What is Forex?

Forex is short for foreign exchange. Trading forex is the practice of trading various currencies against one another in an effort to realize some profit, based on some predicted price movement.

Forex traders take advantage of the fact that the exchange rate between currencies fluctuates over time. A given amount of one currency can purchase different amounts of another at different times. Let's take a look at a rather simple example of how Forex might work.

A Simple Example

Two commonly traded currencies are the US dollar and the Euro. Let us say that you have 1000 USD and you want to convert it to Euros.

It just so happens that at the time you execute the trade, 1000 USD is worth 700 Euros. You make the trade and now have 700 Euros.

You wait one year, and the US economy performs better than the European economy, so the exchange rate changes. Now that 700 Euros you have is worth 1100 USD. By converting your Euros back to US dollars, you realize a profit of 100 USD (1100 - 1000).

While this example is incredibly simple, this is the basic principle behind the Forex market, converting money from one currency to another with the expectation of a particular price movement. Let us look at some more principles of Forex in further detail.

How Forex Works

Unlike the stock market, there is no central exchange for Forex. All trades occur between individuals or banks, usually mediated by a broker or market maker over the telephone or through a digital line. Because of the vast size of the market, through a large broker on a major currency pair, trades can be executed in a manner of seconds.

Many Forex traders use one of the many available online brokers to execute their trades. Generally, when an order is sent to a broker, the broker passes the order along to the Interbank Market, where the money is actually converted from one currency to another.

It is important to note, that converting 1000 USD to Euros isn't as simple a process as you might imagine. You need to find someone willing to pay 700 Euros for that 1000 USD. For this reason, Forex is referred to as an over-the-counter market. Luckily for traders who want fast trade execution, when trading through a large broker on a major currency pair, there is rarely a shortage of buyers/sellers, and trades can be executed in a matter of seconds.

Another thing to consider is that trading Forex is a zero-sum game. Zero-sum games are an economic principle referring to the fact that for every interaction or trade, someone wins and someone loses. There is no net increase in wealth through trading Forex, so in order to realize profit, you must beat the market. To be a good investor, it helps to be a good strategist. Some of the best investors in the world also excel at games such as chess or poker.

Ultimately, understanding how to be a successful Forex trader does not require a thorough understanding of the underlying processes. Rather, it involves a complex interaction between the fundamentals, the technical signals, and your own personal preference for risk assessment. Trading Forex is a lot like trading other securites in many ways, but there are also several fundamental differences.

Unique Benefits

There are several reasons why many investors find the Forex market appealing. Below is just a short list of some of the unique advantages offered by Foreign Exchange trading.

Market Uptime: Unlike the stock market, which has set daily hours, the Forex market is a true 24 hour market. Trading starts when the markets open in Australia on Sunday evening, and ends after markets close in New York on Friday. This means that with the exception of a weekend period, trades can be executed at any time, day or night. This allows traders to immediately respond to indicators of price movements.

Low/Zero Commission: Through most Forex brokers, the commission is built into the bid/ask price spread (see Forex Quotes). This means that executing a trade does not incur some preset commission, allowing many transactions to occur in a way more responsive to the market, without losing money on the commission.

Profit Possibility Independent of Market Conditions: The Forex market is the easiest market to enter either short or long positions. Thi means that you have the potential to realize profit in a market where your native currency is doing well or poorly. See Forex Orders for more information about long/short positions.

Leverage: Leverage is the ability to hold positions with greater value than that in the trader's account. Because of the size of the Forex market, this is easy for brokers to allow traders to do. Leverage is usually given as a ratio, like 20:1. A leverage ratio of 20:1 would mean for every $1,000 in your account, you could hold an equivalent positions of $20,000. This increases your chances of making profits, but it also increases your risk. Most brokers close you account before you would incur a negative balance due to leverage, so a small price drop could have serious ramifications. It is important to use leverage responsibly and not to overdo it.

Liquidity: Liquification is the process of converting your assets to cash which can be used to purchase goods. Because Forex literally involves trading money, it is very easy to quickly exit a position and realize whatever cash you can. This means you can easily claim your profits or cut your losses.

Learning More...

At this point, you are beginning to understand how the Forex market works. Let us investigate further into the specifics of Forex, and take a look at Forex Quotes, the way Forex prices are expressed.