Having briefly charted the history of the foreign exchange market and its evolution into the multi-trillion-dollar-a-day operation that it is today, we will now turn our attention to the many benefits and advantages of forex trading. The first obvious such benefit stems from the development of the market itself, since ever it became an over-the-counter (OTC) market, it stopped being the prerogative of large companies or a handful wealthy individuals and became instead open and accessible to a much wider audience, effectively to everyone who is willing and able to trade forex.
The Benefits of Forex Trading
The two inherent characteristics of the forex market, which at the same time pose as the most important benefits of trading forex is the high liquidity and volatility of the market itself. Indeed, the forex market is the largest and most liquid of all the financial markets, boasting a daily activity that often exceeds $4 trillion USD, of which over $1.5 trillion is conducted in the form of spot trading. A forex spot trade is essentially a contract to trade a given amount of a currency pair with a market-maker, at the advertised buy / sell price, thus called the spot rate.
A useful term to understand and remember when it comes to forex trading is that of liquidity, which is the actual n number of buyers and sellers in the market willing to trade at any given time. A greater amount of willing buyers and sellers means that the greater is also the number of trades completed, translating in turn into higher trading volumes.
An even more essential concept to grasp is that of volatility, which is the measure of how much the price of a currency changes over time. Greater volatility also increases the risk potential in the forex market, but it is exactly the existence of volatility that makes the forex market work, as it is volatility that enables traders to take advantage of exchange rate fluctuations for speculative purposes.
Another benefit of forex trading are its extensive market hours, since the market operates 24 hours a day, five days a week. There is a strong link between liquidity and market activity and it is therefore important for traders to be aware that the greatest liquidity in the forex market occurs when operational hours in multiple time zones overlap.
Its low cost is yet another advantage of forex trading. This cost, also known as spread, is the difference between the bid and the ask price. When compared to the spreads applied in other forms of securities trading, such as stocks, the forex spreads are much less, or in market language much tighter, thus rendering the over-the-counter trading of forex one of the most cost-effective means of investment trading.
Other advantages to forex trading stem from the fact that over the counter trading is usually done through margin-based trading accounts offered by forex brokers. Margin-based accounts are different from credit-based accounts because they entail that you must first open an account with your broker, and then fund the account by depositing money into the account. Having done this you can then engage in any trading activity you choose, provided you have sufficient margin remaining in your account. However, a great potential for returns exists through the use of leverage, which makes it possible to trade larger positions than one’s actual account balance. Nevertheless, leverage increases also the risk potential since it means that significant losses can occur in a short period of time.
It is possible that some of the terminology used so far in this section may still be puzzling to you. There is no need to worry however, as these are further explained in the next chapter which deals with the Essential Knowledge that each forex trader should have before trading.
Another advantage of forex trading is that it can give a trader the potential to make profit, regardless of the actual market direction. This can happen during a short sale, which is the selling of a currency pair before you buy it. In this case, to achieve profit you must buy the currency back for less than you received when you sold it. The difference represents your profit or loss and under these conditions it is possible to make a profit irrespective of which way the market is trending. More specifically, this can occur because when currency exchange rates are increasing, you can earn a profit if you buy (go long) a currency pair, and then sell it later for more than you paid. Inversely, when rates are falling, you can earn a profit if you sell (go short) a currency pair, and then buy it later for less than you earned when you originally shorted the currency pair.
Understanding the notions of leverage ratio as well as what is known as the minimum margin requirements is also very crucial for every aspiring online forex trader. Forex brokers impose margin requirements and these determine leverage, which is expressed as a ratio. If your broker requires you to maintain a minimum 2% margin in your account, this means that you must have at least 2% of the total value of an intended trade available as cash in your account, before you can proceed with that specific trade. If this example is expressed as a ratio, then 2% margin is equivalent to a 50:1 leverage ratio (1 divided by 50 = 0.02 or 2%). Moreover, in this example, the 50:1 ratio means that for every fifty dollars you commit to a trade, you must have one dollar in your account. Obviously then, trading with leverage comes both with significant benefits as well as pitfalls. In the current example, with as little as $1,000 of margin available in your account, you can trade up to $50,000 at 50:1 leverage, meaning that while only committing $1,000 to the trade, you have the potential to earn profits on the equivalent of a $50,000 trade. However, in a similar manner you face the risk of losing funds based on a $50,000 trade, running the risk of triggering what is called as margin closeout, which is what happens when traders suffer a loss without sufficient margin remaining in their account. run the risk of triggering a margin closeout.
Margin closeout should be avoided and you can learn more on strategies to achieve this in chapter four of our guide which deals with what you should know before placing your first ever forex trade.
Trading with leverage is like using money “borrowed” from your broker, using as collateral the funds actually present in your account, i.e. the minimum margin. Naturally then, your broker will not allow your account balance to fall below that limit and thus continually calculates the value of all your open positions to find out your Net Asset Value at any time . Therefore, whenever your open positions lose so much potential value that the remaining funds in your account – that is, your remaining collateral – is in danger of falling below the minimum margin limits, you could receive a margin closeout, with the broker automatically closing all your positions, which at the very best scenario could cause you to lose at least half of your balance.
Who are the main Forex Market Participants?
- Consumers and Travelers
Even if we have never even heard of online forex trading all of us in our day to day lives participate in the forex market simply by being consumers or travellers. If we buy anything in a foreign country or place an online order in a foreign currency and pay using our credit card, then the amount we pay in that foreign currency will be converted in the currency of our country on our bank statement. Similarly, when we exchange cash at a bank or exchange bureau into a foreign currency to use when travelling, for work or pleasure at a foreign country, we again become market participants since we need to be aware of the exchange rates to ensure we are not cheated during the currency conversion process.
Similar to the average person on the street, all businesses across the globe are potential market participants in the forex market, since they often need to convert currencies when they conduct trade outside their home country, while this need is further exacerbated in the case of multinational companies that need to convert huge amounts of currency simply to continue their normal day to day operations all over the world.
- Investors and Speculators
Besides being direct market participants of the forex market when they trade in actual currencies in order to achieve profits from the movements in the currency exchange markets, all investors and speculators become market participants whenever they decide to deal with any type of foreign investment, since they need to exchange currency in order to invest abroad either in equities, bonds, bank deposits, or real estate.
- Commercial and Investment Banks
All commercial and investment banks are major participants in the forex market, since they need to trade currencies as a service to their commercial banking, deposit, and lending customers. Moreover, commercial and investment banks also take part in the foreign currency market for hedging and speculative purposes, in order to increase their profits.
- Governments and Central Banks
The market also includes participants who are not seeking to make profit, such as governments and central banks that trade currencies in order to improve the economic conditions in their country or as a means of intervention attempting to adjust economic or financial imbalances. Although not aiming to yield profit, the fact that they are long-term traders of forex, may well lead governments and central banks to actually earn substantial revenues from participating in the forex market.
The Risks of Forex Trading
We have seen the many benefits and advantages associated with trading forex online and identified who are the main participants in this market, but before exploring the field of forex trading any further and highlighting the pre-requisite knowledge that anyone should have before venturing into this online retail industry, we should pause a moment and shed some light on the, admittedly high risk, inherently associated with forex trading, as indeed with all other forms of trading. Many argue that those trading in the forex market expose themselves to risk that is way above average. This may be true under certain conditions, since great amounts of funds could be lost in a short time when performing a forex trade. Therefore, in order to avoid catastrophic losses, that yes may occur, all traders should only trade using their risk capital, i.e. placing on each forex trade an amount of funds that he/she can actually afford to lose.
Besides the risk of losing excessive funds through unsuccessful forex trades, another source of risk when trading forex online is falling victim of unscrupulous brokers, since forex fraud has been a persistent problem since the inception of the market. Forex brokers’ scams and fraud as well as all other forms of forex related fraudulent behaviours are discussed in great length in our dedicated forex fraud survival guide, which can be accessed from HERE.
Although industry-wide efforts, especially by the various watchdogs and regulators in the different jurisdictions, have pushed many fraudster brokers out of the market, many still remain and thus caution is always needed when selecting a forex broker or subscribing to a forex related software or other type of service.
The safer way to avoid unnecessary risks is to only deal with forex brokers and service providers that are members of, and remain in good standing with, a recognized financial regulator. For a detailed list of the main such regulators across the globe, read our relevant post on Forex Regulatory Agencies. In case you are having trouble locating the forex regulator in your location, please email us and we will gladly offer our guidance.