What is the Forex Market?

The Forex market is a cash inter-bank or inter-dealer market established in 1971 when floating exchange rates began to materialize. Today, the exchange of currency has expanded from trading floors to home computers. The simplest definition of foreign exchange is the changing of one currency to another, and, unlike the stock market, one may earn profits whether buying or selling within the currency exchange. In comparison to the daily trading volume averages of $300 billion in the U.S. Treasury Bond market and the less than $10 billion exchanged in the U.S. stock markets, the Forex market is huge. Currently there is often an average of 3.5 trillion levels exchanged daily.
The most important foreign exchange activity is the spot business between the dollar and the four major currencies (Euro, British Pound, Swiss Franc and Japanese Yen). Activity within the market is created by six main groups: central banks, commercial banks, other financial institutions, corporate customers, brokers and independent currency traders who have established home-based businesses.
Forex is not a "market" in the traditional sense. There is no centralized location for trading activity as there is in currency futures. Trading occurs over the telephone and through computer terminals at thousands of established locations, as well as within home-based trading businesses worldwide.
Cash Forex versus Currency Futures
As a potential new trader, it is important for you to understand the differences between cash Forex and currency futures. In currency futures, the contract size is predetermined. Futures traders exercise leverage by utilizing a performance bond or margin to control a futures contract. “Margin” is money deposited by both the buyer and the seller to assure the integrity of the contract.
With liquidity in mind, the futures market may seem limiting because the data flow comes to a stop at the end of the business day (just as it does with the stock market), thus disrupting your perception of the market. For some traders this could lead to a certain level of anxiety. For example, if important data comes in from England or Japan while the U.S. futures market is closed, the next day’s opening could be a wild ride.
In contrast to the futures market, the spot Forex market is a 24-hour, continuous currency exchange that never closes. There are dealers in every major time zone, in every major dealing center (i.e., London, New York, Tokyo, Hong Kong, Sydney, etc.) willing to quote two-way markets. The size of this market, a $1.5 to $3.5 trillion dollar per day market gives you near perfect liquidity. Because of the advantages of sheer volume and daily volatility, the excitement of this market is unparalleled.
What moves the Market?
The primary factors influencing exchange rates include the balance of payments, the state of the economy, implications drawn from chart analysis and political and psychological factors.
Ebb and flow of capital between nations, otherwise known as Purchasing Power Parity (PPP), is the central factor that determines market momentum. In addition, fundamental economic forces such as inflation and interest rates are constantly influencing currency prices. Faith in a government’s ability to stand behind its currency will also impact currency price. This is done in two ways: controls and intervention. Controls restrict citizens from doing things, which have a negative effect on the exchange rate (such as sending money abroad). Intervention takes two forms: changing the interest rate on the currency to make it more or less attractive to foreigners, or buying/selling the currency to raise or lower its market value.
Any of these broad-based economic conditions can cause sudden and dramatic currency price swings if such conditions are seen to be changing. This is a key concept, because what drives the currency market in many cases is the anticipation of an economic condition rather than the condition itself.
Activities by professional currency managers, generally on behalf of a pool of funds, have also become a factor moving the market. While professional managers may behave independently and view the market from a unique perspective, most, if not all, are at least aware of important technical chart points in each major currency. As major support or resistance levels approach, the behavior of the market becomes more technically oriented and the reactions of many managers are often predictable and similar. These market periods may result in sudden and dramatic price swings as substantial amounts of capital are invested in similar positions.
Why is the Forex market attractive to investors and home-based traders?
Professional investors for individual accounts have dramatically increased their level of participation in the cash Forex markets in recent years. Add to this the growing use of cash Forex by individual investors and home-based traders, and you have a rapidly growing industry of cash flow creating profits whether the market goes up or down.
The Forex is very liquid, and this market can absorb trading volumes and per trade sizes that diminish the capacity of any other market. On the simplest level, liquidity is a powerful attraction to any investor or independent trader as it suggests the freedom to open or close a position at will.
A substantial attraction for participants in the Forex market is the 24-hour nature of the market. In Forex, a participant need not wait to react to an unfavorable event, as is the case in many markets.
Many professional investment managers have a particular time horizon in mind when they establish a position. In the Forex market, a position can be established for a specific period of time, which the trader desires.
Because the market is highly liquid, most trades can be executed at a single market price. This avoids the problem of slippage found in futures and other exchange-traded instruments where limited quantities can be traded at one time at a given price.
Over long historical periods, currencies have shown substantial and identifiable trends. Each individual currency offers a unique historical pattern of trends providing investment managers and home-based independent Forex traders diversification opportunities within this massive cash exchange, the Forex.
From 1971 until recent years, the virtual owners of this market were the banks, multinational corporations and large brokerage firms. If an individual wanted to invest in this market, he could invest with a bank and with a $1 million cash deposit backed by the requirement of a $5-$10 million net worth. A slightly better option was provided by the brokerage firms which asked a lower minimum deposit on average of a quarter million dollars.
But now, the Forex market has been opened up to small-scale, home-based traders. Unlike the huge sums previously required by the banks and brokerage firms, comparatively far lower margin requirements are finally available which now allow virtually any individual to trade with the big boys. In addition, independent traders can take advantage of the growing boom in computer and communication technologies that have made this market accessible in ways previously exclusive only to large players.