Forex (FX) or The Foreign Exchange Market in full is an over-the-counter (OTC) decentralized marketplace that facilitates the trading of global currencies as well as determines the exchange rate for different currencies. You might have unknowingly participated in the Foreign Exchange Market if you have ordered imported bags or goods although the clearest example will be buying of foreign currencies when on vacation or business abroad.
What makes FOREX so appealing?
Apart from the huge gains one can make on the market if you play your cards right, Forex still has a lot of features that attracts traders to it. First, The Foreign Exchange Market is a vast one as it comprises of a network of financial centres in different countries all over the world offering a myriad of currencies for traders to trade with. It’s also the market that never sleeps as traders are allowed to trade 24 hours a day through the week to close only on weekends.
In addition, it offers the traders differing levels of volatility while giving traders the benefit to carry out transactions at low costs. However what puts the icing on the cake is its high liquidity as Forex is by far the most liquid market in the world, with an average daily trading volume of $5.1 trillion according to BIS Triennial Survey 2016. This creates ease for traders to enter and exit positions as there are many buyers and sellers for foreign exchange.
How does it work?
The Foreign Exchange Market, as stated above, deals with the buying and selling of currencies. In Forex, these currencies are always traded in pairs, creating relativity between the values of the two currencies. Some of these pairs include the JPY/USD currency pair or GBP/USD currency pair amongst a host of others. Each currency in the aforementioned pair is a three-letter code which the first two letters arecoined from the name of the region while the last letter represents the currency itself. For example, the USD, US represents the region which is the United States while the D stands for the Dollar. The same thing with the JPY as the JP represent Japan while the Y stands for the nation’s currency, Yen.
Another concept we need to grasp is that of the base currency and the quote currency. Consider any of the listedforex pairs above. The first currency listed in the forex pair is called the base currency while the second currency iscalled the quote currency. We know Forex is all about the buying and selling of currencies. This is why they are quoted in pairs, such that the price of a forex pair is simply how much a unit of the base currency is worth in the quote currency.
The principle behind Forex trading is very simple to understand. We buy currencies which we feel the value will go up and sell currencies we feel the value will go down. Let us consider a Forex pair, GBP/USD. If GBP/USD is trading at 1.54371, what this means is a pound is equivalent to the sum of 1.54371 dollars. If the value of the pound should increase, then one pound will be worth more dollars thus leading to an increase of the pair’s price.
However, if the value of the pound should drop, the pair’s price will reduce. Hence, if you feel the base currency in a forex pair, in this case, the GBP will appreciate (go up) against the quote currency which in this case is the USD, you can buy the forex pair which is termed “going long”. However if you feel it will depreciate (go down) against the quote currency, you can sell the pair “going short”.
The Force behind the FOREX Market
The basics of economics as a subject makes us understand that a market is a place of agreement, meeting point or a place of the bargain between two parties which are often referred to as The Supplier(seller) and The Consumer(buyer). If there are no parties to a bargain, it is not a market. Therefore, the concept of Demand and Supply is the major force behind any market, FOREX still.
Demand is basically the willingness and ability of an individual to purchase a commodity and Supply refers to the ability and willingness of a producer to provide his commodities up for sale. The underlying term in both concepts is the “willingness and ability” of both parties.
Let’s also consider a very important factor in this concept, the price of the commodity. Now when both parties agree to meet at a point (market), the bargaining chip is the price of the commodity. How much is the seller willing to give it up for and how much is the buyer willing to pay? Once this is settled, the purpose of the market has been achieved.
Furthermore, there are situations where the demand for a particular commodity increases-this means there are more demands for that commodity than the supply or vice versa which leads to an increase in Supply-where the commodity supplied exceeds the demand for that particular commodity. Too much story, let’s see an example
So you go to the market with an intention to buy a pair of blue trousers and on getting to the store, you see a number of blue jeans to select from (excess supply). The variety of jean available gives you the opportunity to select what suits you. You bargain with the seller and off you go with your pair of jean you bought at a convenient price, if not even lower than budgeted because of excess supply.
After some weeks passed, you decided to visit the same store to purchase another pair of jean but this time with your friend who also has the same intention. On getting there, there’s just one pair of jean available-this is a case of increase in demand and at this point the seller was expecting you to come back but not with a friend hence, supply is low. You’d find out that the seller would attach a price higher than what you budgeted and simply because supply is low and demand is high.
Take out: Increase in demand; Low supply=Increase in price; Excess supply; low demand=prices will drop.
Now, this illustration is simply what goes on in the market everyday of which we all are a part of. With this understanding, let’s have a view on what goes on in the Forex Market. Simply put, they buy and sell currencies. Let’s apply the increase in demand and supply to the Forex Market. It should start getting complex from here, but it won’t, let’s ride together.
Every time a currency is bought in the Forex market, it follows through that there’d be an increase in demand which will make the price of that currency go higher. In the same way, when a currency is sold, it follows in the direction of an increase in supply which only makes the price drop.
Let’s illustrate this with what goes on in the Forex market;
If there’s an increase in demand of US Dollars by Europeans holding their own currency, Euro, trust that they will convert all of their Euros to Dollars. Hence, the price of Dollar will be on a rise while that of Euro will be declining. Don’t forget that this only affects EUR/USD and will not have any effect on any other currency pair involving any of both currencies.
However, there are also forces, though not as major as demand and supply that drives the Forex market. They include;
- Presidential election in a country
- Existing interest rate
- Unemployment Rate
- Inflation rate
- Rate of GDP to Debt, and others.
Who Trades in the Forex Market?
Although, anyone can trade in the Forex market, there are two major categories people are classified under; The Hedgers and The Speculators.
Hedgers are those people who are always very precautious by monitoring strange movements in the exchange rate. In simple words, they are those persons who would not like to be a victim of the fluctuations in the exchange rate. They are all about reducing the risk of their exposure.
Speculators on the other hand, are those persons always seeking for those precarious movements in exchange rate with an intention of taking advantage of them. They understand the volatility aspect of Forex and are willing to undertake the risk with the hope of staying on the winning side. But if the losses come near, they don’t mind, they wait again only this time, more prepared.