What is Forex - Answer

Q. What is Forex?

Forex is short for "Foreign Exchange" and refers to the world foreign exhange markets where the currency of any given country is bought or sold using the currency from a different country.

A simple example may give you a better idea of what forex is all about. Let's say you are an American visiting one of the European Common Market countries... let's say it is France. When you go to France you take dollars with you to spend. But when you get to France you find that the French will not take American Dollars in their stores. They will only take Euros, the standard currency of this European Common Market country. So, you go to a currency exchange booth and give the man behind the counter $100.00. The man gives you back the equivalent in Euros, €78.13.

You are quite tired and instead of spending any money you go to your hotel and fall asleep. The next morning you receive a telegram from your boss, "Come home immediately!" So, the first thing you do before heading to the airport is go back to the man at the currency exchange kiosk and plunk down the €78.13 you received the day before and ask him to change this back to American Dollars. To your happy surprise instead of giving you back $100.00 he gives you back $102.75. You walk away happy, scratching your head. What happened? Why did you get back more than you gave the day before?

Well, it seems that while you were sleeping the United States Federal Reserve Chairman made a public announcement that the U.S. short term interest rate had been lowered from 5% to 4%! Banks and other large investors - perhaps insurance companies, etc. - immediately want to take advantage of the higher European interest rate and start exchanging U.S. dollars for Euros ("selling" dollars and "buying" Euros) so that they can put them into European Common Market Banks to earn the higher interest rate there. Demand for U.S. dollars goes down very quickly as demand for Euros goes up. The law of supply and demand takes over and forces the exchange rate to change in favor of the Euro. So, the Euro, having gained value, can now be exchanged for more dollars than it did the day before .. and you walk away a happier person.

Unlike stocks whose value goes up or down depending often on how well a company is doing, in foreign exchange it is the exchange rate between currencies that is changing and people are betting that it will move one way or the other. So, if you predict Euros will be worth more dollars tomorrow than today you will "buy" Euros today (exchange Dollars for Euros today) and "sell" them tomorrow (exchange Euros for Dollars tomorrow). In doing so you will make a profit, if your prediction was correct.

Also unlike stocks, in Forex there is no actual physical market such as the New York Stock Exchange, for example; and Forex hours are 24 hrs per day, except from 5:00 pm Friday to 5:00 pm Sunday, New York time, when trading comes to a virtual standstill in the US. In Forex there are a number of banks throughout the world that set currency exchange rates. These banks, in turn, electronically transmit these rates, as they change moment to moment, to certain currency brokers throughout the world known as "Market Makers." Market Makers act in a role that for all intents and purposes is similar to stock brokers. Market Makers will make currency exchanges for you at the current rates in return for getting the price differential between a "buy" and "sell" price for a given currency. This price differential is called the "spread." Different Market Maker brokers use different spreads.

As an example, a Market Maker may offer to let you "buy" one Euro (change Dollars into Euros) for $1.2825 and, at the same time offer to let you "sell" one Euro (change Euros into Dollars) for $1.2822. If there are an equal number of sellers and buyers at any given moment you can see that on each transaction the Market Maker has made a profit of $.0003. If, instead of buying or selling one Euro, the transaction involves 100,000 Euros - 100,000 units of any currency is called a single "lot" - then the Market Maker has made a profit of $30.00 on that transaction (do the math ... .0003 X 100,000 = 30). So, if there is but a single lot sold and bought once every second the Market Maker would make an astounding $2,592,000.00 per day in gross revenue - 86,400 seconds per day X $30.00 = $2,592,000.00! So, if you as an investor/trader buy one lot of Euros when the exchange rate is at $1.2825 and then later change those Euros back into US dollars when the exchange rate is at 1.2875 you will have made $500.00 on the deal. Pretty nifty, eh? And how fast will the Euro market move from 1.2825 to 1.2875? Sometimes it only takes a few seconds!! This is the big attraction for most small investors.

Small, individual investors usually trade only one or a few lots per trade. But the fact is, however, that many large investor traders trade Euros vs. US Dollars in multiples of hundreds and even thousands of lots per trade. Also, in the Euro/USDollar (EUR/USD) market, the most heavily traded currency pair in the world, there are probably hundreds of trades per second throughout the world. So, this should give you an idea of just how big the Forex market really is. See this further explanation for more information.

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