What is forex and how does it work?

The forex market is the largest in the world

The financial market is gigantic, we have all heard at least about the stock market and company shares. Not everything ends here. There is a plurality of markets within the entire financial system that ranges from raw materials, to shares, to derivative products and to the forex market. Among many others. What is special about Forex? Forex is the currency market, the currency exchange. In addition, what makes it unique is that it is the largest market that exists, and therefore, the most liquid of all.

The foreign exchange market (or exchange), better known as Forex, was born with the aim of facilitating monetary exchange in an increasingly globalized world. It is decentralized, and mostly serves to exchange currencies. However, not everything ends here. The possibilities that have emerged from it are enormous. You can speculate in this market, in addition to seeking refuge in other currencies, or for example as a currency exchange hedge if we have shares from another country. To understand it better, this article is fully about Forex.

What is Forex?

The forex market is the most liquid of all

Forex is the global currency exchange market. In turn, it is with a loose margin, the world's largest financial market. Its growth in recent years has been so great that the total volume that moves due to international operations of goods and services is very residual. Being the vast majority of its operations due to financial products. In fact, its liquidity is so great that only in 2019 around 6 billion euros were moved per day. In other words, 76 million euros per second.

The characteristics that make this market unique are multiple. The most notable being the following:

  • Large volume of transactions.
  • Extremely liquid.
  • The large number and variety of market participants.
  • Great geographical dispersion.
  • Market open 24 hours a day, except on weekends.
  • The large number of factors that intervene and move the market.

The most relevant news for this market is usually published at specific times that are previously scheduled. So that all participants have access to see the news at the same time. With the only exception that the big brokers can see the orders sent by their clients. This has generated even more strategies to try to win in the market, such as those followed by "strong hands". There are many strategies, and this one specifically aims to anticipate the movements that the currency prices will make based on the volume that has been negotiated.

How does Forex work?

The forex market was born with the aim of facilitating transactions in a globalized world

In the Forex market, currencies are traded with crosses. Each one is noted as XXX/YYY and refers to the ISO 4217 code in which the acronyms of each currency involved are expressed. YYY refers to the quote currency, and XXX the base currency. In other words, XXX represents the amount of YYY needed to be purchased. For example, at the time of this writing, the EUR/USD, also known as the Eurodollar, is trading at 1,0732. This means that 1'0732 US Dollars is equal to 1 Euro.

If the quote value rises, it means that more dollars are needed to buy 1 Euro. And vice versa, if it goes down it means that fewer dollars are needed to buy one euro.

Coins that exist in the market

Among the top 20 currencies that are traded we find the following:

  • USD, US Dollar.
  • EUR, Euro.
  • JPY, Japanese Yen.
  • GBP, British Pound.
  • AUD, Australian dollar.
  • CAD, Canadian Dollar.
  • CHF, Swiss Franc
  • CNY, Chinese Yuan.
  • HKD, Hong Kong dollar.
  • NZD, New Zealand Dollar.
  • SEK, Swedish Krona.
  • KRW, South Korean Won.
  • SGD, Singapore dollar.
  • NOK, Norwegian Krone.
  • MXN, Mexican Peso.
  • INR, Indian Rupee.
  • RUB, Russian ruble.
  • ZAR, South African Rand.
  • TRY, Turkish Lira.
  • BRL, Brazilian Real.

Being an exchange market, and its price being a cross between a pair of different currencies, that is, always one currency accompanied by another, the plurality of combinations that are derived is even greater.

How can you trade in the forex market?

There is a range of different products among which participants can carry out their operations. The objective pursued may be different, but not the type of product. In the same way, similar objectives can be pursued, but with a different product. It all depends on the implications and the type of nature that the participant considers. Among the most common products or instruments are the following.

There are different instruments to invest in the forex market

  • Foreign exchange spot transactions. The time that elapses in these operations until the settlement of the currencies is two days. If the settlement is made in 1 day, it is called T/N (tom/next).
  • Foreign exchange forward transactions. This type of instrument is the most used, and represents 70% of all transactions made. Here the foreign exchange trading is fixed in the contract, but its settlement is carried out later on the date previously indicated in the contract.

Where it is gaining popularity due to the ease that some brokers offer to invest in Forex is thanks to derivative products. The 4 most relevant would be the following.

  • Currency financial options. Where the buyer has the right, but not the obligation, to buy or sell a currency at a future price already determined on a predetermined date.
  • Currency futures. It is an agreement to exchange currencies on a scheduled date under a predetermined rate.
  • forward futures. A single exchange of one currency for another at the rate of a given future day.
  • Currency swap. It is a contract between two parties to buy and sell a number of currencies, and to repurchase and resell a number of currencies at a certain rate on a predetermined date.

To consider

The interest rate between countries can vary, and this translates into the difference in interest that is paid or charged in currency exchanges, especially in brokers. Understanding that each night a small difference can be charged or paid can create a small headache. For this, and being a complex subject, I recommend this article that I leave below in which I talk about the differences in the interest of currencies and how to take advantage of it.

Related article:
What is the swap in forex?

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