency (the selling currency) and ‘long the other (the buying currency). By trading frequently, investors profit on currency fluctuation to increase the net value of their investment. There is no physical exchange of commodities; all transactions take place electronically and profits are calculated in USD. Investors could be described as ‘buying a share in the country’. When they change money into a certain currency, they are betting on whether the country’s ‘stock’ will go up or down. Just like other markets, profits are made on the accuracy of the bet and the ability of the dealer to astutely judge the timing of each trade.
What do you need to know to start trading?
- Just like other markets, financial jargon on Forex can be intimidating for a new trader. There are four ‘major’ currencies and three ‘commodity’ pairs (see our PDF) which account for 95 percent of the ‘speculative’ trading on Forex. The most common type of trade is called a ‘carry trade’ which is based on converting ‘interest rate differential’ between different currencies into profit by using a low interest currency to invest in one with a higher interest rate. Widely divergent interest rates can allow investors to carry a huge profit margin on this type of transaction.
- PIP is a common Forex term which stands for ‘percentage in point’. This is the smallest amount to which a currency will be calculated, usually the fourth decimal point with the one major exception. Trades that exchange US dollars and Japanese yens are only calculated to two decimal points. A round number is referred to as a ‘Figure’ on FX while the term ‘Yard’ is shorthand for one billion units.
- Knowing currency nicknames is another vital asset for investors on the FX market. For instance the UK pound can be called ‘Cable’ or ‘Sterling’, while US dollars are known as ‘Greenbacks’ or ‘Bucks’. ‘Swissie’ and ‘Aussie’ are obvious nicknames for Swiss and Australian currencies, but nicknames for the Canadian dollar, ‘Loonie’ or ‘Little Dollar’ might be less easy to recognise.
It takes many years to become an experienced currency trader like Ashay Mervyn. As with all financial markets, much knowledge can only be gained through actual practice. However the nice thing about Forex is that it’s open to anyone, anywhere in the world. Novice investors need only a computer and internet access to open an account and begin trading on this profitable market.