About currency trading & foreign currency exchange

Most people are aware that nearly every country in the world issues its own currency. When visiting, moving to or doing business with another country, it is more than likely that one currency will have to be exchanged for another by performing a currency conversion before it can be spent. In time, the need to exchange money evolved into a free market. One-by-one, major world powers converted their currency systems from a standard based on precious metal reserves to a floating system using only the value of the currency given to it by the market. As the currency market grew, financial investors began to speculate on the future value of world currencies, and currency trading became a major vehicle for investment and profit.

The foreign currency exchange

The market on which currencies are valued and traded is the foreign currency exchange. It is also commonly known as the Forex or FX market. Since it first began forming in the 1970s, the Forex has grown substantially. It is now the largest free market in the world, with an average daily turnover many times greater than that of any stock exchange. In 2010, the average amount of money traded each day on the Forex was over $3.67 trillion AUD.

Although the foreign exchange is often compared to other markets used for investment, such as the stock market, it is unique in several ways. One of the most unique and important characteristics of the forex is that it is completely decentralised and dispersed geographically throughout the world. In theory, the forex is a free and pure market, untouched by external controls. In reality, most countries have passed legislation regarding currency trading, either in an attempt to control local trading or to prevent abuse.

Because the Forex market is decentralised and has no official headquarters or building, it is called an over-the-counter (OTC) market. It operates completely through a network comprised of individual banks and currency brokers. The decentralised nature of the forex has made it a 24 hour per day market because, although it opens and closes locally, another is always open in a different time zone. The exact hours of the market in any given week are from 00:00 GMT Monday to 22:00 GMT Friday.

Currency trading basics

Currency trading is essentially the purchase of one currency using another currency. Therefore, currency is always traded in pairs. When currency is traded for profit, it is a speculative trade in that the hope is the new currency will eventually rise in value so it can be traded into more of the original currency than was initially spent. However, in modern currency trading, individual traders do not usually fully convert their currency. The trading is done by banks or other entities on the traders’ behalf, and the value is kept track of electronically as a single currency. This allows the trader to make deposits or withdrawals from the trading account at any time.

While most of the world’s currencies are listed on the foreign exchange, several currencies and currency pairs make up the bulk of the trading. The top five currencies exchanged, as of April 2010, are as follows:

• United States dollar (USD) 84.9%
• Euro (EUR) 39.1%
• Japanese yen (JPY) 19.0%
• Great Britain pound sterling (GBP) 12.9%
• Australian dollar (AUD) 7.6%

Currency trading by individuals is carried out directly through a bank or through a currency broker. The majority of trades are accomplished through proprietary online systems called platforms. A platform provides a currency trader with account information, real-time quotes, tools for analysis and the ability to execute trades. Since the market is open 24 hours/day during weekdays, trades can usually be instantly executed.

Currency trading has an advantage over other equity trading by not always charging commissions for trades. While some brokers and banks charge a trading fee or a commission, the most highly competitive do not. This is because the forex market works on a multi-tiered system. The largest banks and financial organisations trade on the top tier, called the interbank exchange. Individuals trade on a lower tier with slightly higher rates. This allows the banks to make money from all individual trades without having to charge a fee or commission. This is similar to wholesale and retail prices in the retail business or to a bid and ask price on the stock market.