Monday, July 15, 2024
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Forex market: how it works

Forex is the market where all the negotiations involving the different currencies take place. Not surprisingly, the term Forex itself derives from the English FOReign EXchange market.

It has ancient origins and was born from the commercial needs of exchanging one currency for another, in order to conclude transactions.

The forex market today operates via mobile thanks to a global interbank network, spread over four major trading centers covering all global time zones (London, New York, Sydney and Tokyo).

Without going into the technical details of the industry, mobile Forex trading platforms are also divided into two main categories. Just as in the case of standard platforms, we distinguish between native mobile clients and mobile platforms accessed via the web.

The first and most important feature of Forex lies in liquidity. It is undoubtedly the most liquid market in the world and this high liquidity allows prices to suffer less speculative movements and to always find a counterparty for any trade.

What is Forex? is the currency market and it is not single currencies that are traded, as is often said, but pairs of currencies. For example, you can’t just sell dollars. You have to sell dollars and buy, at the same time, another currency, for example the euro.

Therefore, in Forex we think in terms of currency pairs: for example, EUR/USD indicates the euro/dollar exchange rate.

How do currency pairs work?

Transactions on the forex market always involve the simultaneous sale of one currency and the purchase of another. For this reason we speak of “currency pairs”.

For example, the euro dollar is referred to as EUR/USD. The currency to the left (EUR) is referred to as the primary or base currency, while the currency to the right (USD) is the secondary or counter currency.

In our case, the euro (EUR) is bought or sold in exchange for a certain amount of secondary currency, depending on the applicable exchange rate.

The price to the left is referred to as the bid price and is the price at which you are willing to buy a currency pair.

Conversely, the price to the right is referred to as the ask or offer price, i.e. the price at which one is willing to sell a currency pair.

The difference between the bid price and the ask price is commonly known by the English term of spread. This is the cost of the trading operation, i.e. of the sale.

In our example, this differential is equal to 0.0002. For ease of notation, we tend to indicate it as 2 pips (point in price), 2 percentage points.

Forex pairs

As we have seen, currencies are traded in pairs.

Although it is possible to exchange virtually any world currency for another, there are some currencies that attract a greater volume of trade, mostly based on the importance of the relevant economy and the global exchanges carried out. These are called major pairs.

These are the most commonly traded group of currencies, accounting for more than 80% of the total trades that take place on the foreign exchange market.

The high availability and liquidity mean that the trading conditions (meaning to trade or negotiate) on these pairs are particularly advantageous, with relatively low spreads compared to other less traded pairs.

How does Forex work?

The secret of how Forex works is in the c.d. “exchange ratio”, which constitutes the “price” at which one currency is exchanged against the other.

Forex therefore serves to determine the value of one currency in relation to another. This value estimation is all-important because it serves multiple practical purposes that directly affect our daily lives.

If you travel outside the Eurozone, for example in the United States, you will be able to exchange your euros into US dollars based on the current exchange rate established in the foreign exchange market, i.e. Forex.

If you have an import/export company, the value of the goods you buy or sell abroad is influenced by Forex.

Even the price of basic necessities and petrol is directly influenced by the currency market, often without us realizing it.

Forex trading is therefore nothing more than the buying or selling of foreign exchange (currencies).

Like us, banks, central banks, corporations, institutional investors and ordinary traders trade the forex market to meet various needs, including international trade, tourism, investment, market stabilization or simply to try to generate a profit the difference between the purchase price and the sale price.

As we have seen, Forex has a very important practical function. Most traders need a foreign currency for international trade or financial exchange.

To date, however, the currency market has also become something else, there are speculative traders, i.e. those who operate on forex to earn such as:

Banks and financial institutions that are among the main players in Forex: they conduct the largest operations, often even for speculative purposes. Central banks also participate in Forex, such as the ECB.

Large commercial companies: these participate essentially to do business and to hedge their exposure, acting on the market balance.

Retail traders: these are private financial operators, i.e. small and large investors who participate in Forex with the aim of earning large sums of money.

How do the operations take place?

Forex trading operations mainly take the form of three different contracts:

Spot: contracts in which the parties agree to buy and sell currency at the current market price. This contract is executed “spot”, (in English “on the spot”).

Forward (forward): Also known as forward contracts, these involve a forex contract where a certain price is stipulated at which one currency must be exchanged for another. It means that until the currency reaches that price, the exchange will not take place. This form of contract can be open (with no expiration date) or have a deadline by which the contract can be performed, but after which it will be cancelled.

This type of contract is commonly used in trading strategies to set an order at a specific price not currently available.

Futures: these are contracts in which the purchase and sale of currencies is agreed at a specific price on a specific date. The essential difference between forward (forward) contracts and futures contracts is that futures contracts are binding on the parties, who are required to fulfill the exchange agreement within the expiration date.

It is important to remember, however, that the objective of the forex market is not to guarantee traders profits, but on the contrary to make international commercial and financial transactions possible.

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