Although forex is the largest financial market in the world, it is relatively unfamiliar terrain for retail traders. Until the popularization of internet trading a few years ago, FX was primarily the domain of large financial institutions , multinational corporations and secretive hedge funds. But times have changed, and individual investors are hungry for information on this fascinating market.
Whether you are an FX novice or just need a refresher course on the basics of currency trading , read on to find the answers to the most frequently asked questions about the forex market.
Unlike stocks, futures or options, currency trading does not take place on a regulated exchange. It is not controlled by any central governing body, there are no clearing houses to guarantee the trades and there is no arbitration panel to adjudicate disputes. All members trade with each other based on credit agreements. Essentially, business in the largest, most liquid market in the world depends on nothing more than a metaphorical handshake. At first glance, this ad-hoc arrangement must seem bewildering to investors who are used to structured exchanges such as the NYSE or CME.
However, this arrangement works exceedingly well in practice; because participants in FX must both compete and cooperate with each other, self regulation provides very effective control over the market. Furthermore, reputable retail FX dealers in the United States become members of the National Futures Association NFA , and by doing so they agree to binding arbitration in the event of any dispute.
Therefore, it is critical that any retail customer who contemplates trading currencies do so only through an NFA member firm. The FX market is different from other markets in some other key ways that are sure to raise eyebrows. Feel free to short the pair at will. There is no uptick rule in FX as there is in stocks.
If your biggest Japanese client, who also happens to golf with the governor of the Bank of Japan tells you on the golf course that BOJ is planning to raise rates at its next meeting, you could go right ahead and buy as much yen as you like. No one will ever prosecute you for insider trading should your bet pay off. There is no such thing as insider trading in FX; in fact, European economic data, such as German employment figures, are often leaked days before they are officially released.
Before we leave you with the impression that FX is the Wild West of finance, we should note that this is the most liquid and fluid market in the world. It trades 24 hours a day, from 5 p. EST Sunday to 4 p. EST Friday, and it rarely has any gaps in price.
Its sheer size and scope from Asia to Europe to North America makes the currency market the most accessible market in the world. This makes it the perfect market for traders that use technical tools. If you want to learn more about technical analysis from one of the world's most widely followed technical analysts, check out Investopedia Academy's technical analysis course.
Investors who trade stocks, futures or options typically use a broker , who acts as an agent in the transaction. The broker takes the order to an exchange and attempts to execute it as per the customer's instructions.
For providing this service, the broker is paid a commission when the customer buys and sells the tradable instrument. The FX market does not have commissions. Unlike exchange-based markets, FX is a principals -only market. FX firms are dealers, not brokers. This is a critical distinction that all investors must understand. Unlike brokers, dealers assume market risk by serving as a counterparty to the investor's trade. They do not charge commission; instead, they make their money through the bid-ask spread.
In FX, the investor cannot attempt to buy on the bid or sell at the offer like in exchange-based markets. On the other hand, once the price clears the cost of the spread, there are no additional fees or commissions. Every single penny gained is pure profit to the investor. To learn more, see Scalping: Pip stands for "percentage in point" and is the smallest increment of trade in FX. In the FX market, prices are quoted to the fourth decimal point.
Among the major currencies , the only exception to that rule is the Japanese yen. The short answer is "nothing". The retail FX market is purely a speculative market. No physical exchange of currencies ever takes place. All trades exist simply as computer entries and are netted out depending on market price. For dollar-denominated accounts, all profits or losses are calculated in dollars and recorded as such on the trader 's account. The primary reason the FX market exists is to facilitate the exchange of one currency into another for multinational corporations that need to trade currencies continually for example, for payroll , payment for costs of goods and services from foreign vendors , and merger and acquisition activity.
Because currencies always trade in pairs , when a trader makes a trade he or she is always long one currency and short the other.
To better understand this dynamic, let's use a concrete example. You would be exchanging your dollars for a computer.
The exact same principle applies to the FX market, except that no physical exchange takes place. While all transactions are simply computer entries, the consequences are no less real. Although some retail dealers trade exotic currencies such as the Thai baht or the Czech koruna, the majority trade the seven most liquid currency pairs in the world, which are the four "majors":.
To read more, check out Popular Forex Currencies. Carry is the most popular trade in the currency market, practiced by both the largest hedge funds and the smallest retail speculators. The carry trade rests on the fact that every currency in the world has an interest rate attached to it. These short-term interest rates are set by the central banks of these countries: The idea behind the carry is quite straightforward.
The trader goes long the currency with a high interest rate and finances that purchase with a currency with a low interest rate. The New Zealand economy, spurred by huge commodity demand from China and a hot housing market, saw its rates rise to 7. Now you can understand why the carry trade is so popular!
But before you rush out and buy the next high-yield pair, be aware that when the carry trade is unwound, the declines can be rapid and severe. This process is known as carry trade liquidation and occurs when the majority of speculators decide that the carry trade may not have future potential.
With every trader seeking to exit his or her position at once, bids disappear and the profits from interest rate differentials are not nearly enough to offset the capital losses. Anticipation is the key to success: To learn more about this type of trade, see Currency Carry Trades Every discipline has its own jargon, and the currency market is no different. Here are some terms to know that will make you sound like a seasoned currency trader:.
Dictionary Term Of The Day. Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. A celebration of the most influential advisors and their contributions to critical conversations on finance. Become a day trader. How does the forex market differ from other markets?
Where is the commission in forex trading? What is a pip? What are you really selling or buying in the currency market? Which currencies are traded in the forex market? Although some retail dealers trade exotic currencies such as the Thai baht or the Czech koruna, the majority trade the seven most liquid currency pairs in the world, which are the four "majors": What is a currency carry trade?
The Bottom Line Every discipline has its own jargon, and the currency market is no different. Here are some terms to know that will make you sound like a seasoned currency trader: How much a fixed asset is worth at the end of its lease, or at the end of its useful life.
If you lease a car for three years, A target hash is a number that a hashed block header must be less than or equal to in order for a new block to be awarded. Payout ratio is the proportion of earnings paid out as dividends to shareholders, typically expressed as a percentage.
The value of a bond at maturity, or of an asset at a specified, future valuation date, taking into account factors such as No thanks, I prefer not making money. Get Free Newsletters Newsletters.More...