The Basics of the Foreign Exchange Market

At the completion of this lesson, you should understand:

Overview:

What is Foreign Exchange?

Forex
An abbreviation of foreign exchange.

Speculator
A sophisticated individual who trades with significant leverage, taking on above average risk in hopes of above average returns.

Foreign exchange consists of trading one type of currency for another. Unlike other financial markets, the FX market has no physical location and no central exchange. It operates "over the counter" through a global network of banks, corporations and individuals trading one currency for another. The FX market is the world's largest financial market, operating 24 hours a day with enormous amounts of money traded on a daily basis.

Unlike any other financial market, investors can respond to currency fluctuations caused by economic, political and social events at the time they occur, without having to wait for exchanges to open. Access to modern news services, charting services, 24- hour dealing desks and sophisticated online electronic trading platforms has seen speculation in the FX market explode, particularly for the individual trader.

The currency markets are not new. They've been around for as long as banks have been doing business. What is relatively new is the accessibility of these markets to the individual speculator, particularly the small- to medium-sized trader

A Short History of the Foreign Exchange Trading Market

Arbitrage
The simultaneous sale (or purchase) of a financial instrument and the taking of an equal and opposite position in a similar instrument to provide a profit. That is, exploiting pricing differences (anomalies) across markets. True arbitrage is risk free.

Exchange Rate
The rate at which one currency is traded against another.

Margin in the context of FX & CFDs
A cash deposit provided by clients as collateral to cover losses (if any) that may result from the client's trading activities.

"Pegged" Currency
A currency is pegged or fixed when its country's Central Bank decides to tie its value to a stronger currency, in an effort to stabilize its own currency. Currencies such as the Hong Kong Dollar have historically pegged to the US Dollar.

Speculator
A sophisticated individual who trades with significant leverage, taking on above average risk in hopes of above average returns.

Foreign exchange markets originally developed to facilitate crossborder trade conducted in different currencies by governments, companies and individuals. While these markets primarily existed to provide for the international movement of money and capital, even the earliest markets had speculators.

Today, an enormous proportion of FX market activity is being driven by speculation, arbitrage and professional dealing, in which currencies are traded like any other commodity.

Traditionally, retail investors' only means of gaining access to the foreign exchange market was through banks that transacted in large amounts of currencies for commercial and investment purposes. Trading volume has increased rapidly over time, especially after exchange rates were allowed to float freely in 1971.

From 1944 until 1971, most of the world's major currencies were pegged to the US dollar under an arrangement called the Bretton Woods Agreement. Participating countries agreed to try and maintain the value of their currency with a narrow margin against the US dollar and a corresponding rate of gold, as needed. These countries were prohibited from devaluing their currencies to gain a foreign trade advantage. Consequently, the foreign exchange market was relatively static.

Trading Margin FX

Bid Price
The highest price a prospective buyer is willing to pay at a particular time for securities, futures contracts or foreign currencies.

Bid/Offer Spread
The standard differential between the price of buying and selling securities. It is usually quoted as a monetary amount for shares, a percentage term for unit trusts.

Margin in the context of FX & CFDs
A cash deposit provided by clients as collateral to cover losses (if any) that may result from the client's trading activities.

Spread
The difference between the market-maker's bid and offer price for a currency.

When trading FX on margin, the dealing prices quoted to you are directly correlated to those prevailing in the interbank foreign currency market. You are, therefore, gaining access to the professional currency market at the wholesale dealing spreads, without being a major corporation, bank or financial institution and without the need for interbank credit lines. A client is provided with two prices: a bid and an offer. This is referred to as the spread and depends upon the size, volatility and the currency being quoted. The quotes are valid only for a short time.

Since the mid 1990s, with the advent of online foreign exchange trading on margin, clients now have the advantage of trading on live streaming prices. This transparency and ease of dealing has accelerated the growth of currency trading speculation and, essentially, given the retail trader access to a huge market for speculation.

Note: CMC Markets is the world pioneer of online margin FX trading. CMC Markets executed the very first online margin FX trade in 1996 and was the driving force behind retail investors accessing global currency trading on interbank spreads, previously only available to major institutions.

Margin FX - The New Frontier

Margin in the context of FX & CFDs
A cash deposit provided by clients as collateral to cover losses (if any) that may result from the client's trading activities.

For many years foreign exchange was a market only accessible by the largest of institutions and a few very wealthy individuals. Margin FX trading, by comparison, has the potential of unlocking this vast market to millions of individual traders.

Control
You, the trader, have control and can choose your level of risk. It is up to you to manage your positions and exposure in the FX markets. It is very important that you actively manage your investment and the risk. Because currency trading involves the use of leverage, risk and potential loss can be magnified.

Summary

Investor - Markets - Currencies - Calculator