FOREX TRADING CONCEPT
What Is the Forex Market?
The foreign exchange market is where currencies are traded. Currencies are important to most people around the world, whether they realize it or not, because currencies need to be exchanged in order to conduct foreign trade and business. If you are living in the U.S. and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French for the cheese in euros (EUR). This means that the U.S. importer would have to exchange the equivalent value of U.S. dollars (USD) into euros. The same goes for traveling. A French tourist in Egypt can’t pay in euros to see the pyramids because it’s not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate.
One unique aspect of this international market is that there is no central marketplace for foreign exchange. Rather, currency trading is conducted electronically over the counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney—across almost every time zone. This means that when the trading day in the U.S. ends, the forex market begins anew in Tokyo and Hong Kong. As such, the forex market can be extremely active any time of the day, with price quotes changing constantly.
History of Forex Trading
Unlike stock markets, which can trace their roots back centuries, the forex market as we understand it today is a truly new market. Of course, in its most basic sense—that of people converting one currency to another for financial advantage—forex has been around since nations began minting currencies. But the modern forex markets are a modern invention. After the accord at Bretton Woods in 1971, more major currencies were allowed to float freely against one another. The values of individual currencies vary, which has given rise to the need for foreign exchange services and trading.
Commercial and investment banks conduct most of the trading in the forex markets on behalf of their clients, but there are also speculative opportunities for trading one currency against another for professional and individual investors.
There are actually three ways that institutions, corporations and individuals trade forex: the spot market, the forwards market, and the futures market. Forex trading in the spot market has always been the largest market because it is the “underlying” real asset that the forwards and futures markets are based on. In the past, the futures market was the most popular venue for traders because it was available to individual investors for a longer period of time. However, with the advent of electronic trading and numerous forex brokers, the spot market has witnessed a huge surge in activity and now surpasses the futures market as the preferred trading market for individual investors and speculators. When people refer to the forex market, they usually are referring to the spot market. The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.
More specifically, the spot market is where currencies are bought and sold according to the current price. That price, determined by supply and demand, is a reflection of many things, including current interest rates, economic performance, sentiment towards ongoing political situations (both locally and internationally), as well as the perception of the future performance of one currency against another. When a deal is finalized, this is known as a “spot deal.” It is a bilateral transaction by which one party delivers an agreed-upon currency amount to the counter party and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present (rather than the future), these trades actually take two days for settlement.
Unlike the spot market, the forwards and futures markets do not trade actual currencies. Instead they deal in contracts that represent claims to a certain currency type, a specific price per unit and a future date for settlement.
In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves.
In the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange. In the U.S., the National Futures Association regulates the futures market. Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments that cannot be customized. The exchange acts as a counterpart to the trader, providing clearance and settlement.
Both types of contracts are binding and are typically settled for cash at the exchange in question upon expiry, although contracts can also be bought and sold before they expire. The forwards and futures markets can offer protection against risk when trading currencies. Usually, big international corporations use these markets in order to hedge against future exchange rate fluctuations, but speculators take part in these markets as well.
Note that you’ll often see the terms: FX, forex, foreign-exchange market, and currency market. These terms are synonymous and all refer to the forex market.
How Forex Markets Work
There are three primary forex markets — spot, forwards, and futures markets. The spot market is by far the most popular, and consists of the real asset that both the futures and forwards markets are based on.
Forex market participants range from international banks to enterprises that deal in various countries who are looking to hedge risk on the exchange rates they use for dealing in multiple currencies.
The spot market is where currencies are bought and sold at their current market price. The prices of currencies fluctuate consistently, many times by only a tiny fraction of their current value. A mixture of economic, political, and supply/demand affect the price of currencies, and markets are exceptionally liquid for primary trading pairs around the world.
For instance, the EUR/USD trading pair is the most traded currency pair in the world. Listed as EUR/USD makes the EUR the ‘base’ currency and USD the ‘counter.’ The price in the spot market next to this pair indicates the price of one Euro in USD. There will be a buy and a sell price, and the difference between the two is commonly referred to as the ‘spread.’
Spreads & Leverage
The spread between currencies is often minuscule, and price quote changes are typically measured to the fourth decimal place — known as a ‘pip.’ Traders are always buying or selling the first currency in a pair and can profit or sustain losses from the resulting movement of the spread.
Obviously, with such tiny spreads, profiting from forex trading often requires trading high volumes or trading on margin. Due to the massive liquidity of the forex market, banks allow for significant leverage for traders to buy currencies on margin.
Trades on the spot market are settled in cash and are comprised of an agreement between counter-parties to buy a specific amount of one currency in exchange for a fixed amount of another currency at the current market price.
Forwards markets in forex trading deal in contracts that specify explicit parameters for buying or selling currencies in an OTC transaction. Futures contracts are settled on major commodities exchanges like CBOE and CME and contain specific delivery dates and standard sizes.
Futures and forwards contracts are typically settled in cash also and are often used for hedging risk on future price movements.
Numerous entities participate in the forex market, and it is a primary reason for the enormous liquidity of the market.
The forex market is divided into tiers based on the amount of money being traded. The upper layer consists of major commercial banks and securities dealers, who account for 51 percent of all transactions in the market. Citigroup Inc. is the leading currency trader in the foreign exchange market, accounting for 12.9 percent of the overall market in 2016.
The subsequent layers are comprised of smaller banks, corporations, market makers, insurance companies, mutual funds, and more.
In particular, one of the primary applications of the forex market is for companies that deal in multiple international currencies to hedge risk. They may need to pay employees located in numerous countries or reduce the adverse consequences of price fluctuations during business transactions.
For example, if Company A is based in the U.S. and wishes to use the EUR/USD trading pair to buy Euros to pay employees located in Europe, they would tap the forex market. However, if the price quote rapidly changes between several hours and Company A is set to exchange a large sum of USD for EUR, then a small adverse price fluctuation could have a significant impact on their bottom line.
Companies may also leverage futures or forwards contracts to hedge against adverse price movements on predetermined transaction dates, which is a widespread practice among international corporations.
Another major participant is central banks of countries who use foreign exchange fixing as a specific indicator for market trends and evaluating their own currencies. Similarly, central banks tap foreign exchange services with reserve currencies (i.e., the US Dollar) to attempt to stabilize markets.
A growing portion of forex market participants is retail traders who invest through banks or brokers. The two primary types of brokers for retail traders are brokers and market makers. Brokers take a fee from customers for finding the best price and trading on behalf of them while market makers are the principal in a transaction against a retail trader.
The demand for social trading services has become more prevalent as retail investors also seek to become more prudent in their broker selection following endemic fraud that many retail traders have historically faced. Regulation has also increased noticeably in forex markets over the last decade, and many smaller brokerage companies employing questionable operational practices have been removed from the market.
Other forex participants include money remittance companies. Remittance companies provide a highly practical service for migrant workers sending money home but have been justly criticized for their exorbitant fees and inefficient services.
We have covered quite a few Forex Brokers here on Blockonomi, these brokers are open to retail traders or professionals and offer a wide range of trading instruments such as Forex, Cryptocurrencies, Commodities, Shares and so on.
They typically use Contracts for Difference (CFDs) which means you don’t own the underlying asset but they are essentially a bet between the opening and closing prices of a specified financial instrument.
Digital Assets and The Future of Forex Trading
The sheer size of the forex market is astounding. Driven by an ecosystem of floating fiat currencies without a stable price peg, the forex market has come to dominate global financial markets as the most liquid asset class in the world.
Interestingly, the emergence of cryptocurrencies and digital assets have provided a viable alternative to traditional foreign exchange services like remittances.
Digital assets are also expected to become more ingratiated with the conventional financial system, and the expansion of trading pairs of many digital assets serves as a stark indicator of their inclusion within the financial portfolio and investment services of brokers.
The forex market is a unique financial ecosystem that has been referenced as the closest market to perfect competition due to its massive size and continual operation.
However, proponents of sound money like Bitcoin and gold take a hesitant outlook on the long-term sustainability of floating fiat currencies. The forex market’s size and complexity are a direct result of the dissolution of Bretton Woods and are indicative of the challenges required for an international monetary order of various national floating currencies to persist without the potential for black swan events.
What is a base and quote currency?
A base currency is the first currency listed in a forex pair, while the second currency is called the quote currency. Forex trading always involves selling one currency in order to buy another, which is why it is quoted in pairs – the price of a forex pair is how much one unit of the base currency is worth in the quote currency.
Each currency in the pair is listed as a three-letter code, which tends to be formed of two letters that stand for the region, and one standing for the currency itself. For example, GBP/USD is a currency pair that involves buying the Great British pound and selling the US dollar.
So in the example below, GBP is the base currency and USD is the quote currency. If GBP/USD is trading at 1.35361, then one pound is worth 1.35361 dollars.
If the pound rises against the dollar, then a single pound will be worth more dollars and the pair’s price will increase. If it drops, the pair’s price will decrease. So if you think that the base currency in a pair is likely to strengthen against the quote currency, you can buy the pair (going long). If you think it will weaken, you can sell the pair (going short).
To keep things ordered, most providers split pairs into the following categories:
Major pairs. Seven currencies that make up 80% of global forex trading. Includes EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD and AUD/USD
Minor pairs. Less frequently traded, these often feature major currencies against each other instead of the US dollar. Includes: EUR/GBP, EUR/CHF, GBP/JPY
Exotics. A major currency against one from a small or emerging economy. Includes: USD/PLN (US dollar vs Polish zloty) , GBP/MXN (Sterling vs Mexican peso), EUR/CZK
Regional pairs. Pairs classified by region – such as Scandinavia or Australasia. Includes: EUR/NOK (Euro vs Norwegian krona), AUD/NZD (Australian dollar vs New Zealand dollar), AUD/SGD
What moves the forex market?
The forex market is made up of currencies from all over the world, which can make exchange rate predictions difficult as there are many factors that could contribute to price movements. However, like most financial markets, forex is primarily driven by the forces of supply and demand, and it is important to gain an understanding of the influences that drives price fluctuations here.
Supply is controlled by central banks, who can announce measures that will have a significant effect on their currency’s price. Quantitative easing, for instance, involves injecting more money into an economy, and can cause its currency’s price to drop.
Commercial banks and other investors tend to want to put their capital into economies that have a strong outlook. So, if a positive piece of news hits the markets about a certain region, it will encourage investment and increase demand for that region’s currency.
Unless there is a parallel increase in supply for the currency, the disparity between supply and demand will cause its price to increase. Similarly, a piece of negative news can cause investment to decrease and lower a currency’s price. This is why currencies tend to reflect the reported economic health of the region they represent.
Market sentiment, which is often in reaction to the news, can also play a major role in driving currency prices. If traders believe that a currency is headed in a certain direction, they will trade accordingly and may convince others to follow suit, increasing or decreasing demand.
Economic data is integral to the price movements of currencies for two reasons – it gives an indication of how an economy is performing, and it offers insight into what its central bank might do next.
Say, for example, that inflation in the eurozone has risen above the 2% level that the European Central Bank (ECB) aims to maintain. The ECB’s main policy tool to combat rising inflation is increasing European interest rates – so traders might start buying the euro in anticipation of rates going up. With more traders wanting euros, EUR/USD could see a rise in price.
Investors will try to maximise the return they can get from a market, while minimising their risk. So alongside interest rates and economic data, they might also look at credit ratings when deciding where to invest.
A country’s credit rating is an independent assessment of its likelihood of repaying its debts. A country with a high credit rating is seen as a safer area for investment than one with a low credit rating. This often comes into particular focus when credit ratings are upgraded and downgraded. A country with an upgraded credit rating can see its currency increase in price, and vice versa.
How does forex trading work?
There are a variety of different ways that you can trade forex, but they all work the same way: by simultaneously buying one currency while selling another. Traditionally, a lot of forex transactions have been made via a forex broker, but with the rise of online trading you can take advantage of forex price movements using derivatives like CFD trading.
CFDs are leveraged products, which enable you to open a position for a just a fraction of the full value of the trade. Unlike non-leveraged products, you don’t take ownership of the asset, but take a position on whether you think the market will rise or fall in value.
Although leveraged products can magnify your profits, they can also magnify losses if the market moves against you.
What is the spread in forex trading?
The spread is the difference between the buy and sell prices quoted for a forex pair. Like many financial markets, when you open a forex position you’ll be presented with two prices. If you want to open a long position, you trade at the buy price, which is slightly above the market price. If you want to open a short position, you trade at the sell price – slightly below the market price.
What is a lot in forex?
Currencies are traded in lots – batches of currency used to standardise forex trades. As forex tends to move in small amounts, lots tend to be very large: a standard lot is 100,000 units of the base currency. So, because individual traders won’t necessarily have 100,000 pounds (or whichever currency they’re trading) to place on every trade, almost all forex trading is leveraged.
What is leverage in forex?
Leverage is the means of gaining exposure to large amounts of currency without having to pay the full value of your trade upfront. Instead, you put down a small deposit, known as margin. When you close a leveraged position, your profit or loss is based on the full size of the trade.
While that does magnify your profits, it also brings the risk of amplified losses – including losses that can exceed your margin . Leveraged trading therefore makes it extremely important to learn how to manage your risk.
What is margin in forex?
Margin is a key part of leveraged trading. It is the term used to describe the initial deposit you put up to open and maintain a leveraged position. When you are trading forex with margin, remember that your margin requirement will change depending on your broker, and how large your trade size is.
Margin is usually expressed as a percentage of the full position. So, a trade on EUR/GBP, for instance, might only require 1% of the total value of the position to be paid in order for it to be opened. So instead of depositing AUD$100,000, you’d only need to deposit AUD$1000.
What is a pip in forex?
Pips are the units used to measure movement in a forex pair. A forex pip is usually equivalent to a one-digit movement in the fourth decimal place of a currency pair. So, if GBP/USD moves from $1.35361 to $1.35371, then it has moved a single pip. The decimal places shown after the pip are called fractional pips, or sometimes pipettes.