FOREX is an acronym for Foreign Exchange. It will often be seen written as Forex or Fx, but in all forms, it is a noun referring to the international market for exchanging one currency for another.
Reasons for the Foreign Exchange
Anyone who needs to convert a currency in his or her possession for a different currency can do at an exchange rate determined by the foreign exchange market. Travelers will often do this ahead of going to a foreign country or as soon as they arrive. Since this exchange often involves banks, those banks will also maintain a supply of different currencies. International companies often need to convert currency from that of where they are based to the local currency where employees live. Governments often exchange currency as part of trade agreements.
Speculative Currency Exchange
Any purchaser of goods or services will often attempt to find the lowest possible price. Sellers of goods or services want to get the highest possible price to maximize their profits. Forex traders try to purchase currency on the exchange at the lowest price in order to potentially sell it at a higher price or sell it for a high price, and then buy it back for a lower price. This practice is known as currency speculation.
Retail Forex Trading
Retail Forex trading got its start when the European Common Market was formed and started issuing the common currency known as the euro. Nineteen countries currently use the euro and it has made trading currency much simpler. A trader need only monitor one exchange rate for all nineteen countries compared to any other world currency.
A Forex broker combines two different currencies in a currency pair. The euro/United States dollar, abbreviated as EUR/USD or EURUSD is the most popular pair, accounting for well over $1 billion worth of currency exchanges every day. Other popular pairs include any of the other five world currencies that are considered major currencies. These are the British pound, Swiss franc, Japanese yen, and the Australian and Canadian dollars. The broker decides which of the currencies to combine and in which order. They rely on supply and demand to tell them which currencies to offer. Many traders are interested in pairs formed by the major currencies, but fewer would be interested in currency pairs involving, for example, the Polish Zloty or the South African Rand. These uncommon currencies are referred to as exotic currencies.
Brokers make currency pairs available to traders for a small fee called the spread. The lowest spreads usually come from a type of broker known as a market maker. Market maker brokers participate in trades with a trader by taking the opposite position from the trader. The other type of trader is the Electronic Clearing Network (ECN). ECN brokers do not participate in trades; they match traders who want to sell a currency pair with those wishing to purchase it. They charge a commission for doing this, along with a spread.
Basic Mechanics of a Forex Trade
All retail Forex trading is done electronically on the Internet. Here is an example of trades involving the EUR/USD.
A trader thinking that the euro will gain value compared to the dollar will electronically send an order to the broker to buy a certain number of units. One unit equals one euro and one dollar. The trader buys the desired number of euros while simultaneously selling the same number of dollars. That trader is said to be long the EUR/USD. If the euro does increase, the trader makes a profit. A trader thinking the value of the euro will decline in value compared to the dollar will sell the desired units. That trader is said to be short the EUR/USD. The trader will profit if the value of the euro compared to the dollar goes down.
Forex trading is a high risk/high reward activity. There are many other facets beyond the basics mentioned here. Anyone interested in trading Forex online should be prepared to spend time learning as much as possible before risking actual money.