Forex — An Introduction
Forex, or foreign exchange, is the buying of 1 currency with that of another. Although it is called foreign exchange, this is just a relative term. The terms domestic and foreign is relative to the person using the term. What is foreign to one person is domestic to another. Currency exchange would be the more proper term.
The main reasons to exchange foreign currency for domestic currency is to pay for goods and services in the foreign country, to invest in its financial assets, to hedge against unfavorable rates of exchange in the future, or to profit from those changes. Foreign currency holders need to convert it back to their domestic currency to take profits, so that businesses, governments, and other organizations can use the money at home.
Hedging is exchanging currency, either in the spot market or by using forwards or futures contracts, to protect against unfavorable changes in the future. Most hedgers are governments and businesses that need to buy or sell in a foreign country sometime in the future. Speculators are people who are exchanging currency purely for profit. Governments, usually through their central banks, influence the exchange rate to some extent as well, either by buying or selling foreign currency, or by creating or destroying domestic currency. Thus, currency rates fluctuate because demand and supply for each currency fluctuates.
The foreign exchange market, often called the FX market, is an over-the-counter (OTC) market. Its consists of a network of dealers—central banks, commercial and investment banks, funds, corporations, and individuals. Transactions are done electronically, usually over the Internet, and traders buy and sell through a broker. Thus, the forex market operates as a spot market. Although there are futures and forward contracts on currencies, most forex transactions use the spot market. There is no central exchange for the spot market, and brokers and dealers are located throughout the world, so the forex market is a 24 hour market during the weekdays. Forex is the largest financial market in the world—over 4 trillion USD equivalent values of currency are traded daily.
Currency rates are listed as pairs, and there are many sites on the Internet that display current quotes. The rate of exchange is the amount of the foreign currency that is equal in value to a unit of domestic currency, or, more generally, it is the amount of currency received for each unit of the currency tendered. Thus, for instance, the Great Britain pound (GBP) has, at 1 time, passed the $2 mark in value. That means that $2 buys £1.
Virtually every country, with some small exceptions, has its own currency, and most of them can be traded. However, the currencies of a few countries are the most actively traded, and constitute, by far, the largest volume of trades. The big 5 are the United States dollar (USD), Euro (EUR), Japanese yen (JPY), the British pound (GBP), and the Swiss franc (CHF).
Each currency is symbolized using 3-letter ISO (International Organization for Standardization) codes: the 1st 2 letters designate the country, the 3rd designates the currency. The most famous illustration of this is for the United States dollar—USD. However, sometimes the country name or currency that is symbolized is not the most common name. Thus, the symbol for the Swiss franc is CHF, where CH stands for Confederation Helvetica, which refers to Switzerland, and MXN stands for the Mexican Nuevo Peso, even though the most common name for Mexico's currency is simply the peso.
Advantages of Forex Trading
There are many advantages to trading currencies for profit. Because there are no organized exchanges for the foreign currency spot market, there are no clearing fees or other exchange fees, and because the forex market is decentralized, there are no government fees. The lack of organized exchanges and its decentralization among worldwide trading centers creates a 24 hour market during the weekdays. The large size of the market provides liquidity and fast transactions.
Investing in currencies is also a good way to diversify assets, because it has little correlation with stocks or bonds. You can make money regardless of whether a currency is rising or falling with respect to another currency. If the target currency is expected to rise, you buy it, then sell it later at a higher price, hopefully; if it is falling, you sell it short, then buy it later at a lower price, if you predicted correctly. Thus, there is no up or down market in the FX market—if one currency is up with respect to another, then the other, obviously, is down, and vice versa. And because of the FX market's huge size and decentralization, there is no possibility that prices will be manipulated by accounting frauds. No Enron's or WorldCom's in this market—not even the possibility. Nor can such a huge market be cornered. And because currency prices are not the result of what any single organization does, there can be no insider trading. Nor can any bubble arise, as has happened to stocks in the late 90's, and to real estate more recently. The size of the market is simply too vast and too interrelated for bubbles to form.
FX metals — gold, silver, palladium, platinum — can also be traded in forex accounts. For instance, XAU represents gold. Each XAU/USD pair represents 1 troy ounce of gold. A pip is equal to a penny, 1 lot equals 10 ounces of gold and 10 FX XAU/USD lots is identical to trading 1 lot of the traditional gold futures contract listed on the COMEX exchange. However, the pip spread in FX metals is 2 to 3 times greater than those for the equivalent futures contract. Another disadvantage is that only dealing desk brokers offer FX metals, so the trader would be buying or selling at the broker's price rather than the market price.
Opening an account to trade currencies requires very little money—in some cases, as little as $200 in so-called mini-accounts. Many firms offer up to 50:1 leverage ratios in mini-accounts, so a trader with $200 in a mini-account can trade up to $10,000 worth of currencies. Leverage greatly amplifies both profits and losses. Before 2010, brokers advertised much higher leverage ratios — as high as 400:1 — but US regulations have capped the leverage ratio to 50:1. Because currencies are naturally range-bound, leverage is necessary to earn a reasonable profit. That currency prices do not change much is what allows brokers to offer such a high leverage ratio.
Is the Forex Market Liquid?
Liquidity is the ability to quickly sell an asset for what it is worth. In illiquid markets, assets usually have to be sold for less than what they are worth, especially if the sale must be completed quickly. Forex brokers love to advertise that the forex market is the most liquid market because more than $4 trillion worth of currency is traded daily. However, this is misleading because the currencies are not traded on the same network — there is no centralized exchange for trading currencies, so there is no global price competition for forex orders.
Liquidity depends on which currency pairs are traded, whether the trade is with a dealing desk broker or with an electronic communication network (ECN), and, if using an ECN, the number and activity of the participants on that ECN. The largest and most active ECNs have the most liquidity.
Some currency pairs are very illiquid. Much of the retail forex trading is done with dealing desk brokers, who set the bid/ask prices on all the currencies that they offer, so there is absolutely no price competition with a dealing desk broker. Although currencies can be bought and sold, the prices will be worse than what could have been gotten on a competitive ECN.
Taxation of Forex Trades
Forward contracts on currencies are classified as 1256 contracts by the tax code, but gains and losses in the forex spot market are treated as ordinary income unless the taxpayer opts out. There are 2 methods of reporting gains and losses in forex trading in the spot market. The regular method, which is the default method is governed by IRC §988, which taxes forex trades as ordinary income. However, the trader can opt out of the §988 treatment so that spot forex trades are treated the same as 1256 contracts, where, regardless of the holding period, 60% of the gain or loss is considered long-term and the remaining 40%, short term. This election can be beneficial since long-term capital gains are taxed at a lower rate than ordinary gains. Trades treated as 1256 contracts are reported on Form 6781, Gain and Losses from Section 1256 Contracts and Straddles.
Updated Forex Statistics
The Bank for International Settlements (BIS) surveys central banks throughout the world in regards to their currency transactions and reports the results quarterly. In addition to reporting the total volume of spot trades, it also reports statistics on:
- currency derivatives, which are used to hedge risk or make profits
- cross currency swaps, where 2 parties agreed to exchange interest payments in different currencies for specified time, and
- emerging market currencies, which now account for more than 20% of all currency trading.
Forex trading continues to grow, due to improving and cheaper technology, with more than $4 trillion of currency values traded daily. Hedge funds and individual investors continue to represent a significant part of the increase. No doubt that this trend will continue for the foreseeable future.