Although the foreign exchange (also known as “forex” or “FX”) is the largest financial market in the world, it is relatively unfamiliar terrain to retail traders. However the big slide in the U.S. dollar since early in 2002 has opened the eyes of many investors to the global currency markets. Until the popularization of internet trading a few years ago, FX was primarily the domain of large financial institutions, multinational corporations and secretive hedge funds. But times have changed, and individual investors are hungry for information on this fascinating market.
All currency has a value relative to other currencies on the planet. Currency trading uses the purchase and sale of large quantities of currency to leverage the shifts in relative value into profit. It is estimated that in excess of US$2 trillion is traded every day. Compare this to the New York Stock Exchange’s daily transactions of approximately US$50 billion, and you can see that the magnitude of the currency trading market exceeds all other equity markets in the world combined.
There are two reasons the relative value of a currency fluctuates. The first is because of a ‘real’ market: as outside investors or visitors wish to buy things within a country, they are forced to convert their domestic currency into the currency of the country they are buying within. Similarly, as money leaves the country, people must sell their currency for the foreign currency they will need to spend or invest abroad.
The second force for currency fluctuation is speculation. As investors feel a given currency will act strongly or weakly, they will buy or sell accordingly. This speculation can have drastic consequences on a national currency and consequently on a country’s economy. During the East Asia Crisis in 1997, for example, as nations in Asia began facing economic downturns, speculators used currency trading to realize enormous profits and in many analysts’ view helped to exacerbate the problem.
Unlike the trading of stocks, currency futures trading, currency options trading, and currency trading does not take place on a regulated exchange. It is not controlled by any central governing body, there are no clearing houses to guarantee the trades and there is no arbitration panel to adjudicate disputes. All members trade with each other based upon credit agreements. Essentially, business in the largest, most liquid market in the world depends on nothing more than a metaphorical handshake.
Currency trading has many very real benefits over equity trading like the stock exchange:
- Ease of Entry: You can get started in the currency market with an account as small as $250. You don’t need to have a lot of money to start making great returns on your investments. Anyone can take advantage of the benefits of the currency market.
- Profit Potential: Profit potential is what every investor wants to hear about, and the currency market has plenty of it.
- Tax Advantages: Currently, short-term capital gains are taxed at your current tax rate, and long-term capital gains are taxed at only 15%. Obviously, it is much better to pay less in taxes. In the Forex market, much to investors’ delight, it doesn’t matter if you take your profits one minute after you enter a trade, or one month after you enter a trade: the first 40 percent of your profits are taxed at short-term capital gains rates, and the remaining sixty percent is taxed at long-term capital gains rates.
- No Commissions: You never have to pay a sales commission when you trade currencies.
- Increased Leverage: This is perhaps the advantage that is most appealing to aggressive investors. Increased leverage allows you to control a large holding of currencies with very little money up front.
- Guaranteed Stops: You have the ability in the Forex market to determine at exactly which price you would like to enter a trade and at exactly which price you would like to exit a trade, and these prices are guaranteed.
- Trading Hours: The currency market is open 24 hours a day, nearly seven days a week.
Trading in forex requires a slightly different way of thinking than the way required by equity markets. Yet, for its extreme liquidity, multitude of opportunities for large profits due to strong trends and high levels of available leverage, the currency market is hard to resist for the advanced trader. With such potential, however, comes significant risk, and traders should quickly establish an intimate familiarity with methods of risk management.