Foreign exchange (or forex) is the marketplace for trading all of the world’s currencies and is the largest financial market in the world. There are numerous entities taking part, including banks, financial institutions, retail traders and brokers, all speculating on the movements of currency pairs. In this article, we will take a look at why people trade forex and the advantages it brings to forex in Singapore.
What is forex trading?
Forex trading is simply the buying and selling of one currency into another. Currencies are traded in the foreign exchange market, a global marketplace that is open 24 hours a day five days a week. All forex trading is conducted over-the-counter (OTC), meaning there is no physical exchange (as there is for stocks). Instead, a global network of banks and other financial institutions oversee the market instead of a central exchange like that of the New York Stock Exchange (NYSE).
A vast majority of trade activity in the forex market occurs between institutional traders, banks, fund managers, multinational corporations, and other financial institutions. These traders do not necessarily intend to take physical possession of the currencies themselves but instead may be speculating about or hedging against future exchange rate fluctuations.
A forex trader may buy US dollars and sell euros if they believe the dollar will strengthen in value and therefore be able to buy more euros in the future. On the other hand, another trader may use the forex market as a hedge in the event the euro weakens, protecting themselves from adverse price movements.
How currencies are traded
All currencies are assigned a three-letter code. This is similar to a stock’s ticker symbol. All forex trading is expressed as a combination of the two currencies being exchanged. The following seven currency pairs, which are known as majors – account for about 75% of trading in the forex market. These are:
- EUR/USD
- USD/JPY
- GBP/USD
- AUD/USD
- USD/CAD
- USD/CHF
- NZD/USD
Ways to trade Forex
Most forex trades are not made for the purpose of exchanging currencies, but rather to speculate about future price movements, similar to stock trading. Forex traders are attempting to buy currencies whose values they think will increase relative to other currencies or to get rid of currencies whose purchasing power they anticipate will decrease.
There are three different ways to trade forex, which will accommodate traders with varying goals:
The spot market: This is the primary forex market where currency pairs are swapped and exchange rates are determined in real-time, based on supply and demand.
The forward market: Instead of executing a trade at the current time, forex traders can enter into a binding private contract with another trader and lock in an exchange rate for an agreed-upon amount of currency on a future date.
The futures market: Similarly, traders can opt for a standardised contract to buy or sell a predetermined amount of a currency at a specific exchange rate at a date in the future. This is done on an exchange rather than privately, like the forwards market.
The forward and futures markets are typically used by forex traders who are looking to speculate or hedge against future price changes in a currency. The exchange rates in those markets are based on what is happening in the spot market, which is the largest of the three and is where a majority of forex trades are executed.
Advantages of trading forex
Many traders are drawn to forex as a result of the market’s volatility and extended trading hours when compared to other markets such as the stock market. Below we have explained and broken down a few of the main benefits of trading forex.
Trade around the clock
The forex market is open 24 hours a day, five days a week. These long trading hours are made possible because forex transactions are completed over the counter (OTC) rather than through a central exchange.
Because forex is a truly global market, traders can always take advantage of different active sessions’ forex trading hours. That said, it is important to remember that the forex market’s opening hours will vary depending on the region and time zone.
Capitalise on high liquidity
Forex is the most liquid market in the world because there is a large number of buyers and sellers looking to make a trade at any given time. In fact, each day over trillions of dollars is being converted by individuals, companies, and banks.
The forex market’s high liquidity means that transactions can be completed relatively quickly and easily. It also means that spreads are often very tight – meaning the underlying market price will not have to make a significant positive move in order for a trade to be potentially profitable.
Hedge with forex
Hedging is a technique that can be used to reduce the risk of unwanted moves in the forex market by opening multiple strategic positions. Although volatility is a major reason for what makes forex so exciting, hedging can be a good way of mitigating or limiting potential losses to a known amount.
There are a variety of strategies that can be used to hedge forex, but one of the most common is hedging with correlated currencies. By opening opposing positions on forex pairs that are positively correlated – like EUR/USD and GBP/USD, traders can limit their downside risk. So, a loss on a short GBP/USD position could be mitigated by a long position on EUR/USD.
Alternatively, traders can use forex to hedge against loss in other markets, such as commodities. For instance, USD/CAD typically has an inverse relationship with crude oil. So, a long position can be used as a hedge against falling oil prices.
Low transaction costs
Not only does the forex market require little capital for entry, but there are also low transaction costs. Typically, brokers make money from spreads, which are measured in pip. This is factored into the price of a currency pair.
Spreads are also usually low, making forex trading relatively cheap. However, traders should still look into all the associated costs when picking a broker to work with, as their fees, products, and services may differ from each other.
Take advantage of leverage
The availability of leverage is perhaps the most appealing as it allows people to open a high position with a relatively small amount of capital. Most forex brokers permit retail traders to put down a deposit and borrow against this in order to control a much higher stake.
A trader’s available leverage is often expressed as a ratio, with most regulated forex brokers limiting maximum leverage for retail traders, with 1:30 and 1:50 being common. While this opens up the potential for increased profits, it can also lead to greater losses, so leverage should always be used with caution.
Good technology for trading
Compared to other financial markets, such as those dealing with stocks, forex trading is a relatively new practice. As such, it has been quicker to adapt to the technological advancements of the trading and financial world.
Its decentralised nature also means connectivity, which is vital to its existence and software developers are continuing to improve the platforms available to forex traders.
Innovations in mobile applications, trading algorithms and global connectivity, continue to make it easier for individuals to trade effectively in real-time from anywhere in the world. As such, it makes technology one of the major benefits of forex trading.
