What is Forex?
Forex or FX, short for foreign exchange, is simply the market where currencies are traded. The existence of currencies is of essence to any human being across the globe as it is the mean of satisfying needs. No matter where you live, any foreign product consumed or purchased is paid for in its national currency and hence the exchange of currencies is required.
Currencies move within a very narrow range each day making it the least volatile financial market despite the interaction of financial institutions, central banks, hedge funds and average investors. The currency usually moves less than 1% of the value of the pair which results in investors entering the markets with a large amount of leverage to increase the movements and benefit more.
The Forex market is the largest and most liquid market in the world with approximately $3.7 trillion in volume. The market is used to help ease business and investments overseas as well as a source of money for traders who do understand the market and attempt to exploit the movements. But how did all this start?
History of Forex
Forex dates back to the establishment of the gold standard monetary system in 1875 when international trade was conducted by trading gold and silver as means of payments. The problem was the fact that the metal continued to be affected by any external supply and demand factors including the discovery of a new mine which would eventually drag down the metal’s price.
It was common across the globe to use gold since governments allowed their currency to be converted into amounts of gold and vice versa. Gold exchange standards at the time were set by calculating the difference of the ounce between two currencies.
This system lasted from 1875 to 1914 with the beginning of World War I where political instability resulted between several countries after failing to finance large military products due to the insufficient amount of gold to exchange for paper currency. After the war, the system was back until the beginning of World War II when the Allied nations said that a monetary system is needed.
In 1944, more than 700 representatives from the Allied nations gathered in Bretton Woods, New Hampshire to create the Bretton Woods systems which was set to define fixed exchange rates, US dollar becoming the reserve currency and the formation of the International Monetary Fund, General Agreement on Tariffs and Trade (GATT) and the International Bank fore Reconstruction and Development.
The main reason behind the Bretton Woods system was to replace gold with the US dollar and making the dollar the only world currency backed by the precious metal. Unfortunately, the reason behind the fall of the system was just that!
The Bretton Woods system lasted until 1971, when US President Richard Nixon ended the system after the US was running balance of payment deficits to help their currency become the world reserve.
This was the turning point on which current monetary systems were based. Governments all over the world now engage in one of the three following systems:
Pegged rate
Dollarization
Managed Floating Rate
Pegged rate system is when a nation decides to fix (peg) the exchange rate of its national currency to a foreign currency allowing it to be exchanged at a fixed rate against a basket of currencies and at the same time avoid the volatility that may occur in the markets. This means that the currency will only move in the markets when the pegged foreign currency moves. A recent and widely known example is the peg of the Chinese Yuan to the US dollar that ended in 2005.
The second system is dollarization. This refers to when a country fails to have its own national currency and adopts a foreign currency to be used within its borders. A very rare system, yet it still has its advantages and disadvantages. First of all, a country that implements dollarization is usually seen safer for investments. However on the other hand, it will fail to have any say in the monetary policy as the central bank is refrained from printing money or even setting the monetary policy.
Finally, managed floating rate is a type of system in which exchange rates move freely according to market supply and demand. In this system, the government or central bank may intervene in the markets if deemed necessary whether the currency appreciates or depreciates as seen in the market recently by the Swiss National Bank when they halted further gains for the Swiss Franc against the US Dollar.
Who participates in the market?
As we mentioned above, there are many market participants. Here we will discuss who they are and what their role in the market is. These participants are categorized as follows:
Governments
Central banks
Banks/financial institutions
Hedgers
Speculators
Arbitragers
Starting off with the governments, they tend to be pretty influential in the markets and are closely interrelated with central banks since many believe that the central bank is another branch of the government. Officials from the central bank and government tend to meet regularly in an attempt to reach the same conclusion on the monetary policy of the economy. However, governments sometimes believe that an independent central bank will have more effect in the economy than one that is a part of the government.
Central banks usually focus on anchoring inflation rates and keeping interest rates at record lows to help spur growth in the economy. Central banks try to control their reserves in order to reach set goals by officials in the bank and the government where in order to do so; they use the foreign exchange market, hence influencing currency movements.
Banks and financial institutions come next as they too are one of the largest participants. Banks usually engage in sell/buy transactions of a currency at the ask/bid prices in the inter-bank market to help set the prices that individual traders usually see on the trading platform. The inter-bank market is the market where banks perform transactions among one another and depends on the relationship of the banks among one another as they usually perform transactions based on credit. This means that a large bank with more credit relationships tends to have better pricings than smaller banks and that is why many banks can have different exchange rates.
Hedgers tend to be those who deal a lot with international transactions and are exposed to foreign-exchange risk facing the high volatility of currency exchange rates. As a result, hedgers attempt to limit the uncertainty in the markets by lowering risk. To do so, some businesses enter the spot market to offset the risk of a contract that is to be settled sometime in the future. However, if the company or investor does not hold sufficient capital/liquidity, their second best option would be to enter future or forward markets to eliminate as much of the exchange-rate risk as possible.
Another type of investor is known as a speculator and work the opposite of hedgers; meaning that they attempt to exploit the markets by taking advantage of currency fluctuations. They make large amounts of profits as they place bets on transactions for certain currencies. Hedge funds are the most famous for their actions as some are unregulated and use unorthodox trading strategies to help earn the large amounts of profit.
Finally, the last investor is an arbitrager who takes advantage of price differences between two or more markets. Since the forex market is international, an arbitrage activity can be executed due to price differentials among several brokers. For example, a trading platform at broker A may have not caught the last trading price that was caught by the trading platform at broker B for any reason. As a result, an arbitrager will then attempt to seek profits by taking the price differential between the two brokers on whichever one is more recent.
Major Types of Markets
After discussing how the forex market started and who participates in the markets, it is time to identify the different types of forex markets. Traders, whether individuals or institutions, can trade forex in any of these three markets:
Spot Market
Future Market
Forward Market
Starting off with the spot market, this the market where currencies are bought and sold based on the current market price. A spot market in general is any market where the underlying is sold for cash and delivered immediately as they are immediately effective.
But what determines the current market price? Any price is determined by supply and demand. However in the forex market, other factors play a major role including: economic activity, interest rates, market sentiment and political issues.
Future and Forward markets are somewhat related as they do not trade actual currencies, but instead they trade contracts between two parties that are settled at a set date sometime in the future.
In the future market, future contracts are bought among the parties where these contracts are regulated with specific details that include the size of the contract, and delivery dates. The National Futures Association in the US regulates the markets. These contracts can then be traded on several exchanges such as the Chicago Mercantile Exchange or the New York Mercantile Exchange where the exchange acts as a counterpart to provide clearance and settlement.
Although contracts are traded in the forward market, no association actually regulates the market as all transactions between the two parties are placed over-the-counter (OTC) with customized terms to suit the two parties. Speculators tend to use such markets as well as hedgers who are attempting to limit their risk.
Among these three major markets are the forex options and swap markets. A foreign exchange option is a derivative that gives the owner the right but not the obligation to exercise the option and exchange one currency for another currency at a pre-determined exchange rate. The two main types of options are call-options and put-options.
A call-option gives the owner the right to buy a specific quantity of a currency at a pre-determined price known as the strike price on or before expiration. On the other hand, a put-option gives the owner the right to sell a specific quantity. Since this is the right and not the obligation, the buyer will only exercise the option when they see best fits and as a result, the seller must fulfill all the terms of the option.
Finally, a currency swap is the most common type of forward transaction where two parties exchange identical amounts of one currency for another currency with two different value dates. The swap consists of two transactions (legs): a spot foreign exchange transaction and a forward foreign exchange transaction.
When are the Forex trading hours?
The Forex market is a dynamic market that is open 24 hours a day, five days a week with Saturdays and Sundays as weekends. This is one of the most unique characteristics of the market as traders are not restricted to certain time periods unless they choose to do so.
There are five major trading centers across the globe which are:
Australia/ New Zealand
Japan
Europe
United Kingdom
United States
These five trading centers overlap throughout the day with trading hours as follows: (Note that the time is GMT)
Trading Center
Open
Close
Australia/New Zealand
21:00
05:00
Japan
23:00
08:00
Europe
07:00
15:00
United Kingdom
08:00
16:00
United States
13:00
21:00
Each trading center has its own volume and that is why many traders tend to chose a specific time to trade depending on the range of movements that is needed in the markets. But before becoming familiar with the range of trading, let’s learn the different currency pairs and how to read a trading quote.
What are currency pairs?
As we stated earlier, currencies are traded in pairs where the first currency is the base currency (transaction currency) whereas the second currency is the quote currency (payment/counter currency). In other words this shows how many units of the quote currency is needed to buy one unit of the base currency and is known as a forex quote.
Quotes are divided into two types: direct and indirect quote. A direct quote refers to the exchange market quote that states the number of units of a local currency that is required to purchase one unit of the foreign currency. An indirect quote is a quote that gives the exact opposite stating how many units of the foreign currency is needed to purchase one unit of the local currency.
For example if the quote for the EUR/USD is 1.4340, this means that one euro is exchanged for 1.4340 US dollars. When this quote increases, this means the euro is getting relatively stronger versus the dollar.
The quote seen in the above example can either be the bid or ask price. The bid price is the price the investor is willing to buy at whereas the ask price is the price the trader is to sell at. The difference between the two prices is known as the spread. Note that the bid price is always lower than the ask price.
In the markets we have several types of currency pairs which are broken down into major pairs, cross pairs and exotic pairs. Let’s take a look at each one individually.
Major Pairs
Major pairs are those where the US dollar is combined with another global currency. They are the most liquid pairs in the markets and make up approximately 90% of total FX trading. These pairs include:
EUR/USD (Euro / US Dollar)
GBP/USD (British Pound / US Dollar)
USD/JPY (US Dollar / Japanese Yen)
USD/CHF (US Dollar / Swiss Franc)
And in some occasions, some include these three among the majors:
AUD/USD (Australian Dollar / US Dollar)
NZD/USD (New Zealand Dollar / US Dollar)
USD/CAD (US Dollar / Canadian Dollar)
Cross Pairs
Cross – currency pairs in the markets are referred to pairs that do not contain the US Dollar with another major currency. Among these are:
EUR/JPY (Euro / Japanese Yen)
GBP/JPY (British Pound / Japanese Yen)
EUR/GBP (Euro / British Pound)
AUD/JPY (Australian Dollar / Japanese Yen)
CAD/JPY (Canadian Dollar / Japanese Yen)
EUR/CAD (Euro / Canadian Dollar)
Exotic Pairs
Exotic pairs are referred to by traders as pairs where the US Dollar is combined with currencies of developing or emerging markets. Some of the pairs that may encounter you during trading include:
USD/SEK (US dollar / Swedish Krone)
USD/NOK (US dollar / Norwegian Krone)
USD/DKK (US dollar / Danish Krone)
USD/HKD (US dollar / Hong Kong dollar)
USD/ZAR (US dollar / South African rand)
USD/SGD (U.S. dollar / Singapore dollar)
USD/MXN (U.S. dollar / Mexican peso)
What is the trading range for currencies in the session?
Important Notes:
1) The range of fluctuation differs for a pair depending on the time period
2) Currencies tend to become more volatile during periods of overlapping sessions
3) Where the pair’s movements are significant a clear trend is seen and vise versa
4) Technical indicators are more reliable when the pair moves in the right direction
5) Best time to trade is when the currency is moving significantly
6) When market movements are thin, avoid trading
Range of Fluctuation for different currency pairs according to Sessions
Asian Session
Asia & EU
EU Session
EU & US
US Session
EUR/USD
51
32
87
65
78
USD/JPY
78
29
79
58
69
GBP/USD
65
43
112
78
94
USD/CHF
68
43
117
88
107
EUR/CHF
53
24
53
40
49
AUD/USD
38
20
53
39
47
USD/CAD
47
28
94
74
84
NZD/USD
42
20
52
38
46
EUR/GBP
25
16
40
27
34
GBP/JPY
112
60
145
99
119
GBP/CHF
96
62
150
105
129
AUD/JPY
55
26
63
47
56
*Fluctuation: The difference between the highest and lowest values during the session
Learning the Forex lingo:
To become a professional trader in the markets, you need to be familiar with the jargon or the dialect used. Currency markets are no different as they too have their own lingo. Here we will provide you with a list of the most commonly used forex jargon:
Euro: Euro vs. U.S. dollar (EUR/USD)
Cable: Great British Pound vs. U.S. dollar (GBP/USD).
Swissie or Swissy: U.S. dollar vs. Swiss franc (USD/CHF)
Loonie: U.S. dollar vs. Canadian dollar (USD/CAD)
Aussie: Australian dollar vs. U.S. dollar (AUD/USD)
Kiwi: New Zealand dollar vs. U.S. dollar (NZD/USD)
Limit Order: An order placed to execute a trade if it reaches a specific price or better
GTC Order: A good-till-cancelled order is an order place that will remain active until manually closed by the trader
OCO Order: One cancel another order is a type of order where two orders are set at a trigger value where the entrance of one automatically cancels the other.
Stop-Loss: level determined by the trader in order to limit losses and prevent them from accelerating
Take Profit: level determined by the trader where if reached, the transaction is automatically closed on profit
Figure: a term used in the markets for a round number such as 1.6000
Margin: Minimum amount needed in the account to execute a trade with a broker
Margin Call: This is made when the account falls below a certain level due to losses and as a result all open transactions are automatically closed
Lots: the size of the transaction placed with the standard being generally $100,000