Forex Trading Markets 101
Table of Contents
- Fixed and Floating Interest Rates
- Market Participants
- Top 10 Forex Traders
- Trading Instruments and Market Breakup
- Forex Market - Geographic breakup
- Types and Characteristics of currency pairs
- Currency Pair wise Trading volume
- What Moves the Forex Market
- Regulations / Regulatory Bodies
- Basic Terms in Currency Trading
With a US$4 trillion daily turnover, the Forex market is the world’s largest financial market. The popularity of currency trading as a retail investment has gone up to great heights during recent years. The following article covers the overview of Forex market with some important facts and figures.
In the foreign exchange market, you buy money by paying money. You pay with one currency to buy other currency. Money never sleeps, and being a globally decentralized market, it functions 24 hours except for weekends and bank holidays. International investments and trades make it necessary to convert one currency into others. Increasing globalization makes the volume of currency trading higher by the day. When the trading volumes are high, the fluctuation of the values of one currency versus another becomes high, and when fluctuation of values is higher, this offers an opportunity to make profits through speculation about the change in the price. This brings in another set of investors who would be active in the currency trading market to benefit from speculative trading.
History of Foreign Exchange Markets
Till 1970, the foreign exchange rates used to be fixed. During the 1970s, there was a switch toward floating foreign exchange rates.
The fixed foreign exchange rates concept came into existence to overcome the pre–World War issues of economic discrimination where some countries had more trade privileges than others. The logic was that major fluctuations in the exchange rates can affect free trade adversely. The rules of exchange rates were decided by delegates from 44 Allied nations during a conference which took place during the first three weeks of July 1944. This conference was held in Bretton Woods, New Hampshire (United States), and hence, the system or the set of rules is called the Bretton Woods system. The basic feature was that each country adopts a monetary policy of pegging or tying their currency to the US dollar with a fixed exchange rate.
Floating Foreign Exchange Rates
In floating forex rates, a currency’s value changes or fluctuates against the other currencies depending on various economic factors and also speculative trading. This is where the speculative trading comes into the picture.
- Banks/Investment banks
- Commercial corporations
- National central banks
- Hedge funds
- Investment management companies
- Retail Forex brokers
- Non-banking Forex companies
- Companies dealing in international money transfers/remittance services
1) Banks and Investment Banks
The largest portion of forex transactions come under inter-bank transactions. Inter-bank transactions cover the following:
- Commercial foreign exchange needs because of international trading by commercial corporations and various forms of investments in international assets as well as mergers and acquisitions.
- Investment trading or speculative trading as the core activity. This activity can be for external customers as well as for the bank’s own investment.
2) Commercial corporations
All major corporations have global operations. And apart from the international trade, there is always a need for foreign exchange to run the day-to-day operations. Be it comparatively smaller amounts for salaries, foreign travel costs, etc., but in some cases, even large sums may be involved.
3) Central Banks/Reserve Banks
Central banks’ responsibility to control the money supply, valuation of currency, and currency’s interest rates make them an important entity in the market. At times, the central banks intervene in the markets by buying or selling very large sums of their currency to make a necessary correction in their currency’s valuation against other currencies. A strong currency is bad for the exports of a country, and a weak currency is bad for imports.
4) Hedge Funds
The high volatility of foreign exchange rates makes it necessary for companies depending of international trade to safeguard themselves from negative movements of foreign exchange rates. A small deviation in exchange rates can be a killing for the businesses at times. This is making the hedge fund companies to grow very rapidly, and this is also making hedge fund companies’ trading volumes grow rapidly. Big hedge funds are the biggest speculators of the currency trading market.
5) Investment Management Companies
Such companies may be involved directly in currency trading as an investment option or need foreign currencies in order to invest in international equities, bonds, assets, etc. These companies deal in large amounts of money on behalf of their customers.
6) Retail Forex Brokers
Since retail forex trading was permitted in developed nations and started becoming popular in many developing countries also, retail trading volumes by individuals have been continuously growing. As of 2009 estimates, retail trading volume was estimated at 12% of the total volume. These individuals use retail forex brokers for trading currencies.
7) Nonbanking Forex Companies for Non-speculative Currency Needs
These companies/brokers take care of the foreign exchange needs of small organizations and individuals. There are also companies whose business is to help in foreign remittances. They are active in trading not as speculators or by trading currencies as investments but for physical delivery of currencies or transferring real money. The amounts for transactions may be small, but a large number of transactions can make the total trading volumes quite high.
As per the 2010 survey of EuroMoney, the share breakdown of the top 10 forex traders is as follows:
|Spot Transactions||As the name suggests, a spot transaction literally means spot delivery of the exchanged currency, but practically speaking, spot transactions need to be settled within two days by directly exchanging one currency for another|
|Outright Forwards||The delivery of the exchanged currency takes place on an agreed future date at an agreed exchanged rate at the time of the contract. The market rate at the time of the exchange dates can be anything and does not matter.|
|Non-Deliverable Forwards||NDFs are similar to outright forwards with the difference being that there is no physical delivery of the currencies. For NDFs, a net cash settlement is made by one part to another based on the movement of the two currencies in question. The settlement is usually done in US dollars.|
|Forex Swaps||Either a contract that simultaneously agrees to buy an agreed amount of currency at an agreed rate and to resell the same amount of currency for a later value at a later date to the same party, also at an agreed rate.
A contract that simultaneously agrees to sell an amount of currency at an agreed rate and to repurchase the same amount of currency for a later value at a later date from the same party, also at an agreed rate. In both cases, the interest is inclusive.
|Currency Swaps||A swap of currencies where interest and principal in one currency are exchanged for interest and principal in another.|
|Forex Options||An option contract gives the buyer the right (but not the obligation) to exchange one currency for another at a predetermined exchange rate on or before the maturity date.|
Trading Breakdown by Financial Instrument
The daily foreign exchange turnover according to April 2010 surveys is estimated to be US$4 trillion. The approximate (estimated) breakdown of this per financial instrument is as follows:
The pie chart above and the table below mentions estimated data of an April 2010 survey. Data sources are mentioned at the bottom of this page.
Size of Market
The foreign exchange market is the most liquid and the largest financial market in the world with an approximate US$4 trillion turnover per day. The largest forex trading center is London, but New York, Tokyo, Hong Kong, and Singapore are all important foreign exchange centers as well. London claims an over 40% share of the total global currency trading turnover. Unlike stocks, which are geography-specific, currency trading happens continuously throughout the day; with the end of the Asian trading session, the European session begins, followed by the North American session and then again the Asian session, excluding public/bank holidays and weekends. The majority of trading takes place in six major centers—namely, London, New York, Tokyo, Singapore, Australia, and Canada.
- Currency majors: You will find different definitions for forex majors or currency majors. One would say that all currency pairs which include USD are majors. However, currency majors are the pairs with the highest trading volumes and hence include major international currencies paired with the U.S. dollar. We can safely say that the currency majors are: EUR/USD, USD/JPY, USD/CHF, GBP/USD, AUD/USD and USD/CAD—are currency majors. Basically, majors are those currency pairs which have the highest trading volumes.
- Currency crosses: Historically when we wanted to convert one currency to another one, the currency to be converted needed to be first converted into the U.S. dollar and then those U.S. dollars used to get converted into the target currency. Hence any currency needed to be converted into the other had to take the dollar route. This process changed over time when other international currencies became powerful, namely EUR, GBP, JPY, AUD, CAD, CHF. The conversion of these currencies with others in this group does not have to follow the dollar route and these can be directly converted into the other. The pairs involving these currencies are called major currency crosses, for example GBP/JPY, EUR/JPY, and AUD/JPY etc. Another category which is used is Euro crosses. Euro crosses are nothing but the pairs involving the mentioned currencies and the euro.
- Currency Minors: The minor pairs are remaining currency pairs which have comparatively lower liquidity and trading volumes.
Currencies’ trading characteristics
Because of the nature of various world economies, different currencies have different characteristics. Let’s see the various currency types.
a. Growth-linked currencies: Growth-linked currencies are currencies of economies which are export-oriented or economies which depend on exports. Exports are good when the global economy or economies of the importing nations are doing well. Hence, when the exports are good or expected to be good, these currencies become relatively stronger. Examples of growth-linked currencies are the Australian dollar (AUD), Canadian dollar (CAD), and New Zealand dollar (NZD). The economies of these countries depend a lot on exports of goods which are required by both fast-developing economies as well as other industrial and manufacturing nations.
b. Carry trade currencies: Carry trade means buying a currency with a much higher interest rate by selling a currency with a very small interest rate. These are generally longer-term trades with the objective of profiting by the substantial interest rate differential. The Japanese yen (JPY) has historically been a carry trade currency against the Australian dollar and the New Zealand dollar because of the substantial interest rate difference. Carry trades take place when risk appetite is high because of a positive outlook on the global economy. The carry trade currency pairs can also change because of the changing interest rates and the states of economies.
c. Safe haven currencies: Safe haven currencies are those which are bought at a time of risk aversion when risk appetite is less. When there are uncertainties about global economic health, people tend to buy assets/currencies which are safer.
Currencies can be considered safe haven because of various factors, and some are as follows:
1. Global dependence: What is the share of that particular currency held by other countries as reserve currency? The US dollar, on average, has had a two-thirds share as reserve currency around the globe and hence has the highest share.
2. Stability of the economy: Considering low inflation and other factors, the Swiss franc has historically been considered a safe currency because of very low inflation rates.
3. Banking systems and legal requirements: There can be various other factors, and we will not go into details, but legal requirements for backing up the currencies are also a factor. For example, till the end of April 2000, Switzerland had a legal requirement that a minimum of 40% of CHF needed to be backed by gold. This requirement was terminated, but still, Switzerland maintains a sizable gold reserve and has a historic banking system.
- Economic factors and economic releases: Supply and demand of a particular currency and hence the relative value of a currency pair largely depends upon the health of the economies. There are various economic indicators to gauge the strength of the economies. Apart from this, the major mergers and acquisitions may also cause temporary supply and demand fluctuations and hence fluctuations in the market.
- Political factors: Political stability is a factor behind the confidence level about a specific economy. Hence, political situations/changes can also cause fluctuations in the Forex market.
- Market psychology/sentiments: As it goes, market psychology and sentiments can always cause major movements in any investment market, including forex. Fear of bad or expectations for good can go wrong and can throw the prices up or down. A negative sentiment about one currency can keep it weaker for great lengths of time even if positive economic data are actually coming out or vice versa. Market sentiments play very important roles in currency trading.
Basis for Trading Decisions
- Fundamental analysis: Please visit our Forex Fundamental Analysis page.
- Technical analysis: Technical analysis is used by a large number of Forex traders. Technical indicators analyze the past and on-going price action and observations can be derived from that. As huge volumes are traded because of the technical observations, the price tends to move in the direction anticipated. Technical analysis itself is not a magic but it does work because of the above mentioned fact. A major signal comes for buying and huge volumes are bought because of that and the price further moves up, it is as simple as that. Some of the most commonly used indicators are Ichimoku cloud, MACD, Moving Averages,Bollinger Bands, Fibonacci Retracements, Relative Strength Index, Average Directional Index, Stochastic Oscillator and Parabolic SAR. Apart from these there arecommon chart patterns which are also used to analyze the price-action and predict the possible trends..
- Combination of fundamental analysis and technical analysis: For short-term trading positions (day trading), a total dependence on technical analysis is possible, though not advisable, but for longer-term positions, depending on only technical analysis may kill. Regardless of the time frame, it is always advisable to base the trading decisions on both fundamental and technical analysis while not forgetting the market sentiments and geopolitical factors which can affect market movements.
- Electronic/automated trading: This is a continuously growing type of trading where the trading decisions are not made manually. A computer program based on different algorithms and logic manages the decisions on trading positions (entry, exit, stop-loss, and take-profit) automatically. The computer programs are complex programs which make the decisions mainly based on technical analysis. The automatic decisions are not only for entry, exit, etc., but also cover the aspects of position timing, order volume (position size), etc. Apart from making the trading decisions, these programs can also take and close the trading positions on forex trading platforms without manual intervention. The latest developments have been to accommodate fundamental analysis also by having the data feed of economic releases and the forex robot’s logic/algorithm also take those data into account in trading decisions. This automated trading is also known as robo-trading or black box trading because of the lack of human intervention .
Considering the trading volumes and fluctuations of the market and continuously growing retail currency (FX) trading, there is always a need for regulations to govern the market to keep the bad elements away and to safeguard the market participants. Unlike the forex market, which is not geography-specific and works seamlessly across borders, the regulatory bodies are geography-specific or national bodies. The regulations or laws cover the players of that particular region/nation. Click for country-specific Forex Regulatory Bodies/Agencies.
Pip is the smallest unit of a currency pair. For most of the currency pairs, 1 pip = 0.0001 of the currency, but for JPY pairs (e.g., USD/JPY, EUR/JPY, etc.), 1 pip = 0.01 of the currency. You may check the pip value calculator to calculate the value of 1 pip in your account currency.
Leverage is the mechanism to be able to take a much bigger position than your account size. Or we can say to be able to take a much bigger trade position than the actual input of money. For example, if you use a 30:1 Forex leverage, that means you can trade USD 30,000 by just using USD 1,000. Increasing leverage increases the chances of both profits and losses more.
Ask price is the “sell price” provided by large international banks at which they will buy the currency. Bid price: bid price is the “buy price” provided by large international banks at which they will buy the currency. Bid-ask spread: bid-ask spread or simply the spread is the difference between the selling price and buying price or ask and bid price. When you wish to buy, then you will have to pay a higher price (ask price), and when you wish to sell, you will get a lower price (bid price). You will find more details about Forex spread in the Forex brokers section.
Base Currency and Counter Currency:
The currency pairs are represented by three-letter international codes for those currencies (e.g., Euro and US Dollar pair is EUR/USD). In this, the first currency is known as the base currency, which in this case is the euro. The second currency is called the counter currency, which in this case is the US dollar.
Selling the currency pair when it is expected that it will go down and buying it later to cover the position.
Buying the currency pair when it is expected that it will go up and selling it later.
A stop-loss order is an order when we close the trading position to stop our further losses if the currency pair moves in a different direction than we had expected and had taken a position for.
Trailing Stop or Trailing Stop-Loss Order:
Moving the stop-loss order in the direction of the movement of the currency pair (i.e., for a buying position, moving the stop-loss up when the currency pair is moving up and vice versa).
A take-profit order is the target price for our trade position. The position is closed at the take-profit order level to realize the profits on the trade.
The ratio of reward (take-profit) and risk (stop-loss). The risk-reward ratio, ideally, should be maintained over 1.
Standard Lot Size:
The standard lot size is 100,000 units of the base currency. You may please also check the various kinds of forex lot sizes.
Putting an order for a future price level which is different than the current price. For example, let’s say that EUR/JPY’s current price is 135.90, and we expect it to go up and want to buy. But we also expect that before going up, it may fall down to 135.60. So we put a limit order for buying at 135.60, which will be filled if EUR/JPY goes down to 135.60. We also put a time limit for the order to be filled because a limit order without any time limit will prove to be dangerous.
Notice from your broker to deposit more money or all your open positions will be closed automatically to prevent your account from getting wiped off completely. This only happens when your risk management was poor and your trading positions went into big losses with the danger that your entire account is on the verge of being wiped out. Please check the margin calculation page for more details.
Price levels where we expect support. Let’s say that a currency pair is moving down. It can’t move down endlessly, and there will be some levels where it can find support. At support levels, either this currency pair reverses the direction and starts moving up, or some upward correction takes place before the fall resumes.
An example of Resistance and Support trend lines on Forex Chart:
A currency pair’s price levels where we expect resistance to further movement. Let’s say that a currency pair is moving up. It can’t move up endlessly, and there will be some levels where it can find resistance. At resistance levels, either this currency pair reverses the direction and starts moving down, or some downward correction takes place before the upward movement resumes.
Please see our Forex Correlation page to know about currency correlations. Some currency pairs may move in the same direction with a strong correlation, while some may have a weak correlation. Similarly, some pairs may have a very strong negative correlation. While trading, some care needs to be taken when taking simultaneous positions with multiple currency pairs which have a strong positive or negative correlation. This safeguards profits on one trade when countered by loss on another trade.
Carry trade is all about buying the assets which give higher returns without speculation about the day-today price action. In Forex trading it means buying the currency which gives higher returns (interest rate). Let’s say the Japanese yen has an interest rate of 0.1% and the Australian dollar’s interest rate is 4.5%, so buying AUD means getting profits because of the interest rate margin.
US Dollar Index:
The US dollar is one of the global reserve currencies and has the informal status of world currency. It is sometimes not only important to see how a currency pair which has the USD (e.g., EUR/USD [euro/dollar], USD/JPY [US dollar/yen], GBP/USD [British pound/US dollar], USD/CHF [US dollar/Swiss franc], etc.) is moving but also see what is really happening to the US dollar in the forex (foreign exchange) market. In general, the dollar is weakening or getting stronger. The US dollar index serves this purpose by measuring USD against the basket of other major currencies. This basket consists of EUR (euro), GBP (British pound), CAD (Canadian dollar), SEK (Swedish krona), JPY (Japanese yen). As mentioned above, the USDX or US dollar index is a weighted indexed value of the USD against a basket of currencies based on their March 1973 valuations. Thus, a value of 83.00 on the index means that the unit is now 83% of its March 1973 value. The US dollar index (USDX) currencies and USD index currency weights have not changed since its inception in 1973 except for the introduction of EUR in the beginning of 1999. The weights of the currencies in the basket are as follows:
Important Committees and Associations
We have listed down some of the main associations, committees, and forums which are related to forex trading. These are also the sources of the trading data given in this overview.
BIS (Bank of International Settlement)
London Foreign Exchange Joint Standing Committee (FX JSC)
Australian Forex (Foreign Exchange) Committee
Canadian Foreign Exchange (Forex) Committee
New York Foreign Exchange Committee
Singapore Foreign Exchange Market Committee
Tokyo Foreign Exchange (Forex) Market Committee
We wish to contribute more to your forex trading and invite you to join our Forex Forum, and in case you wish to get e-mail alerts on forex analysis, then please register for our trading newsletter. We update the technical analysis daily and trading outlook/analysis on weekends.