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What is Foreign Exchange Trading?

John D. Henderson
John D. Henderson

Foreign exchange (FX) trading, sometimes called forex trading, is the simultaneous buying and selling of one currency for another. In foreign exchange trading, each exchange consists of a currency pair, with the base currency being bought and the counter currency being sold. The pairing shows how many units of the counter currency are needed to purchase a single unit of base currency. This creates the exchange rate, or price, of one currency in relation to the other.

When taking part in foreign exchange trading, literally exchanging money or creating foreign bank accounts is unnecessary. Instead, an account can be set up with foreign exchange services or dealers. Unlike the stock market, the foreign exchange market is very decentralized, and all of the trades take place through independent dealers. This means that foreign exchange trading is done over the counter (OTC). Currencies are not traded based on a designated exchange rate around the world, so each dealer can potentially decide its own rate.

Man climbing a rope
Man climbing a rope

There are three types of primary parties that commonly partake in foreign exchange trading. The first is major banking and investment institutions. In most cases, commercial banks will take part in the foreign exchange market as dealers on the behalf of their customers. In most cases, these institutions do not take part in trading as a means of generating revenue because of the foreign exchange risk. This risk comes from the constant fluctuations of the exchange rates.

The second primary party is any business that is involved with international investment or trade. In most cases, these businesses will operate through a dealer, like a commercial bank, but this is not always the case. The third primary party consists of businesses and individuals who try to add foreign exchange trading as part of their portfolio. This group will try to predict the exchange rate and make trades to maximize any gains that are created by market pressures and fluctuations.

There also is an additional group of people who complete foreign exchange trading. They are people who need to exchange currencies for a usability purposes. They could be taking a vacation abroad or just sending money to relatives living in another country. This group uses the foreign exchange market because they need to, rather than because they necessarily want to.

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