Part I: What is the Forex Market and How is it Different?
What is Forex?
exchange market, often referred to as forex, is the market
for the various currencies of the world. It is a market
which, at its core, is rooted in global trade. Goods
and services are exchanged 24 hours a day all over the
world. Those transactions done across national borders require
payments in non-domestic currencies.
For example, a
US company purchases widgets from a Mexican company. To do
the transaction, one of two things is going to happen.
The US firm may, depending on the contract terms, make
payment in Mexican Pesos. That would require a
conversion of Dollars in to Pesos to make payment.
Alternately, the payment could be made in Dollars, in which
case the Mexican company would then exchange the Dollars for
Pesos on their end. Either way, there is going to be
some transaction which takes Dollars and swaps them for
That is where
the forex market comes in. Transactions like that take place
all the time. The market maintains a rate of exchange
between the US Dollar and the Mexican Peso (and between and
amongst all other world currencies) to facilitate that
activity. Consider the amount of global trade which
takes place and you can see why the forex market is the
biggest in the world, dwarfing all others. Literally
trillions of dollars worth of forex transactions take place
each and every day.
How is the Forex Market Different?
There are some
significant differences between the forex market and others
like the stock market. While it may be the feeling
that a good trader should be able to handle any market, the
fact of the matter is that some structural differences in
forex can require a different trading approach.
For most stock
traders, the first difference they will notice between the
forex market and equities is timeframe. Although the hours
of stock trading have been expanding in recent years, the
forex market is still the only one which can truly be viewed
as 24-hour. There is ready forex trading activity in
all time zones during the week, and sometimes even on the
weekends as well. Other markets may in fact transact
24-hours, but the volume outside their primary trading day
is thin and inconsistent.
The lack of an
exchange is probably the next big thing that sticks out as
being different in forex.
While it is true that there is exchange-based forex trading
in the form of futures, the primary trading takes place
over-the-counter via the spot market. There is no NYSE
On the largest
scale, forex transactions are done in what is referred to as
the inter-bank market. That literally means banks trading
with each other on behalf of their customers. Larger
speculators also operate in the inter-bank market where they
can execute multi-million dollar trades with ease.
Individual traders, who generally trade in much smaller
sizes, primarily do so through brokers and dealers.
something which can trouble stock traders. There is no
central location for price data, and no real volume
information is attainable. Since volume is an often
reported figure in the stock market, the lack of it in spot
forex trading is something which takes a bit of getting used
to for those making the switch.
Also, the lack
of an exchange means a difference in how trading is actually
done. In the stock market an order is submitted to a broker
who facilitates the trade with another broker/dealer
(over-the-counter) or through an exchange. In spot forex
much of the trading done by individuals is actually executed
directly with their broker/dealer. That means the
broker takes the other side of the trade. This is not always
the case, but is the most common approach.
The lack of an
exchange and the direct trade with the broker creates
another difference between stock and forex trading. In
the stock market brokers will generally charge a commission
for each buy and sell transaction you do. In forex,
though, most brokers do not charge any commissions.
Since they are taking the other side of all the customer
trades, they profit by making the spread between the bid and
Some traders do
not like the structure of the spot forex market. They are
not comfortable with their broker being on the other side of
their trades as they feel it presents a type of conflict of
interest. They also question the safety of their funds and
the lack of overall regulation. There are some
worthwhile concerns, certainly, but the fact of the matter
is that the majority of forex brokers are very reliable and
ethical. Those that are not don’t stay in business
The forex market is a 100% margin-based market. This
is a familiar thing for those used to trading futures.
In fact, spot
forex trading is essentially trading a 2-day forward
(futures) contract. You do not take actual possession of any
currency, but rather have a theoretical agreement to do so
in the future. That puts you in a position of
benefiting from prices changes. For that your broker requires a deposit on your trades to provide
surety against any losses you may incur. How much of a
deposit can vary. Some brokers will asked for as
little as 1/2%. That is fairly aggressive, though.
Expect 1%-2% on the value of the position in most
Now, unlike the
stock market, margin trading does not mean margin loans.
Your broker will not be lending you money to buy securities
(at least not the way a stock broker does). As such,
there is no margin interest charged. In fact, since
you are the one putting money on deposit with your broker,
you may earn interest in your margin funds.
Rate Carry (Rollover)
When trading forex, one is essentially borrowing one
currency, converting it in to another, and depositing it.
This is all done on an overnight basis, so the trader is
paying the overnight interest rate on the borrowed currency
and at the same time earning the overnight rate on the
currency being held. This means the trader is either paying
out or receiving interest on their position, depending on
whether the interest rate differential is for or against them.
commonly handled is what is referred to as a rollover.
Spot forex trades are done on a trading day basis, and as
such are technically closed out at the end of each day.
If you are holding your position longer than that, your
broker rolls you forward in to a new position for the next
trading day. This is generally done transparently, but it
does mean that at the end of each day you will either pay or
receive the interest differential on your position.
The type of
trader you are and the way your broker handles rollover
will be the deciding factors in determining whether the
interest rate differentials are an important concern for
you. Some brokers will not apply the day’s interest
differential value on positions closed out during the
trading day. By that I mean if you were to enter a position
at 10am and exit at 2pm, no interest would come in to play.
If you were to open a position on Monday and close it on
Tuesday, though, you would have the interest for Monday
applied (the full day regardless of when you entered the
position), but nothing for Tuesday. (Note: There is at least
one broker who calculates interest on a continuous basis, so
you will always make or pay the interest differential on all
positions, no matter when you put them on or took them off).
It should also
be noted that although some folks will claim there is no
rollover in forex futures, the interest rate spread is
definitely factored in. You can see this when
comparing the futures prices with the spot market rates.
As the futures contracts approach their delivery date their
prices will converge with the spot rate so that the holders
will pay or receive the differential just as if they had
been in a spot position.
Fixed income traders know that central bankers, like the
Federal Reserve, are active in the markets, buying and
selling securities to influence prices, and thereby interest
rates. This is not something which happens in stocks,
but it does in the forex markets. This is known as
intervention. It happens when a central bank or other
national monetary authority buys or sells currency in the
market with the objective of influencing exchange rates.
is most often seen at times when exchange rates
get a bit out of hand, either falling or rising too rapidly.
At those times, central banks may step in to try to nullify
the trend. Sometimes it works. Sometimes not.
The US has
traditionally taken a hands-off approach when it comes to
the value of the Dollar, preferring to allow the markets to
do their thing. Others are not quite so willing to let
speculators determine their currency’s value. The Bank
of Japan has the most active track record in that regard.