Many investors often question “Why Forex Trading ?”, what can one gain from forex trading and why trade in the forex market. Millions of traders choose to trade Forex, as they have come to an understanding of why Forex is the best market to trade. These traders explore the potential of the online trading market, and seize all the possible opportunities available to them. So, why is Forex the best market to trade?
In this article below, Doo Prime will explain thoroughly the mechanics and elements to help investors understand why traders are trading forex.
What is Forex?
Forex, also known as the foreign exchange market (or FX), is the largest and the most liquid market in the world. Its retail part came with the development of the Internet. This enabled retail clients to trade Forex online via various trading platforms. Forex opened its doors to retail clients in the late 1990s. At this time, the first retail online brokers began their operations.
Forex, as a market had been functioning for decades before that, but it only accepted institutional clients. Currently there are trillions of US dollars traded daily on the Forex market, with retail clients contributing nearly 5% of the total volume, or around 250 billion US dollars in daily turnover. But why is the Forex market so large?
Large multinational trade companies, financial institutions, hedge funds, and lots of other companies require foreign currencies to operate their businesses. For those unaware, one currency is bought online for another currency, and this creates quite a reasonable flow of funds. In other words, Forex is the global marketplace for trading currencies.
Why Forex Trading ?
There are several reasons why investors choose foreign exchange (forex) trading over trading stocks. For starters, the forex market is the world’s largest market in terms of daily transaction volume, and it’s almost the most liquid. This market is highly accessible given that it’s open 24 hours a day, and investors interested in trading forex can make use of far more leverage than they could by trading stocks.
There are more than 100 different kinds of official currencies in the world. However, most international forex trades and payments are made using the U.S. dollar, British pound, Japanese yen, and the euro. Other popular currency trading instruments include the Australian dollar, Swiss franc, Canadian dollar, and New Zealand dollar.
Currency can be traded through spot transactions, forwards, swaps, and option contracts where the underlying instrument is a currency. Currency trading occurs continuously around the world, 24 hours a day, five days a week.
Who Trades Forex?
The forex market not only has a great number of traders but also a various type of traders. Here we go through some of the major types of institutions and traders in forex markets:
Commercial & Investment Banks
The greatest volume of currency is traded in the interbank market. This is where banks of all sizes trade currency with each other and through electronic networks. Big banks account for a large percentage of total currency volume trades. Banks facilitate forex transactions for clients and conduct speculative trades from their own trading desks.
When banks act as dealers for clients, the bid-ask spread represents the bank’s profits. Speculative currency trades are executed to profit on currency fluctuations. Currencies can also provide diversification to a portfolio mix.
Central banks, which represent their nation’s government, are extremely important players in the forex market. Open market operations and interest rate policies of central banks influence currency rates to a very large extent.
A central bank is responsible for fixing the price of its native currency on forex. This is the exchange rate regime by which its currency will trade in the open market. Exchange rate regimes are divided into floating, fixed, and pegged types.
Any action taken by a central bank in the forex market is done to stabilize or increase the competitiveness of that nation’s economy. Central banks (as well as speculators) may engage in currency interventions to make their currencies appreciate or depreciate. For example, a central bank may weaken its own currency by creating additional supply during periods of long deflationary trends, which is then used to purchase foreign currency. This effectively weakens the domestic currency, making exports more competitive in the global market.
Central banks use these strategies to calm inflation. Their doing so also serves as a long-term indicator for forex traders.
Investment Managers and Hedge Funds
Portfolio managers, pooled funds, and hedge funds make up the second-biggest collection of players in the forex market next to banks and central banks. Investment managers trade currencies for large accounts such as pension funds, foundations, and endowments.
An investment manager with an international portfolio will have to purchase and sell currencies to trade foreign securities. Investment managers may also make speculative forex trades, while some hedge funds execute speculative currency trades as part of their investment strategies.
As outlined, there are several reasons why investors are opting for forex trading. By trading forex, investors can access a market that is far larger in scope than other markets. Because of its size, the forex market offers greater liquidity, which means that investors may be able to enjoy lower transaction costs and more easily enter and exit trades.
The forex market also offers traders greater flexibility, given that it is open 24 hours a day, investors can easily combine more forex trading with other responsibilities. Ultimately, the forex market offers greater leverage than the other market, a factor that can potentially amplify gains as well as losses.
Firms engaged in importing and exporting conduct forex transactions to pay for goods and services. Consider the example of a German solar panel producer that imports American components and sells its finished products in China. After the final sale is made, the Chinese yuan the producer received must be converted back to euros. The German firm must then exchange euros for dollars to purchase more American components.
Companies trade forex to hedge the risk associated with foreign currency translations. The same German firm might purchase American dollars in the spot market, or enter into a currency swap agreement to obtain dollars in advance of purchasing components from the American company in order to reduce foreign currency exposure risk.
Additionally, hedging against currency risk can add a level of safety to offshore investments.
The volume of forex trades made by retail investors is extremely low compared to financial institutions and companies. However, it is growing rapidly in popularity. Retail investors base currency trades on a combination of fundamentals (i.e., interest rate parity, inflation rates, and monetary policy expectations) and technical factors (i.e., support, resistance, technical indicators, price patterns).
How Forex Trading Shapes Business
The resulting collaboration of the different types of forex traders is a highly liquid, global market that impacts business around the world. Exchange rate movements are a factor in inflation, global corporate earnings and the balance of payments account for each country.
For instance, the popular currency carry trade strategy highlights how market participants influence exchange rates that, in turn, have spill over effects on the global economy. The carry trade, executed by banks, hedge funds, investment managers, and individual investors is designed to capture differences in yields across currencies by borrowing low-yielding currencies and selling them to purchase high-yielding currencies. For example, if the Japanese yen has a low yield, market participants would sell it and purchase a higher yield currency.
When interest rates in higher yielding countries begin to fall back toward lower yielding countries, the carry trade unwinds and investors sell their higher yielding investments. An unwinding of the yen carry trade may cause large Japanese financial institutions and investors with sizable foreign holdings to move money back into Japan as the spread between foreign yields and domestic yields narrows. This strategy, in turn, may result in a broad decrease in global equity prices.
As outlined, there are several reasons why investors are opting for forex trading over other forms trading. By trading forex, investors can access a market that is far larger in scope than that of the other market. Because of its size, the forex market offers greater liquidity, which means that investors may be able to enjoy lower transaction costs and more easily enter and exit trades.
The forex market also offers traders greater flexibility than the other markets, given that it is open 24 hours a day, investors can easily combine forex trading with other responsibilities. Ultimately, the forex market offers greater leverage than the other markets which is a factor that can potentially amplify gains as well as losses.
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