The foreign exchange or forex market represents the global market where individuals and institutions come to buy and sell currencies. It is the largest financial market in the world in terms of trading volume and involves numerous participants across different segments. The market is essential to globalization because it facilitates international trade and promotes investments through currency conversion.
Note that on the top of the market is the interbank exchange segment consisting of large international commercial and investment banks. Commercial companies requiring currency conversion to purchase goods and services also represent another segment. Central banks also partake in forex trading by fixing daily exchange rates and accumulating reserves of key currencies as part of their monetary policy.
Other participants of the foreign exchange markets include investment management firms that use forex trading to pay for foreign securities purchases or participate in speculative trading. Non-bank foreign exchange companies provide readily accessible over-the-counter currency conversion services to individuals and smaller organizations while money transfer or remittance companies indirectly participate through global high-volume low-value transfers.
The so-called retail forex traders collectively represent another segment of the forex market consisting of individuals, smaller organizations, and brokers and banks involved in speculative trading. They buy and sell currencies through trading platforms to maximize the highs and lows in market prices to take small albeit more frequent profits.
Pros: The Advantages of Forex Trading
Macroeconomic Benefits to the Global Economy
Trading generally allows money to flow where it is needed the most. Note that currencies do not only serve as a medium of exchange or a store of value. They are assets that can be used as financial instruments that can be traded or held within a certain period to provide future benefits in the form of profit or investment return.
Because the forex market is part of the entire financial markets, when institutions and individuals participate in the trading of foreign currencies, they are indirectly helping in facilitating the smooth operations of capitalist economics. Remember that the forex market also assists international trade and promotes investment and trading.
Unique Characteristics of the Forex Market
In considering the benefits or advantages of forex trading, especially when compared to other assets or financial instruments, it is important to note that the unique characteristics of the foreign exchange market. These include high liquidity due to high trading volume, geographical dispersion, and continuous 24-hour operation during the weekdays.
Other characteristics include low margins of relative profit while the possibility of using leverage to improve profit and loss margins. When compared to other instruments, these unique characteristics make the foreign exchange market the closet to the ideal of perfect competition. To a certain extent, forex trading is somewhat an equalizer.
Specific Benefits of Retail Forex Trading
Retail forex trading has specific advantages to individual traders. These include accessibility and ease of entry that allow virtual to generate profits through different buy-and-sell or trading techniques. The low cost or low capital requirements make the forex market more accessible compared with other financial markets.
The availability of digital trading platforms makes retail forex trading easier. Most of these platforms have features and tools for different trading techniques such as day trading and swing trading. They also include automation features that can be configured using a set of rules or conditions such as stop-loss, programmed entries, and price limitation features.
A Note on Liquidity of the Forex Market
Capitalizing on the liquidity of the foreign exchange market is another advantage of forex trading. Remember that it is the most liquid market in the world because it has the largest trading volume and the largest number of participants. The high level of liquidity allows the efficient fulfillment of large orders of trades without large price deviations.
There are more specific benefits stemming from this high liquidity. These include the potential for higher and faster returns or profits, lower probability of price manipulation and price anomalies, more efficient pricing due to tighter spreads, and almost inexistence of high price volatility or stagnant prices during a particular time of the day.
Cons: The Disadvantages of Forex Trading
Specific Criticism on Currency Speculation
Economists such as Milton Friedman have argued that speculation is a stabilizing force in the market. Because trading is a form of speculation, it has the function of providing financial markets with a risk transfer mechanism from those who do not want to take financial risks to those who are willing and capable to do so.
However, some economists have reservations against individual traders. Some of these people could be “noise traders” that provide little to no value to the financial markets. These traders are not informed actors. Their participation in financial markets can cause the levels of prices and risk to diverge from expectation despite the presence of rational traders.
Others have noted that speculation through retail currency trading is nothing but gambling, similar to the criticisms of cryptocurrency trading. An occurrence in Sweden in 1992 compelled the Swedish central bank to raise interest rates by 500 percent due to the negative impacts of currency speculation on the value of the krona.
Drawbacks of Forex Trading for Individuals
Despite the aforementioned advantages of forex trading, the forex market has certain risks and other characteristics that collectively constitute the disadvantage of retail forex trading. Inexperienced individuals can experience severe losses if they do not know how to calculate leverage or have no idea about capital exposure.
Competition can also be tough. Remember that the foreign exchange market is the largest financial market in the world. Retail traders are competing against other retail traders and larger institutional traders. Institutional traders have better access to market data, subject-matter experts, and sophisticated software and hardware for more efficient trading.
The decentralized nature of the market also means that there is an absence of transparency and a single authority that can oversee the entirety of global foreign exchange trading. This means that some brokers are not required to be as transparent as possible. In addition, the lack of a governing authority allows the continued presence of fraud.
FURTHER READINGS AND REFERENCES
- Friedman, M. 1960. In Defense of Destabilizing Speculation. University of North Carolina Press.
- Glantz, M. and Kissell, R. 2014. “Foreign Exchange Market and Interest Rates.” In Multi-Asset Risk Modeling. 217-246. Elsevier. DOI: 1016/b978-0-12-401690-3.00007-x
- Melvin, M. and Norrbin, S. 2017. “The Foreign Exchange Market.” In International Money and Finance. 3-24. Elsevier. DOI: 1016/b978-0-12-804106-2.00001-0