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What Is Forex Trading?

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Forex, or foreign exchange, trading is an international market for buying and selling currencies, just like the stock market is for shares of a company. Like the stock market, you don't actually take possession of the currency. It is a way to profit from the changing value of these currencies based on their exchange rate. In fact, the forex market is how currency exchange rates are set.

Foreign Exchange Trading Is Growing:

Forex trading kept growing right on through the 2008 financial crisis. Since 2007, trading skyrocketed by nearly 40%. According to the Bureau for International Settlements, average daily forex trading in 2010 was $4.4 trillion, compared to $3.2 trillion traded per day in 2007. Even this was up 30% from $2 trillion per day traded in 2004. (Source: Bureau for International Settlements, Trienniel Central Bank Survey of Foreign Exchange and Derivatives Markets, December 2010)

Why Does Forex Trading Keep Growing?:

There are several reasons for this incredible growth. First, there is simply more hedging by corporations. Multi-nationals must trade in currencies to protect their sales to foreign countries. If not, then if that country's currency declines, the multi-national's sales will, too -- even if the volume of products sold increases.

Second, currency trading by hedge funds and other investment companies is increasing. This is a source of revenue for these banks that saw their profits decline after the sub-prime mortgage crisis. These investment companies are constantly looking for new ways to invest profitably. Currency trading is a perfect outlet for financial experts who have the quantitative skills to invest in complicated arenas.

Fourth, there is more trading in emerging market currencies as they have become more important global economic players. The "BRIC" countries -- Brazil, Russia, India, and China -- were left relatively unharmed by the recession. As a result, forex traders see their economies as less risky than before. Furthermore, as global trade with these markets increases, so too does the need to hedge exposure to their currencies.

Why Didn't the Recession Reduce Forex Trading?:

Despite these long-term trends, the BIS was surprised that the recession didn't affect the growth of forex trading, like it did for so many other forms of financial investing. The BIS survey found that 85% of the growth was because of increased trading activity of "other financial institutions." A lot of the trading is done by just a few high-frequency traders. Many of them work for banks, who are now increasing this portion of their business on behalf of the biggest dealers. Last but not least, is an increase of online trading by retail (or ordinary) investors. It has become much easier for all of these groups to trade electronically.

This shift is compounded by algorithmic trading, or program trading. That means computer experts, or "quant jocks" can set up programs that automatically transact trades when certain parameters are met. These parameters can be central bank interest rate changes, an increase or decrease in a country's GDP, or a change in the value of the dollar itself. Once one of these parameters are met, the trade is automatically executed.

An Underlying Reason -- Lower Volatility:

In addition to the reasons mentioned above, a long-term trend is that forex volatility is declining. This includes historical volatility (how much prices actually went up and down) and implied volatility (how much future prices are expected to vary, as measured by futures options). In the late 1990s, volatility was usually in the teens, sometimes as high as 20% (U.S. dollar vs yen). Today, volatility, especially with the euro and the yen, is below 10%.

Why Is Volatility Lower?:

One reason volatility has been lower is that inflation has been low and stable in most economies. Central banks have learned how to measure, anticipate, and adjust for inflation. Second, central bank policies are more transparent, meaning they signal more clearly what they intend to do, so markets are less likely to overreact. Third, many countries have also built up large foreign exchange reserves, which discourages speculation in their currency. Speculation creates volatility.
Fourth, more countries are adopting flexible exchange rates, which allow for natural, and gradual, movements. Fixed exchange rates are more likely to let pressure build up. When market forces finally overwhelm them, it causes huge swings in exchange rates. Fifth, better technology allows for faster response on the part of forex traders, leading to more natural currency adjustments. The more traders, the more trades, contributing to additional smoothing in the market.

How Forex Affects the U.S. Economy:

Lower volatility in forex trading means less risk in the global economy than in past decades. Why? Central banks have become smarter, while the forex markets are now more sophisticated, and therefore less likely to be manipulated. This means that dramatic losses based on currency fluctuations alone (like we saw in Asia in 1998) are less likely to happen.

However, the global recession means fewer opportunities for trading and profitability in other areas, such as the stock market, commodities futures and real estate. This means traders may start speculating more in the forex market. This could create a bubble that could be as damaging as the ones in those other sectors. Because of the trillions traded in forex, even larger losses could be incurred.

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