The foreign exchange market, also known as the forex market or foreign exchange market, is the largest and most liquid financial market in the world, where currencies of different countries and regions are traded.
The foreign exchange market allows participants to buy, sell, exchange and speculate on currencies in order to make profits or hedge risks.
What are the characteristics of the foreign exchange market?
The foreign exchange market has the following characteristics:
- It is a global global y decentralized marketIt operates 24 hours a day, 7 days a week, in the main financial centers of the world, such as London, New York, Tokyo, Sydney, etc.
- It is an interbank interbank marketwhich connects central banks, commercial banks, brokers, dealers, companies, investors and speculators, who act as buyers and sellers of currencies.
- It is an electronic electronic marketIt uses online communication platforms and networks, such as the Electronic Broking System (EBS) or the Foreign Exchange Dealing System (Reuters Dealing), to carry out operations quickly and efficiently.
- It is a volatile volatile y competitiveIt is subject to fluctuations in the supply and demand of currencies, as well as economic, political, social and psychological factors that affect their value.
What instruments are traded in the foreign exchange market?
The instruments traded in the foreign exchange market are currencies, which are the monetary units of each country or region, such as the US dollar (USD), euro (EUR), Japanese yen (JPY), pound sterling (GBP), etc.
Currencies are traded in pairs, i.e. you buy one currency and sell another, such as EUR/USD, USD/JPY, GBP/USD, etc.
The price of each currency pair is called the exchange rate, which indicates the amount of one currency needed to obtain one unit of another currency, such as 1 EUR = 1.18 USD, 1 USD = 109.50 JPY, 1 GBP = 1.38 USD, etc.
The instruments used to trade currencies are derivatives, which are contracts that derive their value from another underlying asset, in this case, currencies.
The most commonly used derivative products in the foreign exchange market are:
- The futures contractsFutures contracts, which are contracts that obligate the parties to buy or sell a specific amount of a currency at a future price and date, fixed in advance. Futures contracts are traded on organized and regulated markets, such as the Chicago Mercantile Exchange (CME) or the International Monetary Market (IMM).
- The option contractsOptions contracts, which are contracts that grant the parties the right, but not the obligation, to buy or sell a specific amount of a currency at a future price and date, fixed in advance, paying a premium or price for the contract. Option contracts are traded both on organized and regulated markets, such as the Philadelphia Stock Exchange (PHLX) or the International Securities Exchange (ISE), and on over-the-counter (OTC) markets.
- The contracts for difference (CFDs), which are agreements between two parties to exchange the difference between the purchase price and the sale price of a currency, without the need to physically own it. Contracts for difference are traded in over-the-counter (OTC) markets, through online platforms of brokers or dealers.
What are the advantages and disadvantages of the foreign exchange market?
The foreign exchange market has advantages and disadvantages, which should be considered before participating in it. Some of these advantages and disadvantages are:
Advantages
- Allows access to a global and diverse market, with a wide variety of currencies and derivative products to trade.
- Allows trade at any time and from anywhere, with an internet connection and an online trading platform.
- Allows take advantage of market opportunities by anticipating trends and movements in currency exchange rates.
- Allows leveragei.e., to operate with a larger amount of money than one has available, which increases the potential profitability, but also the risk.
Disadvantages
- Implies assuming high risk, as it is exposed to fluctuations in currency exchange rates, which may result in losses exceeding the capital invested.
- Implies paying operating costs, such as spreads, commissions, swaps, taxes, etc.
- Implies being being subject to high competition, facing other market participants, such as banks, brokers, dealers, companies, investors and speculators, who have more resources, information and experience.
- Implies being attentive to the factors that influence the market, such as economic data, political news, social events, agents’ expectations, etc.
What are some tips to follow when trading in the foreign exchange market?
Some tips to follow when trading in the foreign exchange market are:
- Get to know y respect the investment profile, aligning the strategy, term and risk of operations with the personal, financial and psychological characteristics of the investor.
- Get informed y keep up to date about the foreign exchange market, following trends, news, analysis and recommendations from experts, as well as current regulations and standards.
- Select y diversify currencies and derivative products, choosing those that suit the strategy, the market and the time you wish to trade, as well as combining different currency pairs, products, maturities and prices, thus reducing risk and increasing the chances of success.
- Assign y control capital, distributing the available capital among the different operations, according to their importance and contribution to the investment portfolio, as well as monitoring the margin level, leverage, profit or loss, etc.
- Evaluate y compare the performance of operations, measuring the result obtained by each operation, contrasting it with the established objective and with the performance of other similar operations.
- Check y adjust operations, adapting the position and leverage level, according to changes in the foreign exchange market or in the performance of operations.
