What Is FOREX?
The commonly used term FOREX is simply an abbreviation for “foreign exchange.” You might also hear this referred to as FX or, as U.S. regulatory bodies refer to it, “retail off-exchange currency market.” The FOREX market is a worldwide, decentralized, over-the-counter financial market in which counterparties can facilitate the trading of currencies. The true FX market is composed of several electronic communication networks (ECNs) between banks, institutions, and speculators. As you will later learn, not all FOREX brokers provide their clients with access to an actual ECN marketplace; instead, their clients trade in a synthetic environment that merely appears to be a free market.
Unlike equities, or even most futures and options, FX trading does not occur on an exchange floor, nor are trades executed through a common exchange (such as the Chicago Mercantile Exchange or the New York Stock Exchange). Instead, buyers and sellers are facilitating electronic contractual agreements in regard to the exchange of underlying currencies with assorted counterparties and under various arrangements. Accordingly, currency contracts traded in FX are said to be “off-exchange” products.
According to Wikipedia, a counterparty is a financial term identifying a party to a contract or agreement. In FOREX, counterparty holds the same definition and is used to refer to any party that executes a buy or sell in the foreign exchange market. This might be a bank, a central bank, a corporation, a speculator, or even the brokerage firm executing the transaction.
Although a counterparty can be on either side of the trade, it is most commonly used as a description of the party taking the other side of a retail trader’s order. If a trader buys 100,000 worth of the USD/JPY, somebody else has to sell it to her and that somebody is known as the counterparty.
Trades executed in the FX market are known as “spot” transactions. The term spot typically refers to an immediate exchange of assets, but in the case of FOREX it is actually a two-day delivery. Therefore, the concept of trading in FOREX is similar to that of futures trading, in which delivery of the underlying asset takes place at a specified time in the future. Nonetheless, the time frames are much different. Whereas FX contracts are deliverable within a few days, futures are often deliverable months in advance.
Also similar to trading futures contracts, a currency trader in FOREX is buying and selling agreements to make or take delivery of the underlying asset at a specific time and date. Nonetheless, speculators are rarely interested in being part of the delivery process and therefore repetitively roll their obligation out into the future until they are ready to exit the position by offsetting their liability with their counterparty. We will later discover that FX brokers automatically roll client positions to avoid the hassles of delivery. Perhaps this is why you don’t hear tall tales about FX traders being forced to accept 100,000 Euro like you do about the infamous corn trader who had to store 5,000 bushels on the front lawn.
Beginning traders are often overwhelmed by the concept of selling something before buying it. Because FX traders are exchanging agreements with each other, rather than the actual underlying assets, there is no need to “own” anything before selling. FOREX traders can buy and sell in any order, depending on the direction they believe prices will move. We will discuss the mechanics later, but traders who expect the value of the Euro to depreciate relative to the U.S. Dollar might “go short” (sell) the Euro against the Dollar. A different trader might “go long” (buy) the Euro against the Dollar if she expects the Euro to appreciate; these trades can be made in any order and without regard to any ownership. Whether a trader buys or sells an instrument to enter a speculative position, the exit of the trade can only be accomplished by performing the opposite action in the same quantity of currency.
FX Swung the Door Open to Currency Volatility
Global ECN markets, collectively referred to as FX, were created to simplify the transfer of assets between businesses, banks, and countries worldwide. Nonetheless, improvements in technology throughout the years and lower barriers to entry have opened the door to a hotbed of speculation. In the beginning, trading was only available to relatively high-net-worth individuals with a certain degree of clout. Today, it is possible to open a micro FX brokerage account in a matter of hours by completing an electronic application; minimum funding requirements for micro FX accounts are as low as a Dollar. Yes, that’s right...I said a Dollar. But don’t expect to get much done with this—you are likely better off buying a lottery ticket with the money.
I’m not here to judge whether or not the additional liquidity brought by speculators has been a positive for the market place, but in the end, the FOREX market and all of its participants determine the relative value of various currencies in relation to others. With so many opinions being expressed through buying and selling of currency pairs, there are bound to be some intense price moves.