What Is FX?
FX stands for foreign currency exchange. Whenever anyone, from a tourist traveling abroad to multinational corporations with operations in a dozen countries, wants to make a transaction in another country, they must exchange their money for the local currency. As the currencies are traded, their exchange rates fluctuate in response to news and market trends. FX is a favorite of speculators who try to make money from these changes in currency exchange rates.
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Identification
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The FX (or Forex) market is where institutional and individual traders exchange one country's currency for another. There are no central locations like stock exchanges. FX trading is done "over the counter" through banks and wholesale or retail currency dealers. The Forex market is largely self-regulating with little government oversight. Currencies always trade as pairs. An example is the U.S. dollar and the Euro (the most widely traded currencies). Using ISO (International Organization of Standards) notation, you might see this pair listed as EUR/USD = 1.4316, meaning it takes $1.4316 to buy one Euro.
History
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Prior to 1971, currency rates were fixed with respect to the U.S. dollar (then tied to the gold standard). In that year the system was discontinued to promote greater trade flexibility. By the 1980s this change, combined with the rise of the "Eurodollar market" (U.S. dollars deposited in foreign banks), had given rise to a brisk foreign currency market with a volume of $70 billion/day. The advent of the Internet, with real-time quotes and electronic funds transfer, resulted in massive growth. By 2007, FX trading reached an average daily volume of $3.2 trillion, making it the largest financial market in the world. FX trading begins each week at 22:00 Greenwich Mean Time (GMT), when markets in Australia open, and continues 24 hours a day until 22:00 GMT, when the last U.S. markets close.
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Function
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About 80% of the FX market volume is generated by institutional and individual speculators attempting to make a profit off of fluctuations in currency exchange rates. Retail dealers (usually called brokers) offer liberal margins to traders. The ratio of margin required to currency held can reach 400:1. Thus, 1 lot of $100,000 can be secured with as little as $250. Good brokers provide real-time quotes and online trading software. Traders can choose to go long (hoping a currency will rise in value against another) or short (hoping the currency will fall in value).
Features
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Currency sellers state an asking price, and buyers a bid price, as in other financial exchange markets. In FX, the spread between bid and ask is very small. Wholesale dealers use a spread of just 1-2 "pips." A pip is the smallest possible price change. For example, the pip for the EURO/USD pair is $0.0001 (1/100 cent). Retail dealers mark the bid/ask spread up to 3-20 pips and keep the difference represented by the spread, instead of charging commissions. For the FX trader, the goal is to correctly anticipate which direction a given currency exchange rate will move. If the trader is right and the change is greater than the spread, the trade shows a profit.
Considerations
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While the low margins used in FX mean potentially high profits, they also mean FX trading is high-risk. If you are interested in trading on the FX market, learn as much as you can about trading strategies and risk management first. Get an understanding of how factors like market trends, news events, and national trade and monetary policies affect exchange rates. FX is an unregulated market, so be sure you deal with a reputable broker. In the United States the best course is to choose a broker who is a member of the self-regulatory National Futures Association and has agreed to adhere to their standards of conduct.
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