What Is Forex Trading?

A look at the world of Foreign Exchange and the tools of Forex Trading

Foreign exchange, also known as Forex Trading, is a critical part of every international business relationship, allowing businesses in every corner of the globe to send and receive payments for goods and services. In order to best take advantage of forex trading, it is important to understand how it works: from the basics of understanding currency markets, to the Forex trading tools available, and how to use the markets and tools in order to execute effective transactions.

Forex Trading: How It Works

Arguably the largest and most important market in the world is the global currency market. If, hypothetically, all trading in equities, fixed income, derivatives, and commodities were to suddenly cease, currency trading would still continue, as people, businesses, and governments would still have to pay for various goods and services between each other. To do so, they would still require forex trading in order to transform and move currencies from one country to another. Forex trading is the “other side of the coin” of all global trade; no goods or services move from one country to another with a corresponding foreign currency transaction.

In 1971, the majority of countries ceased linking their currencies to the value of gold. Once the international standard for nearly all currencies was removed, the values of currencies became based on the relevant value of other countries’ currencies. This enabled countries’ central banks, and each country’s government, to tailor their monetary and fiscal policy with an eye towards stabilization, or valuation or devaluation, of their currency. As a result of the move away from gold as a pricing standard, the forex trading market (and surrounding industry) blossomed. With the exponential growth in forex trading volume came a corresponding increase in liquidity and volatility, as well as a dramatic increase in trading and pricing speed. Making the forex trading market even more complex is the fact that, unlike other securities markets, it is a truly twenty-four hour market. Forex trading takes place in every country, giving rise to arbitration opportunities every moment of every weekday. Because of this, timely and accurate pricing quotes are paramount in executing profitable forex trades. When there are discrepancies in pricing, the opportunity for triangular arbitrage arises, and for traders who can execute forex trades in milliseconds, there are profits to be made.

Forex Trading Tools

There are some basic forex trading tools everyone should be familiar with when executing currency trades: spot contracts, forward contracts, and futures contracts.

Forex trading revolves around one central piece of data: the exchange rate of each currency, the spot rate. Every second of every day, Monday through Friday, there is a live quote for every actively traded currency in the world. Knowing this spot rate gives a business the ability to calculate, at every moment, the value of the currencies that business holds, as well as the value of accounts receivable in foreign currencies, and the obligations due in foreign currencies. To trade using the spot rate, a spot contract is used. The spot contract allows a business to buy or sell a currency at the very moment it places a currency transfer, similar to how someone generally buy gasoline to fill up their car: whatever the price is at the moment they purchase the gallon of gasoline is the price they accept and pay.

A forward contract allows a business to purchase or sell a specific amount of currency in the future, at a price they agree to at now. This would be like agreeing to pay (or receive) a specific price for a gallon of gasoline at a future date. Using forward contracts to lock in forward rates is also a useful forex trading tool, allowing a business to accurately predict its cash inflows and outflows, by locking in exchange rates for a future point in time. By knowing precisely how much foreign currency they will receive (or have to pay out) in the future, at what exchange rate, the business can focus on its business, instead of fretting over their cash management. Forward contracts are best locked in with foreign exchange providers, who can ensure swift and seamless transfers on the settlement date.Future contracts are similar to forward contracts in forex trading, but they are pre-existing currency exchange contracts, which can be bought and sold on derivatives exchanges. While forward contracts are generally used to hedge a company’s currency position, future contracts are generally used to speculate on currency exchange rate movements.