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Currency Trading | Overview of Forex Market - ForexAbode.com
Last Updated (Sunday, 25 December 2011 23:35) GMT
Currency Trading: An Introduction
In this article we will touch upon the needs of Forex trade, history and various data related to trading including geographical break-up, trading instruments and common terms.
With US$ 4 Trillion daily turnover, the currency trading market is the world’s largest financial market. The popularity of currency trading as retail investment has increased to great heights during the recent years. Money never sleeps and in foreign exchange market you buy money by paying in money: one currency for other by paying the relative value of the currencies. Being a globally decentralized market it functions 24 hours except the weekend and bank holidays.
International investments and international trade in other countries’ asset makes it necessary to convert one currency into other. Increasing globalization makes the volumes of currency trading higher by the day. Now when the trading volumes are high, the fluctuation of the values of once currency v/s another currency becomes high and when fluctuation of values is high, it offers an opportunity to make profits by speculations about the possible market movement. Here comes the other set of investors with other purpose than the basic purpose of international trade and international investments. That is currency or Forex trading for speculation to make profits.
History of Foreign Exchange Markets:
Before 1970 the foreign exchange rates used to be fixed. During 1970’s there was a switch towards floating foreign exchange rates, which change continuously.
Fixed foreign exchange (Forex) rates concept came into existence to overcome the pre-world war issues of economic discrimination where some countries had more trade privileges that others. In order to promote free trade by free convertibility of individual currencies the fixed Forex rate system came into existence. The rules of 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 (US) and hence the system or the set of rules is called Bretton Woods system.
Floating Forex Rates:
In floating Forex rates a currency's value changes or fluctuates in foreign exchange market unlike the fixed rates.
Market Entities:
- Banks/Investment Banks
- Commercial Corporations
- National Central banks
- Hedge funds
- Investment management companies
- Retail Forex brokers
- Non-banking Forex companies
- Companies dealing in Money transfer/remittance services
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The largest portion of the Forex transactions come under interbank transactions. The interbank transactions cover both of the following:
a) The commercial foreign exchange needs because of international trading by commercial corporations and various forms of investments in the international assets as well as merger and acquisitions.
b) The investment trading or speculative trading as the core activity. This activity can be for external customers as well as for Bank’s own investment.
2) Commercial corporations:
All major corporations have global operations. And apart from the international trade there is a always a need of foreign exchange to run the day-today operations. May it be comparatively smaller amounts for salaries and 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 vary large sums of their currency to make necessary correction in their currency’s valuation against other currencies. A strong currency is bad for the exports of the country and weak currency is bad for imports.
4) Hedge Funds:
The high volatility of foreign exchange rates makes it necessary for companies depending of international trades to safeguard themselves from negative movement of foreign exchange rates. A small deviation in exchange rates can be 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 investment option or need foreign currencies in order to invest in international equities, bonds and 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, the retail trading volumes by individuals are continuously growing. As per the year 2009 estimates the retail trading volume is estimated as 12%of the total volume. The individuals use retail Forex brokers for their trading in currencies.
7) Non Banking Forex companies for non speculative currency needs:
These companies/broker are to take care of the Forex needs of small organizations and individuals. There are also companies whose business is for foreign remittances. They are active in trading not as speculators or trading currencies as investment tool but for physical delivery of currencies or transferring real money. The amounts for transactions may be small but large number of transactions can make the total trading volumes quite high.
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As per the 2010 survey of EuroMoney the breakup share of Top-10 Forex traders is as follows:
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| Type of Forex Instrument |
Explanation |
| Spot Transactions |
As the name suggests a spot Transaction literally means spot delivery of the exchanged currency but practically Spot Transactions need to be settled within 2 days by directly exchanging one currency into other |
| Outright Forwards |
The delivery of the exchanged currency takes place at 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 |
NDF's are similar to Outright Forwards with the difference that there is no physical delivery of the currencies. In NDF's a net cash settlement is made by one part to other 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 of currency at an agreed rate and to resell the same amount of currency for a later value date to the same party, also at an agreed rate.
or
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 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 until the maturity date. |
Trading Breakup - Financial Instrument wise:
The daily Foreign Exchange turnover according to April 2010 surveys is estimated to be US Dollars 4 Trillion. The approximate (estimated) break up of this as per various financial instruments is as follows:
The above pie chart and the table below mentions estimated data of April 2010 survey. Data sources are mentioned at the bottom of this page. |
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Australia |
UK |
US |
Canada |
Singapore |
Tokyo |
| Outright Spot |
59.67 |
642.00 |
418.00 |
17.06 |
94.55 |
96.50 |
| Outright Forwards |
7.81 |
194.00 |
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5.69 |
40.33 |
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Non deliverable
Forwards |
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28.00 |
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| Total Forwards |
7.81 |
222.00 |
104.00 |
5.69 |
40.33 |
28.70 |
| FX Swaps |
117.39 |
756.00 |
203.00 |
34.28 |
103.64 |
161.30 |
Traditional Fx
Turnover |
184.88 |
1620.00 |
725.00 |
57.03 |
238.52 |
286.50 |
| Currency Swaps |
4.44 |
17.00 |
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1.16 |
30.42 |
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| OTC Options |
1.87 |
110.00 |
30.00 |
1.99 |
20.90 |
7.60 |
| TOTAL TURNOVER |
191.18 |
1747.00 |
755.00 |
60.18 |
289.84 |
294.10 |
Size of Forex Market:
Foreign exchange market is the most liquid and the largest financial market in the world with approx 4 Trillion USD 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 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 6 major centers namely London, New York, Tokyo, Singapore, Australia and Canada.
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Types of Currency Pairs:
- Currency Majors: You will find different definitions for Forex majors or currency majors. One which would say that all currency pairs which include "USD" are majors and another will say that the four pairs namely EUR/USD, USD/JPY, USD/CHF, GBP/USD are currency majors. Basically majors are those currency pairs which have highest trading volumes.
- Currency Crosses: A currency-cross is any currency pair which does not have the US Dollar either as the base currency or the counter currency. For example, USD/JPY, AUD/NZD, EUR/JPY, and AUD/JPY etc are currency crosses
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 the economies which are export oriented or economies which depend on exports. Exports are good when 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.
The examples of growth linked currencies are 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 much higher interest rate by selling a currency with very small interest rate. These are generally longer term trade with the objective of profiting by the substantial interest rate differential. Japanese Yen (JPY) has historically been a carry trade currency against Australian Dollar and New Zealand Dollar because of substantial interest rate difference.
Carry trades take place when risk appetite is high because of positive outlook of the global economy. The carry trade currency pairs can also change because of the changing interest rates and the state of economies.
c) Safe Heaven currencies:
Safe heaven currencies are those which are bought at the 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 heaven because of various factors and some are:
1) Global dependence: What is the share of that particular currency held by other countries as reserve currency. US Dollar one an average has been having two third share as reserve currency around the globe and hence has the highest share.
2) Stability of the economy: Considering low inflation and other factors. Swiss Franc has historically been considered a safe currency because of very low inflation rate.
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 end of April 2000 Switzerland had a legal requirement that minimum 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.
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- 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 etc may also cause temporary supply and demand fluctuations and hence fluctuation in Market.
- Political Factors: Political Stability is a factor behind the confidence level about a specific economy. Hence political situations/changes also can cause fluctuations in the Forex market.
- Market Psychology/sentiments: As it goes, the market psychology and sentiments can always cause major movements in any investment market including Forex. Fear of bad or expectations for good go wrong can throw the prices up or down. A negative sentiment about one currency can keep it being weaker for great times of lengths even if actually positive economic data is coming out or vice versa. Market sentiments play very important roles in currency trading.
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Basis for Trading Decisions:
- Fundamental Analysis: Please visit Forex Fundamental Analysis Page
- Technical Analysis: To know about the basics please visit our Forex Technical Analysis section and please visit Forex Analysis for our technical analysis updates for major currency pairs.
- 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 for longer-term positions depending on only technical analysis may kill. Regardless on the time frame it is always advisable to base the trading decisions one both Fundamental and technical analysis, while not forgetting the market sentiments and Geo-political factors which can affect the market movements.
- Electronic/Automated Trading: This is a continuously growing type of trading where the trading decisions are not taken manually. The computer program based on different algorithms and logics manage the trading positions decisions (entry, exit, stop-loss and take-profit) automatically. The computer programs are complex programs which take the decisions mainly based on the technical analysis. The robotic decisions are not only for entry and exit etc but also cover the aspect 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 trading platforms without manual intervention. The latest developments have been to accommodate fundamental analysis also by having the data feed of economic releases etc and the Forex robot's logic/algorithm take those data also in account in trading decisions..
This automated trading is also known as Robo-Trading or Black Box Trading because of the lack of human intervention.
Foreign Exchange Regulatory Bodies:
Considering the trading volumes and fluctuations of the market and continuously growing retail currency (Fx) trading, there is always a need of 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 work seamlessly across the 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 wise Forex Regulatory Bodies/Associations.
Pips:
The smallest unit of a currency pair. For most of the currency pairs a 1 pip = 0.0001 of the currency but for JPY pairs e.g. USD/JPY or EUR/JPY etc 1 pip= 0.01 of the currency.
Leverage:
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 much bigger trade position than the actual input of money. For example if you user 30:1 leverage that means your you can trade USD 30,000 by just using USD 1,000. Increasing leverage increases the chances of both profits and loss more.
Ask Price:
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).
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 EURUSD. In this the first currency pair is known as the “Base currency”, which in this case is Euro. The second currency is called “Counter Currency”, which in this case is US Dollar.
Short-Selling Position:
Selling the currency pair when it is expected that it will go down and buying it later to cover the position.
Long Position:
Buying the currency pair when it is expected that it will go up and selling it later.
Stop-Loss Order:
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
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.
Take-Profit order:
A Take-Profit order is the order when we exit the trade (close our trading position) to make profit on our trade. This we analyze based on the chances of reversal of the current movement and hence to avoid making a profitable trade reverse the direction and cut the profits.
Risk-Reward ratio:
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 usually 100,000 units of the base currency.
Limit order:
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.
Margin call:
Notice from your broker to deposit more money or your all open positions will be closed automatically to prevent your account to get wiped off completely. This only happens when your risk management was poor and your trading positions went into big losses with the danger that yur entire account is on the verge of wiping out.
Support levels:
Price levels where we expect support. Let’s say that a currency pair 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:
Resistance Levels:
Currency pair's price levels where we expect resistance for further movement. Let’s say that a currency pair moving up. It can’t move down 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.
Forex Correlations:
Please see our Forex Correlation page to know about currency correlations. Some currency pairs may move in same direction with strong correlation while some may have weak correlation. Similarly some pairs may have very strong negative correlation. While trading some care needs to be taken about taking simultaneous positions with multiple currency pairs which have a strong positive or negative correlation. This safeguards profits on one trade to be countered by loss on another trade.
Carry Trade:
Buying the assets which give higher returns. In Forex trading it means buying the currency which gives higher returns (interest rate). Lets say Japanese Yen has an interest rate of 0.1% and Australian Dollar’s interest rate is 4.5% so buying AUD means getting profits because of the interest rate margin.
US Dollar Index:
US Dollar is one of the global reserve currencies and is has the informal status of the world currency. It is sometimes not only important to see how a currency pair is moving which has USD i.e. EUR/USD (Euro Dollar), USD/JPY (Dollar Yen), GBP/USD (British Pounds/Dollars), USD/CHF (US Dollar Franc) etc but to see what really is happening to the US Dollar in the Forex (foreign exchange) market. In general the Dollar is weakening or getting stronger. 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 of 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 it's inception in 1973 except for the introduction of EURO in the beginning of 1999.
The weights of the currencies in the basket are as follows:
| Currency |
Weight |
| Euro |
57.6 |
| Japanese Yen |
13.6 |
| British Pound |
11.9 |
| Canadian Dollar |
9.1 |
| Swedish Krona |
4.2 |
| Swiss franc |
3.6 |
| Total |
100 |
Important Committees and Associations related to Forex Market:
We are listing 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.
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Important Pages:
Forex Trading - Technical Analysis
Analysis Update for Trading Forex
Forex Trading - Fundamental Analysis
Psychological Aspects in Forex Trading
Forex Trading Strategies
Forex Correlations
Forex Pivot Points
Forex Trading Holidays
Forex trading Resources
Forex Trading Tools
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