What Is Forex Trading?

Find out about how to buy or sell currencies on forex markets and the risks involved.
By Richard Barrington

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Forex-Trading

“Forex trading” is an exotic-sounding investment term that can represent anything from a very ordinary and fairly safe transactions to extremely high-risk, speculative trading.

If you’ve ever traveled to a foreign country, you may have engaged in forex trading in a small way already.

If you own non-U.S. investments or do a lot of business in other countries, forex trading may be a way for you to moderate your financial risk.

You may also have seen advertisements touting forex trading as a way to make money. Naturally, though, any investment that can make you money can also lose you money.

The point is, there are a number of reasons why you might be curious about forex trading. As with all forms of investing, the more you learn about forex trading the better prepared you’ll be to make decisions about it.

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What Is Forex Trading?

“Forex” is a shortening of the phrase “foreign exchange.” Foreign exchange trading involves using one country’s currency to buy the currency of another country.

A common example of foreign exchange occurs when a traveler is going to a foreign country. Suppose you’re an American going to Europe and want to have some local currency in your pocket as you travel. You would exchange some American dollars for euros, the currency used by 19 countries in Europe.

In doing that, you would deal with something called the exchange rate. Different currencies have different values, and the exchange rate determines how much of one currency you have to spend to buy one unit of another currency.

When exchanging U.S. dollars for euros, for example, you might find that it takes about $1.20 to buy one euro. If so, that would be the exchange rate for dollars to euros.

Exchange rates are quoted in this form: EUR/USD = 1.20. This means that the value of one euro divided by the value of one U.S. dollar is 1.20.

An important thing about exchange rates is that they do not stay the same. If you traveled to Europe a month later, you might find that the exchange rate was now 1.25. This would mean it would take $1.25 to by a Euro.

These changes in foreign currency exchange rates create both risk and opportunity. They can affect the value of investments or business profits made in another country. They also make it possible to gain or lose money by investing based on how you expect exchange rates to change.

What Affects Foreign Exchange Markets?

Why do currency exchange rates change? Why could a euro be worth $1.20 one day and $1.25 a few weeks later?

The value of a country’s currency is affected by several things. Here are some of the major factors:

  • Confidence

    This is a matter of how comfortable traders feel with conditions in a given country. Is the economy solid? Is the government stable? The more confidence traders have in a country, the more likely they will be to want to own that country’s currency.

  • Interest rates

    If traders can earn a higher interest rate in a foreign country than they can at home, that is an incentive to buy the currency of the foreign country so they can invest it there. Of course, there may be offsetting reasons why interest rates in another country are higher; but all things being equal, higher rates make a currency more attractive.

  • Inflation

    Inflation erodes the value of a currency because it means a unit of that currency will be able to buy less in the future. A country that has an especially high inflation rate will typically find the value of its currency declining relative to other currencies. Note that a high inflation rate will often offset the benefit of high interest rates.

  • Demand

    Major currencies like the dollar, the euro and the Japanese yen are constantly in high demand because a lot of the world’s business is done in those currencies. However, when people want to do less business with a country, there will be less demand to support the value of its currency.

Forex markets are active trading exchanges where traders buy and sell different currencies based on the current value of those currencies and their expectations for the future value of those currencies.

Forex traders are typically aware of all the conditions described above. Their differences of opinion about what they mean are a big reason why one trader might be buying a particular currency while another is selling it.

Spot vs. Forward Forex Trading

Because currency exchange rates change all the time, the value you receive depends on when the trade takes place. To reflect the potential for changes, foreign currencies are traded on both spot markets and forward markets.

  • The spot market is the current exchange rate. You make a trade today at whatever today’s exchange rate happens to be.
  • The forward market is an agreement to exchange currencies on a given future date, at a prearranged price.

With a forward contract, you benefit if the currency you are buying has risen above the prearranged exchange rate by the time the forward exchange date rolls around. However, it will cost you if that currency declines in value so it is worth less than the price you have agreed to buy it for on that date.

Futures and Options in Forex Trading

A forward contract is a specific agreement between two parties to exchange currencies or commodities at some date in the future. The amount to be traded, the price and the date are stated in the contract.

Futures are a standardized version of forward contracts that can be publicly traded. Futures represent a method of trading with leverage, because you can arrange the purchase of a large amount of a currency or commodity with relatively little up-front investment.

Unlike futures contracts, options don’t represent a commitment to buy or sell the security in question. They simply give you the right to buy or sell that security by a given date at a given price.

In the case of a foreign currency, you would buy a call option if you thought the value of that currency was likely to go up. You would buy a put option if you thought it was likely to go down.

Buying options is also a form of leveraged investment because you can obtain the right to buy or sell a given amount of a security while putting relatively little money up front. However, if the price does not move in your favor by the expiration date of the option, you would lose the entire amount you invested.

Hedging with Foreign Currency

While there are significant risks associated with foreign currency trading, it can also help you hedge certain exposures to risks.

For example, suppose you owned a stock that was traded in a foreign currency. You bought the stock because you like its business model, but you are concerned that the value of its native currency might decline. This would detract from the value of any gain on the stock in dollar terms.

A forward contract to sell the country’s currency in the future at today’s terms would hedge your risk by allowing you to lock in the current exchange rate. You could also accomplish something similar by buying put options on the currency.

Besides investors, corporations that do a lot of business in foreign countries often use forex trading to hedge the risk that currency fluctuations will hurt their profits from business operations in those countries.

Speculating in Foreign Currency Trading

Forex trading can hedge a risk when it is used to offset a financial exposure to a currency resulting from investment holdings or business operations. You can also speculate on changes in currency values by buying or selling a currency without any offsetting business or investment risk.

As an example, if you expect a foreign currency to increase in value relative to the U.S. dollar, you could try to profit in the following ways:

  • You could exchange dollars for the foreign currency at the spot market rate. You would then gain or lose money depending on how the foreign currency that you own moves relative to the dollar.
  • You could buy a futures contract to buy the currency in the future at today’s price. This would allow you to put less money up front and profit if the currency gained relative to the dollar. However, if the currency declined in value, you could lose more than your original investment.
  • You could buy a call option on the currency. This would give you the option to buy the currency in the future at a specified exchange rate. If the currency rose in value above that rate before the option expired, you could profit. However, if the option expired without the currency rising above the specified exchange rate rate, it would become worthless.

Risks of Forex Trading

Currency trading is very risky for two reasons:

  • As noted in the above section on things that affect exchange rates, currency values are driven by complex factors that are hard to predict.
  • Some common forms of forex trading, such as those involving futures and options, are leveraged and thus carry the risk of heavy losses. When you buy options, you could lose the entire value of your investment. Worse, with futures, you could be liable for even more than the amount of your original investment.

Beyond these risks, there is also a cost to forex trading.

Currencies are traded on a bid/ask spread, with the investor typically accepting the less attractive side of that spread. Therefore, the wider the spread for a particular currency exchange rate, the more trading in that currency is likely to cost.

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How to Open a Foreign Currency Trading Account

Opening a foreign currency trading account is only slightly different from opening a regular brokerage account.

First, you should research the broker you are considering. You can check the registration status and regulatory history of firms and individuals on the National Futures Association’s BASIC database.

Once you’ve chosen a broker, you may be required to provide more info about your financial status and investment background than you would for a regular brokerage account. This is in recognition of the fact that currency trading is more complex than ordinary stock trading and can involve greater risk. It is not suitable for all investors.

In fact, because of the complexity and risk of foreign currency trading, if you are not absolutely sure about what you are doing, you might be wise to seek help from a qualified financial advisor when starting out. Note that currency trading is a highly specialized field, so you should look for a financial advisor who is qualified and experienced in it.

Currency trading is a vital part of the global economy. Like global economics, it creates both new opportunities and additional risks.

Frequently Asked Questions

Q: What determines currency exchange rates?

A: While currency movements relative to one another are determined by shifting economic conditions, the absolute value of exchange rates is somewhat arbitrary. Different countries set their currencies at denominations that seem convenient, based on what they can purchase and how their populations are used to dealing with money. Occasionally, those levels can be reset to adjust to changing times.

For example, there are more than 100 yen to the U.S. dollar. To think of this differently though, suppose we valued things purely in terms of cents not dollars. One yen would be fairly close to equaling one cent. The size of the units can change, without changing the underlying value the currencies.

Whatever the absolute exchange rate, that rate moves based on interest rates, political policies, economic growth, military threats, etc. This brings up the question of whether those changes create a good opportunity for retirement investing.

Q: Are currencies good retirement investments?

In its purest form, currency trading would be a highly risky form of investing for retirement savings for three reasons:

1. Changes are based on very complex sets of economic conditions

This kind of analysis isn’t for everybody. It’s tough enough to analyze an individual company or industry. Trying to account for all the geopolitical and economic factors that drive currency movements requires highly sophisticated resources.

2. It can be a highly-leveraged form of trading

If you invest in currencies through vehicles like futures or options, you incur the possibility of large, permanent losses, as opposed to the normal up-and-down fluctuations associated with more mainstream retirement investments.

3. Returns are highly unpredictable

Since retirement planning is usually based around some sort of return assumptions, this unpredictability makes it more difficult to figure out how much you need to save and what your asset mix should be.

While foreign exchange investing may not be for the average investor, there is a strong case to be made for international diversification. Investing in the stock markets of other countries gives you some participation in the currencies of those countries, along with their underlying economic conditions.

For starters, see what international investing options your 401(k) retirement savings plan has. It may have broadly-diversified international funds, or even funds that let you choose specific country participation. Incorporating some international investments into a broader asset mix can give you a moderate amount of participation in foreign currencies and markets. This can happen without you having to wake up in the middle of the night to find out where the Japanese yen or the Ethiopian birr closed at the end of their trading days.

Q: Why is the dollar so dominant?

The U.S. has the world’s largest economy, and while the U.S. has had its share of ups and downs, you would be hard-pressed to find a major economy that has had such consistent growth since World War II. The combination of size and stability makes a very compelling argument for using the dollar as, in effect, the international language of finance.

Q: Is the dollar’s popularity a blessing or curse?

Being used so ubiquitously creates demand for the U.S. dollar, which helps support its value. That is good for U.S. consumers who pay less for imports than they would if the dollar were weak.

It is not so good for U.S. companies trying to compete with foreign companies whose cheaper currencies can give them a pricing advantage.

Similarly, the impact of the dollar’s popularity on interest rates is a mixed blessing. Demand for the dollar and dollar-denominated securities helps keep U.S. interest rates low, despite the massive amount of debt racked up by the U.S. government (and individual consumers). You would appreciate the low interest rates if you had recently taken out a mortgage, but you would not be so wild about them if you have a lot of money in savings accounts earning practically nothing in interest.

It can also be argued that cheap borrowing is a form of hazard because it encourages the accumulation of large debts which might become unmanageable, especially if interest rates do eventually rise.

Overall though, most financial people would argue that being the world’s trading currency is a positive: It lets investors focus on the supply-and-demand fundamentals of the commodities they are buying, rather than having to also account for currency as an unstable variable.

Q: Will other currencies topple the dollar?

Of course, it is not a given that the dominance of the dollar will last forever. Various currencies have played a similar role in the past, and just as the dollar took over from the English pound in the last century, another currency might someday eclipse the dollar.

After all, there have been challengers. The euro was formed in part to create a multi-national currency with enough critical mass to rival the dollar. More recently, China’s yuan currency has gained credibility as its economy has grown, and the country’s plan to launch an energy futures exchange this year shows a clear intention to play a role as a trading currency. However, euro countries and now China will have to solve their own economic problems before their currencies are a serious threat to the dollar.