The Long and Short of Forex

Forex. It used to be just for the big boys. The popularity of the Internet, however, is making it increasingly popular investment among small-time but aggressive investors who want a high return rate on their investments.

But the expectation of big bucks is exactly how an investor gets on the road to being conned by many scammers; excitement gets in the way of understanding how the forex market actually works.

The forex market works very much like the stock market, only that you're buying and selling currencies. Your profit margin or loss depends largely on the difference between the forex rate at the BUY stage and the forex rate at the SELL stage.

When you're trading in forex, you're actually like buying shares in a country, except that there are no prospects for dividends. Around US$1.9 trillion are traded daily in forex markets worldwide, with the US dollar being the most traded currency. The Euro comes in second and the Japanese Yen, third.

The same law of supply and demand that affects stocks, and other commodities for that matter, also affects forex; an increase in demand for the dollar also increases its exchange rate. In general, forex demand and supply is affected by a combination of (a) a country's economic factors such as economic policy and economic growth, (b) political conditions in that country, and (c) market perception on the country and/or currency.

The big boys that are used to forex trading are large international banks, commercial companies, central banks, investment management firms, hedge funds. Small-time forex investors who just invest several hundred dollars in forex trading are only able to trade through brokers and banks. (It is precisely because of this prevailing indirect involvement that individual investors are being targeted by scammers.)

Within the forex market several financial instruments are used: spot transaction, forward transaction, futures, currency swap, and options.

A spot transaction has a turn-around time of two days. This involves cash transactions of buying and selling currencies. Spot transactions comprise the largest volume of forex transactions among forex instruments.

In a forward transaction, the buyer and seller agree to exchange monies at a future date, at a rate that would prevail over the prevailing forex rate on the specified date. A futures instrument is a forward transaction with set contract sizes and maturity dates; $500,000 at an agreed forex rate in January 2008, for example. Futures are traded on the futures market exchange.

In currency swap, parties agree to exchange currencies for a certain time period and reverse the process at a future date.

Options, meanwhile, allow an investor to exchange on currency into another currency at a pre-agreed exchange rate on an agreed-upon date.

Knowing about these instruments should help individual investors throw the right questions at their forex brokers - scammers or otherwise.