Currency exchange is the trading of one currency against another. Professionals refer to this as foreign exchange, but may also use the acronyms Forex or FX.

Currency exchange is necessary in numerous circumstances.

Consumers typically come into contact with currency exchange when they travel. They go to a bank or currency exchange bureau to convert one currency (typically, their "home currency") into another (i.e. the currency of the country they intend to travel to) so they can pay for goods and services in the foreign country. Consumers may also purchase goods in a foreign country or via the Internet with their credit card, in which case they will find that the amount they paid in the foreign currency will have been converted to their home currency on their credit card statement. Although each such currency exchange is a relatively small transaction, the aggregate of all such transactions is significant.

Businesses typically have to convert currencies when they conduct business outside their home country. For example, if they export goods to another country and receive payment in the currency of that foreign country, then the payment must often be converted back to the home currency. Similarly, if they have to import goods or services, then businesses will often have to pay in a foreign currency, requiring them to first convert their home currency into the foreign currency. Large companies convert huge amounts of currency each year; for example, a company such as General Electric (GE) converts tens of billions of dollars each year. The timing of when they convert can have a large affect on their balance sheet and "bottom line.

Investors and speculators require currency exchange whenever they trade in any foreign investment, be that equities, bonds, bank deposits, or real estate. For example, when a Swedish investor buys shares in Sun Microsystems on the NASDAQ, she will have to pay for the shares in U.S. Dollars and likely have to convert Swedish Krona to U.S. Dollars. Similarly, a Japanese real estate investor who sells a New York property may well want to convert the proceeds of the sale in U.S. Dollars to Japanese Yen.

Investors and speculators also trade currencies directly in order to benefit from movements in the currency exchange markets. For example, if an American investor believes that the Japanese economy is strengthening and as a result expects the Japanese Yen to appreciate in value (i.e. go up relative to other currencies), then she may want to buy Japanese Yen and take what is referred to as a long position. Similarly, if an American investor believes that the Euro will go down over time, then she may want to sell Euro to take a short position. Interestingly, investors and speculators can profit equally from currencies becoming stronger (by taking a long position) or from currencies becoming weaker (by taking a short position). Speculators are often day traders, trying to take advantage of market movements in very short time periods; buying a currency and then selling it again may happen within hours or even minutes. They are attracted to currency trading for numerous reasons, including (i) the size and daily volatility of the market, which gives them unparalleled excitement, (ii) the almost perfect liquidity of the currency exchange market, (iii) the fact that the currency exchange market is "open" 24 hours a day market, and (vi) the fact that currencies can be traded with no brokerage charges.

Commercial and Investment Banks trade currencies as a service for their commercial banking, deposit and lending customers. These institutions also generally participate in the currency market for hedging and proprietary trading purposes.

Governments and central banks trade currencies to improve trading conditions or to intervene in an attempt to adjust economic or financial imbalances. Although they do not trade for speculative reasons --- they are a non-profit organization --- they often tend to be profitable, since they generally trade on a long-term basis.

Currency exchange rates are determined by the currency exchange market. (The currency exchange market is described further below.) A currency exchange rate is always quoted for a currency pair using ISO code abbreviations. For example, EUR/USD refers to the two currencies Euro (the European currency) and U.S. Dollar. The first is referred to as the base currency, while the second as the quote currency. The EUR/USD exchange rate specifies how many US Dollars you have to pay to buy one Euro, or conversely how many US Dollars you obtain when you sell one Euro. More generally, if buying, an exchange rate specifies how much you have to pay in the quote currency to obtain one unit of the base currency, and if selling, the exchange rate specifies how much you get in the quote currency when selling one unit of the base currency.

A currency exchange rate is typically given as a pair consisting of a bid price and an ask price. The ask price applies when buying a currency pair and represents what has to be paid in the quote currency to obtain one unit of the base currency. The bid price applies when selling and represents what will be obtained in the quote currency when selling one unit of the base currency. The bid price is always lower than the ask price.

In the currency market, the following abbreviation for the currency exchange rate pair is used:

0.8423/28

The first component (before the slash) refers to the bid price (what you obtain in USD when you sell EUR), and in this case includes four digits after the decimal point. The second component (after the slash) is used to obtain the ask price (what you have to pay in USD if you buy EUR). The ask price is obtained by increasing the first component until the last two decimal places are equal to the digits in the second component. In this example, the ask price is 0.8428. As another example, 0.8498/03 refers to a bid price of 0.8498 and an ask price of 0.8503. (Note that for some exchange rates it is customary to quote rates in units of 100, as is the case with USD/JPY.)

The difference between the bid and the ask price is referred to as the spread. When trading large amounts of $1M or higher, the spread obtained in a quote is typically 5 basis points or PIPs, with each basis point referring to 0.0001 (or 0.01 when, say, the Yen is involved). In the example above, the spread is 0.0005 or 5 PIPs. When trading smaller amounts, the spread may be larger; for example, when trading less than $100,000, spreads of 50-200 PIPs are common. Credit card companies typically apply a spread of 200-300 PIPs. Banks and exchange bureaus typically use a spread in the range of 200-1000 PIPs (in addition to charging a commission). For investors and speculators, a lower spread translates into easier profit taking due to movements in exchange rates.

The currency exchange market is an inter-bank or inter-dealer market that was established in 1971 when floating exchange rates began to materialize. In addition, it is an Over-The-Counter market, meaning that transactions are conducted between any two counter parties that agree to trade via the telephone or electronic network. Trading is thus not centralized, as is the case with many stock markets (i.e. NYSE, ASE, CME) or as the case for currency futures and currency options, which trade on special exchanges. Dealers often "advertise" exchange rates using a distribution network, such as the one provided by Reuters or Bridge. Dealers then use the information obtained there (or directly) to "agree" to a rate and a trade.

The major dealing centers today are: London, with about 30% of the market, New York, with 20%, Tokyo, with 12%, Zurich, Frankfurt, Hong Kong and Singapore, with about 7% each, followed by Paris and Sydney with 3% each.

In terms of trading volume, the currency exchange market is the worlds largest market, with daily trading volumes in excess of $1.5 trillion US dollars. This is orders of magnitude larger than the bond or stock market. For example, the New York Stock Exchange has a daily trading volume of approximately $60 billion. Thus, the currency exchange market is by far the most liquid market in the world today. Because of the volume in trading, it is impossible for individuals or companies to affect the exchange rates. In fact, even central banks and governments find it increasingly difficult to affect the exchange rates of the most liquid currencies, such as the US dollar, Japanese Yen, Euro, Swiss Frank, Canadian Dollar or Australian Dollar.

The currency exchange market is a true 24-hour market, 5 days a week. There are dealers in every major time zone. Trading begins Monday morning in Sydney (which corresponds to 3pm EST, Sunday) and then daily moves around the globe through the various trading centers until closing Friday evening at 4:30pm EST in New York.

Today, over 85% of all currency exchange transactions involve a few major currencies: the US Dollar (USD), Japanese Yen (JPY), Euro (EUR), Swiss Frank (CHF), British Pound (GBP), Canadian Dollar (CAD), and Australian Dollar (AUD). In the currency exchange market, most of the currencies are traded only against the US Dollar. The term cross rate refers to an exchange rate between two non-dollar currencies. Trading between two non-dollar currencies usually occurs by first trading one against the US Dollar and then trading the US Dollar against the second non-dollar currency. Because of this, the spread in the exchange rate between two non-dollar currencies is often higher. (There are a few non-dollar currencies that are traded directly, such as GBP/EUR or EUR/CHF.) The following directly traded currency pairs make up the vast majority of the trading volume and are thus considered to be the most important ones: EUR/USD, USD/JPY, EUR/JPY, USD/CAD, EUR/GBP, GBP/USD, USD/CHF, AUD/USD, and AUD/JPY.

Trading currencies has a number of benefits over equity trading, including:

• 24 hour trading:
  The currency exchange market is a true 24-hour market. In contrast, equity trading is restricted to the operating hours of their exchanges (which some are extending to accommodate the requirements of traders). While after-hours trading has become available through Electronic Communication Networks (ECN), there are no guarantees that the market will be liquid at all times, there are no guarantees that trades will be executed at "market prices", and often traders will receive a significantly higher spread.
• High liquidity:
  It is always possible to find dealers willing to buy or sell currencies at fair market price, because trading volume in the currency market can be 50-100 times larger than on the New York Stock Exchange and because the currency market is "open" 24 hours a day. In contrast, equities are more vulnerable to liquidity risks. Without liquidity, large price movements may occur when individual transactions take place.
• Intra-day volatility:
  Large volume and liquidity combined with fewer instruments generates greater intra-day volatility (i.e. rate fluctuations) in the currency market than exists in the equity markets. This volatility can be profitably exploited by day-traders.
• Low spreads:
  Currency trading offers spreads that are much lower than what can be obtained when buying or selling equities (especially in after-hour markets). Equity spreads are typically significantly higher than currency spreads. Although the tight currency spreads of 5 PIPs historically have been available only for transaction sizes of $1M or higher, a shift towards offering these tighter spreads for smaller transaction sizes is occurring. OANDAs Currency Trading System offers these types of tight spreads (and lower) for transactions as small as $1.
• No transaction costs:
  A currency transaction typically incurs no commission or transaction fee. This is in stark contrast to the equity market, where commissions for stock trades range from $8 to $70 in addition to the quoted spread.
• Profit potential in both rising and falling markets:
  In the currency market, it is equally easy to buy currency (where the speculator benefits if the rate goes up) as it is to sell short (where the speculator benefits if the rate goes down). This is in contrast to the equity market, where it is significantly more difficult to short a stock.
• Equal access to market information:
  Information that might affect currency rates is typically released by governments and is equally accessible to everyone. In contrast, professional traders and analysts in the equity market have a huge advantage by obtaining access to important corporate information, such as earning estimates and press releases, before the public has access to them.
• Leverage:
  Margin trading allows currency speculators to trade much larger amounts than they have deposited. For example, with a margin ratio of 20:1 and a deposit of $10,000, a speculator can trade amounts up to $200,000. Typically, larger margin ratios are associated with trading currencies than with trading equities. (Margin is described in more detail below.)
  

Currency trading is always done with currency pairs, such as EUR/USD, and so it is useful to consider the currency pair as an instrument, which can be bought or sold.

• Buying the currency pair implies buying the first, base currency and selling (short) an equivalent amount of the second, quote currency (to pay for the base currency). (It is not necessary for the trader to own the quote currency prior to selling, as it is sold short.) A speculator buys a currency pair, if she believes the base currency will go up relative to the quote currency, or equivalently that the corresponding exchange rate will go up.
• Selling the currency pair implies selling the first, base currency (short), and buying the second, quote currency. A speculator sells a currency pair, if she believes the base currency will go down relative to the quote currency, or equivalently, that the quote currency will go up relative to the base currency.

After buying a currency pair, the trader will have an open position in the currency pair. Right after such a transaction, the value of the position will be close to zero, because the value of the base currency is more or less equal to the value of the equivalent amount of the quote currency. In fact, the value will be slightly negative, because of the spread involved.

In todays currency market, a trade goes through a three-step process:

1. the trader communicates the currency pair and the amount he/she would like to trade with another dealer.
2. the dealer responds with a bid and an ask price
3. the trader responds to the bid and ask price with one of:
1. buy (by saying "Mine" or "I buy" or "I take")
2. sell (by saying "yours" or "I give you" or "I sell")
3. refuse.

The transaction occurs if the final response is either a buy or a sell. The dealer is required to quote a "good" market price, since he does not know whether the trader will buy or sell.

The currency exchange market described above is referred to as the spot market and the transaction described is referred to as a spot deal. A spot deal consists of a bilateral contract between a party delivering a specified amount of a given currency against receiving a specified amount of another currency from a second counter party, based on an agreed exchange rate, within two business days of the deal date, which is referred to as the settlement date. (The settlement date for USD/CAD is one business day after the deal date.) Speculators rarely deliver, however. Instead, they use what is referred to as a rollover swap. The rollover swap is designed to allow the changing of an old deal date to the current date by simultaneously closing an open position for todays date and opening the same position for the next day at a price reflecting the interest rate differential between the two currencies.

When a trader buys or sells a currency pair, the value of the currency pair, as an instrument, initially is close to zero. This is because (in the case of a buy) the quote currency is sold to buy an equivalent amount of the base currency. As the market rates fluctuate, however, the value of the currency pair position held will also fluctuate. Thus, if the rate for the currency pair goes down, the speculators long position will lose in value and become negative. To ensure that the speculator can carry the risk for the case where the position results in a loss, banks or dealers typically require sufficient collateral to cover those losses. This collateral is typically referred to as margin.

To limit down-side risk, traders often specify a Stop-Loss rate for each open trade. The Stop-Loss specifies that the trade should be closed automatically when the currency exchange rate for the currency pair in question reaches a certain threshold. For long positions, the Stop-Loss rate is always lower than the current exchange rate; for short positions, it is always higher. Traders, at times, also specify a Take-Profit rate for their trades in order to lock in a profit when the exchange rate reaches a certain threshold. For long positions, the Take-Profit rate must be above the current rate, while for short positions, it must be below the current rate.

A trader may also leave an order with a bank, broker or dealer. These so called leave orders are orders that a trade should be executed (in the future) when certain market conditions occur. There are three types of leave orders:

1. entry orders: specifies that a currency pair should be traded when it reaches a certain exchange rate. Entry orders are used when the trade would not offset a current position.
2. take-profit orders: are used to clear a position by buying (or selling) the currency pair of the position when the exchange rate reaches a specified level.
3. stop-loss orders: are used to clear a position by buying (or selling) the currency pair of the position when the exchange rate reaches a specified level.

Currency traders make decisions using both technical factors and economic fundamentals. Technical traders make decisions using two primary tools: (i) charting tools, such as trend lines, and support and resistance levels, and (ii) quantative trading models which make sue of mathematical analyses to identify trading opportunities.

Fundamentalists make decisions assuming that currency exchange rates are affected primarily by economic and political conditions, and occasionally by central banks intervening in the currency market in an attempt to influence the value of their currencies. Fundamentalists thus use economic information, including news, government-issued indicators and reports to evaluate trading opportunities. This includes changes in interest rates, inflation, money supply, productivity, gross national product, consumer spending government spending, investments, industrial production, capacity utilization, factory orders, durable goods orders, inventories, balance of trade, or employment statistics, as well as changes in political leadership, war and natural disasters.

OANDAs Currency Trading System comes from 15+ years of currency trading and econometric research. The OANDA Currency Trading System allows currency trading that is significantly more convenient than through other means. It is truly revolutionary in what it has to offer. The key aspects that set it apart from other solutions are:

• regardless of transaction size:
  The OANDA Trading System offers spreads as low as 2 PIPs, which is significantly lower than what is currently available even for professionals trading million dollar quantities.
• Supports small trading transactions, as small as $1:
  The OANDA Trading Systems supports trades in quantities as low as $1, and it offers the same low spreads even for these trades. This is orders of magnitude smaller than the $1M transaction sizes required by many institutions and the $25,000 or $100,000 minimal trading sizes required by most other Internet-based currency trading systems.
• Immediate settlement, no roll-overs:
  When a currency pair is bought or sold, settlement is immediate, and not within 2 days, as is the case in currency market today. Hence, there is no reason for roll-overs, as is required in the currency market today.
• Continuous interest rates:
  The OANDA Trading System pays (and charges) interest rates on the currency pairs held and does so by the second. Hence if you have 100,000 EUR/USD, then you will obtain interest for the 100,000 EUR and be charged interest rate for the equivalent in USD for every second the instrument is held, until it is cleared.
• 24/7 availability:
  The OANDA Trading System is available for trading 24 hours a day, 7 days a week. This is in contrast to the Forex market, in which there is no trading over the weekend.
• Internet based:
  The front-end Trading Station will run on virtually all Internet-connected browsers. It is thus available anywhere, anytime.
• Real-time rates and market news:
  The front-end Trading Station displays exchange rates in real time. Similarly, real-time market news is available.
• Analysis tools:
  The OANDA Trading System also makes available a number of analysis tools to help the speculator in deciding what currency pairs to trade and when.