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The currency market (also called Forex, or the foreign exchange market) is the largest market in the world. It is a global network of currency dealers, banks and other financial institutions. Currency traders move money around the world and from one currency to another for various reasons. Collectively, their transactions average over $3 trillion each business day (as of 2007).
Put simply, currency traders swap one currency for another. Corporations, governments and other financial institutions move huge sums from one country to another each day as part of normal operations. But by far the largest part of currency exchange (80 percent) is speculative trading. Traders ranging in size from individuals to giant hedge funds buy and sell currencies, hoping to profit off fluctuations in currency exchange rates. Because almost all trading is via the Internet with no physical exchanges, trading continues 24 hours a day, every business day.
Each nation’s currency has a value relative to other currencies. The value relative to any other currency is called the exchange rate. Currencies always trade in pairs, and each pair is considered a different “product.” For example, the Euro and the U.S. dollar (the most widely traded pair) might have an exchange rate at a particular time of $1.3475 per Euro. This will be quoted as EUR/USD = 1.3475. If the rate changes so the dollar declines against the Euro, it will take more U.S. currency to buy Euros, and the quote might change to something like EUR/USD = 1.4054.
To understand what currency traders do, you have to know some specific features of currency trading. A key term is the pip. A pip (percentage in point) is the smallest amount by which an exchange rate can change. For the EUR/USD pair, the pip is $0.0001 (1/100 cent). When a buyer makes an offer (bid) and a seller states a price (ask), the bid/ask difference is called the spread. For currency wholesalers, the spread is only 1 to 2 pips. Retail dealers set the spread higher, at 3 to 20 pips, and keep the difference (rather than charging a commission). At either the wholesale or retail level, the currency trader tries to guess the direction of the market. If the guess is correct and the change in exchange rates “beats the spread,” the trader makes a profit.
Forex is well-known for its high profit potential and equally high risk. Both result from the fact that currency trading is done on margin. It’s common for the ratio between a lot (usually $100,000) and the margin requirement to be up to 400:1—meaning a Forex trader only has to put up $250 to “buy” $100,000 worth of a currency. Consequently, even a change of a single pip becomes important. Small shifts in exchange rates can easily double a trader’s money—or wipe out the funds that were put up to meet the margin requirement.
Good currency traders combine their willingness to take risks with careful analysis and a degree of caution. The successful currency trader studies and keeps abreast of national monetary and trade policies, announcements by central banks and other news, and the patterns revealed by market trends. To be a currency trader, you need a good broker who will provide real-time quotes, online trading software and reasonable prices. It’s also important to be selective in choosing a broker/dealer, since the currency market is almost entirely unregulated. In the U.S., the safest course is to choose a dealer who is a member of a self-regulating organization like the National Futures Association.