What Is the Forex Market?
The forex market allows participants, such as banks and individuals, to buy, sell or exchange currencies for both hedging and speculative purposes. The foreign exchange (forex) marketis the largest financial market in the world and is made up of banks, commercial companies, central banks, investment management firms, hedge funds, retail forex brokers, and investors.
Key Takeaways
- The forex market allows participants, including banks, funds, and individuals to buy, sell or exchange currencies for both hedging and speculative purposes.
- The forex market operates 24 hours, five days a week, and is responsible for trillions of dollars in daily trading activity.
- Forex trading can provide high returns but also brings high risk.
- The forex market is an over-the-counter market (OTC).
- Many forex accounts can be opened with as little as $100.
Understanding the Forex Market
The forex marketis not dominated by a single market exchange but by a global network of computers and brokers from around the world. Forex brokers act as market makersas well and may post bids and ask prices for a currency pair that differs from the most competitive bid in the market.
The forex market is an over-the-counter (OTC) market. This mean trading happens without a single centralized exchange. Currencies move between those who are trading, although with the support of brokers who provide the means to do so. There exists a substantial amount of interbank forex trading. Large banks trade currencies for purposes such as hedging, balance sheet adjustments, and on behalf of clients.
$7.5 trillion
The value of daily forex transactions registered in April 2022, according to the 2022 Triennial Central Bank Survey of FX and OTC derivatives markets.
From Monday morning in Asia to Friday afternoon in New York, the forex market is a 24-hour market, meaning it does not close overnight. The forex market opens from Sunday at 5 p.m. ET to Friday at 5 p.m. ET.
This differs from markets such as equities, bonds, and commodities, which all close for a period of time, generally in the late afternoon EST. However, as with most things, there are exceptions. Some emerging market currencies close for a period of time during the trading day.
History of the Forex Market
Up until World War I, currencies were pegged to precious metals, such as gold and silver. Then, after the Second World War, the system collapsed and was replaced by the Bretton Woods agreement. That agreement resulted in the creation of two international organizations to facilitate economic activity across the globe. They were the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), commonly known as the World Bank. The Bretton Woods meeting also produced the General Agreement on Tariffs and Trade (GATT).
The new system also replaced gold with the U.S. dollar as a peg for international currencies. The U.S. government promised to back up dollar supplies with equivalent gold reserves. But the Bretton Woods currency system was suspended in 1971 when U.S. President Richard Nixon announced a “temporary” suspension of the dollar’s convertibility into gold.
Currencies are now free to choose their own peg and their value is determined by supply and demand in international markets.
Type of Forex Markets
Three are three key types of forex markets: spot, forward, and futures.
Spot Forex Market
The spot market is the immediate exchange of currency between buyers and sellers at the current exchange rate. The spot market makes up much of the currency trading.
The key participants in the spot market include commercial, investment, and central banks, as well as dealers, brokers, and speculators. Large commercial and investment banks make up a major portion of spot trades, trading not only for themselves but also for their customers.
Forward Forex Market
In the forward markets, two parties agree to trade a currency for a set price and quantity at some future date. No currency is exchanged when the trade is initiated. The two parties can be companies, individuals, governments, or the like. Forward markets are useful for hedging.
On the downside, forward markets lack centralized trading and are relatively illiquid (since there are just the two parties). As well, there is counterparty risk, which is that the other part will default.
Futures Forex Market
Future markets are similar to forward markets in terms of basic function. However, the big difference is that future markets use centralized exchanges. Thanks to centralized exchanges, there are no counterparty risks for either party. This helps ensure future markets are highly liquid, especially compared to forward markets.
Big Players in the Forex Market
The U.S. dollar is by far the most-traded currency. The most traded currency pairs all contain the dollar. USD/EUR, USD/JPY, USD/GBP, USD/CNY, and USD/CAD are the top five most traded pairs.In 2022, Deutsche Bank was the largest trader in the forex market with 10.89% market share. UBS was second, with a 9.69% market share. JP Morgan, State Street, and XTX Markets make up the remaining places in the top five.
Advantages and Disadvantages of Forex Trading
Forex markets have key advantages, but this type of trading doesn’t come without disadvantages.
Pros
Lots of flexibility, trading 24 hours a day, five days a week
Plenty of trading options
Low transaction costs
Cons
Less regulation and the decentralized nature of forex markets increases counterparty risk
High leverage amounts allowed
Operational risk
Advantages
One of the biggest advantages of forex trading is the lack of restrictions and inherent flexibility. There’s a very large amount of trading volume and markets are open 24 hours a day, five days a week. With that, people who work nine-to-five jobs can also partake in trading at night or in the morning.
There’s a large amount of optionality when it comes to available trading options. There are hundreds of currency pairs, and there are various types of agreements, such as a future or spot agreement. The costs for transactions are generally very low versus other markets and the allowed leverage is among the highest of all financial markets, which can magnify gains (as well as losses).
Disadvantages
With forex markets, there are leverage risks—the same leverage that offers advantages. Forex trading allows for large amounts of leverage. The leverage allowed is 20 to 30 times and can offer outsized returns, but can also mean large losses quickly.
Although the fact that it operates nearly 24 hours a day can be a positive for some, it also means that some traders will have to use algorithms or trading programs to protect their investments while they are away. This adds to operational risks and can increase costs. To minimize these risks and costs, many recommend not holding positions "overnight".
The other major disadvantage is counterparty risk, where regulating Forex markets can be difficult, given it’s an international market that trades almost constantly. Trading nearly constantly means that global events can impact the trades almost immediately. Further, there is no central exchange that guarantees a trade, which means there could be default risk. However, trading through a clearing house mitigates much of this risk.
Forex Market FAQs
What Exactly Is Forex Trading?
Forex trading is the exchange of one currency for another. Forex trading is the trading of currency pairs—buying one currency while at the same time selling another.
Can You Get Rich by Trading Forex?
Forex trading can make you rich, but it'll likely require deep pockets to do so. That is, hedge funds often have the skills and available funds to make forex trading highly profitable. However, for individual and retail investors, forex trading can be profitable but it's also very risky.
How Do I Start Trading Forex?
To get started in forex trading, the first step is to learn about forex trading. This includes developing knowledge of the currency markets and specifics of forex trading. It also takes a brokerage account set up for forex trading. One of the more important things from there is setting up a trading strategy, which includes the amount of money you’re willing to risk.
How Much Do You Need to Start Trading Forex?
In most cases, you can open and trade via forex account for as little as $100. Of course, the higher the amount you can invest the greater the potential upside. Many recommend investing at least $1,000 and even $5,000 to properly implement a strategy.
The Bottom Line
Forex trading offers several advantages over other markets, such as flexibility with types of contracts and 24 hours a day trading for five days a week. It also allows investors to leverage their trades by 20 to 30 times, which can magnify gains. On the downside, this leverage can also lead to major losses fast.
