Welcome to the most exciting financial market in the world! In this article, we'll cover everything there is to know about Forex.
The foreign exchange market appeared when the United States dropped the gold standard. For a short period between 1944 and the early 1970s, the American dollar was pegged to the price of gold.
But higher deficits, coupled with increased Vietnam war spending, led the United States to drop the dollar's convertibility to gold. What followed was the birth of the currency market as we know it today.
Timid at first but growing exponentially, Forex is subject to substantial transaction volumes today. Measured by the daily turnover, the Forex market dwarfs all other global markets in size.
Simply known as the market in which currencies trade against each other, the foreign exchange market is almost 15 times larger than the daily turnover in the global fixed-income markets. How about equities? It exceeds by 50 times the worldwide turnover of equities, too. Do I have your attention now?
For the speculators out there, such turnover represents the possibility to move large amounts of money quickly. Most other markets have liquidity issues, but that's just not the case with the Forex market.
One can easily dump billions into the FX market, and always there's a buyer for it. The total sum of the pending orders easily makes up for the need for liquidity.
Such a large market can't go unnoticed. Speculators, investors, quant firms, sovereign wealth funds, brokers, retail traders, and everyone else participates, all with the same purpose: making a profit.
But before jumping in and buying or selling currencies, you need to be clear on some things. Thus, this article looks into the particularities of the Forex market, offering a complete and necessary overview.
How Big is the FX Market?
The Bank of International Settlements (BIS) governs all the central banks in the world, and central banks govern the currencies in their jurisdictions. Thus, we can say that the BIS is the mother of all central banks.
Based in Basel, Switzerland, the BIS also has a huge research department in charge of statistics. Judging by BIS estimations, the global FX market is split into different parts.
First, there's the spot FX market. Its turnover represents about 35% of the global FX turnover. Second, the FX swaps market accounts for roughly 45%. Finally, the rest is split between over-the-counter forwards and exchange-traded derivatives.
Another thing to consider when trading the FX market is the proportion of each currency in the overall trading volume. For instance, the daily market volume of six trillion dollars or so belongs mostly to the following pairs: EURUSD, USDJPY, GBPUSD, AUDUSD, and USDCAD.
Those are the major economies in the world. If we take each currency of these pairs and find the corresponding country, we get the United States, the Eurozone, Japan, the United Kingdom, Australia, and Canada.
Over 60% of the daily turnover in the FX market belongs to these five currency pairs. Therefore, when you decide to buy large volumes on any other currency pair, consider that liquidity and execution time are issues.
Also, 60% of that daily turnover happens in the London session. London is the largest financial center in the world. New York comes in as a close second, and then Tokyo is the representative FX hub in Asia.
That means the most active trading hours are between 08:00 A.M. and 11:30 A.M. EST (New York time). Both the London and New York centers are active during those times.
What to Know When Trading Forex
First, know that this market is always open. Physically, it closes over the weekend.
But in reality, events that happen over the weekend are enough to create a gap on Monday's opening. In other words, if events over the weekend are priced in, there's no gap on Monday. If not, there's a gap, and no stop-loss order can help in this case.
Therefore, we can say that the Forex market is always open. It gives traders a bit of a breather over the weekend, but everyone watches the opening levels on Monday to see the implications.
Leaving the weekend events aside, the actual market trades every business day, 24 hours a day!
Electronic communications networks connect traders from all time zones in the world. The diversity of traders can't be stressed enough: From small retail traders actively managing trading accounts to multibillion-dollar investment firms, there's room for everyone.
Second, think of this market as growing and changing every day. Since its incipient phases in the early 1970s, the world has become interconnected in ways never seen before.
International trade has grown to unthinkable levels. However, that would not have been possible without the FX market.
The simple fact that it facilitates the cross-border capital flows crucial in international trade says everything about the most important of its functions.
Naturally, as the name suggests, this Trading Academy focuses on the trading or speculating aspect of the FX market – more precisely, the ability to speculate and bet on market moves to make a profit.
But facilitating profit-making is not the primary function of Forex. It serves a greater scope, and its size and volatility enable traders to buy and sell trades successfully.
An Ever-Moving Financial Market
We now know that the FX market closes for the weekend. But, as explained earlier, it's an ever-moving financial market.
It quickly reacts to everything happening around the world. It opens on Monday in New Zealand, with trading taking place for a couple of hours while it's still Sunday in the United States.
This trading activity taking place in New Zealand isn't reported by all brokers. The so-called "Sunday candle" has been subject to tremendous discussions lately.
Some brokers have decided that the candlestick distorts the charts, as nothing happens during these trading hours. However, if trading activity exists, it should be reflected in the charts.
Next, the major financial centers in Asia enter the market. Tokyo, Brisbane, Sydney, Singapore, Hong Kong, Shanghai, etc. enter the market with their focus on the previous week's levels.
Traders might see a gap in Monday's opening levels. In fact, due to the high liquidity environment, the only chance to see a gap in the FX market is over the weekend. Otherwise, there's always someone on the other side of a trade.
Monday sees some tricky price action because some important economic releases are made public over the weekend. For instance, Chinese economic data comes out on Sunday. Data related to inflation, GDP, etc. reveal the state of the Chinese economy.
This is important for Asian currencies, as China is a significant trade partner for most Asian countries. It is also, and especially, true for Australia and the Australian dollar (AUD).
Because most of Australia's exports go to China, the economic developments in China affect the size of Australia's GDP and, indirectly, the value of its currency.
Therefore, when the Chinese data comes out on any given Sunday, the AUD pairs will react.
Understanding ISO Codes
All currencies in the world have a three-letter code International Organization for Standardization (ISO) code. For instance, while you may read in a financial publication or hear over the news that the euro has appreciated or depreciated against the American dollar, according to the ISO codes, that means EURUSD has risen. EUR stands for the euro, and USD for the U.S. dollar.
Here are other examples illustrating the three-letter currency code convention:
- JPY – Japanese yen
- CAD – Canadian dollar
- AUD – Australian dollar
- RUB – Russian ruble
- HKD – Hong Kong dollar
All these currencies are part of the FX dashboard. A currency trader can't open positions on all of them at the same time — at least not when using manual trading.
Trading systems exist that use automated trading. Trading algorithms or robots place orders on the market and open and close positions on all currency pairs.
However, to successfully run such algorithms, one needs to consider the market correlations, the leverage, the available margin, and other factors — more on this subject in a dedicated article later in the trading academy.
One thing that newbie traders struggle with is the distinction between a currency and a currency pair. A currency pair reflects changes in both of the currencies that make up the pair and not the changes of a single currency only.
Countries and Currencies
The easiest way to form a clear understanding of the currency market is to think of the entire world. More precisely, just open a world map.
Each country — well, most countries — on the map has its own currency.
For instance, most Eurozone countries share the same currency, the euro. That means that the euro is the currency for nearly all 19 countries of the Eurozone. The Eurozone is a monetary union.
However, other currency regimes exist in other parts of the world. For instance, in Antigua and Hong Kong, there's a currency board system that uses USD as an anchor. That means that the USD reserves cover at fixed parity all the monetary bases in Hong Kong (i.e., the bank reserves plus HKD notes). There's a crawling band currency system in Azerbaijan, and so on.
These are particularities, and some other countries use other different currency regimes. Countries typically opt for a currency regime when their government and central bank fail to control the value of money and inflation affects the everyday lives of citizens.
- Comparing Different Economies
Currencies belong to a specific country or region. Thus, they reflect the economic strength of that country or region.
This is one of the most relevant particularities of the Forex market. For traders with a longer time perspective (e.g., swing traders or investors), the macroeconomic analysis implies an economic comparison of countries and regions worldwide.
Based on the outcome, traders buy or sell a given currency against other currencies. For instance, a trader might use the economic data of the Eurozone for the past quarter.
The trader looks at the unemployment rate, GDP, PMI (Purchasing Managers Index), inflation, and so on and uses the same criteria to analyze the UK economy.
If the results of the analysis point to a stronger economic performance in the Eurozone for the previous quarter, the trader sells GBP and buys EUR. In the FX market, that means the trader buys the EURGBP pair.
Currencies and Central Banks – the Most Important Relationship Every Trader Must Know
For every currency in the world, a central bank exists. The role of any central bank is to preserve the currency's value.
Now is the time to refer to the first article of this trading academy: A History of Money. If anything, the central banks protect the functions of money as described in that article.
Central banks have a ruling body. Called a committee, governing council, or something else similar, the ruling bodies meet regularly.
Typically every six weeks, the members get together and analyze the economic data. At the end of the meeting, the central bank states a monetary policy.
The statement presents the monetary policy for the period ahead. Because the interest rate level is the primary monetary policy tool, changing it creates volatility in all financial markets.
However, the mandate of a central bank is price stability, and currencies reflect this better than anything. Hence, the currency market reacts the most to changes in monetary policy, particularly in the interest rate level.
Central banks tighten their monetary policy when they raise interest rates. This is a hawkish view and bullish for the currency. Traders go long or buy the currency.
On the other hand, it is said that the monetary policy is eased when central banks cut interest rates. Such action is dovish, or bearish, for the currency. Consequently, traders go short or sell the currency.
This means the relationship between the value of a currency and the central bank is one of the most vital Forex market particularities. Everything in the FX market depends on the central banks' actions.
Active Forex Market Players
The Forex market is where any individual or entity can exchange large amounts of money. Some do it to speculate on the imminent increase or decrease in the value of a particular currency.
Some others do it because their clients instruct them to (e.g., banks). Even foreign tourists exchanging currency when visiting another country are market participants.
The sum of all these participants' actions makes up the foreign exchange market. The individual retail traders that operate on the currency market do not make up the bulk of it.
Instead, other market players are responsible for the five trillion or more in daily volume. Because this Trading Academy addresses retail traders, a key component of understanding the FX market is understanding who the other market players are.
Central Banks as FX Market Players
We already know that central banks control monetary policies. Besides the role of maintaining price stability, central banks also actively trade on the FX market.
Few retail traders know that central banks are profitable organizations too. For instance, the ECB (European Central Bank) distributes its profits each year to the national central banks of the Eurozone member countries. The SNB (Swiss National Bank) is also a private organization listed on the stock exchange.
In other words, central banks have an active role in buying and selling currencies besides setting the monetary policy. However, their purpose differs significantly from that of retail traders, and the resources available to central banks considerably exceed the resources of any other market player.
When conducting monetary operations, central banks effectively buy or sell the currency in the open market. They may do so to prevent a currency from depreciating too fast or ceasing its appreciation.
The world is full of such examples. A quick look at almost all emerging market countries shows that they all have a problem with currency depreciation.
The central bank intervenes directly in the market to keep the currency steady or to slow a depreciating trend. Argentina and Turkey provide such examples, with their central banks fighting the depreciation of the peso and lira, respectively.
Some other central banks intervene directly to stop their currency from appreciating. The SNB is famous for pegging the value of the CHF (Swiss franc) to the EUR at a fixed rate of 1.20 for the EURCHF pair.
The pair hasn't broken below the 1.20 floor because the SNB consistently buys it every time the pair threatens to fall below the 1.20 mark.
- Conducting Monetary Operations
Eventually, the SNB was forced to drop the peg due to billions and billions in losses and the inability to fight the CHF's bullish trend.
What's important to note here is that the central banks have more resources than any other institution. They can influence other market participants to trade in the same direction with their decisions.
Since the 2008 financial crisis that started in the United States, central banks worldwide have begun to use unconventional monetary policies. Up to that point, whenever inflation threatened an economy, the central bank would intervene by raising the interest rate level. It would ease the monetary policy when inflation dropped by cutting the interest rate.
But rate cuts only didn't work anymore. The world needed new measures, so the central banks began using unconventional monetary policies.
One Forex market particularity is that it reacts instantly to any central bank decision. For instance, if the central bank announces it will start buying government bonds, the FX market reacts in anticipation.
However, in the end, the central banks, via their trading department, start buying those bonds and directly influence future levels, even if the FX market reacts at the moment of the announcement.
Central banks' reserve managers are responsible for managing the FX reserves, so they are also active participants in the FX market. Don't take this for granted because the FX reserves of some countries are substantial.
The decision to shrink the exposure of one currency and increase that of another is enough to have a significant impact on the currency market.
Corporations Involved in Cross-Border Mergers and Acquisitions
The M&A sector creates large currency flows. When a corporation from one country buys another one in a different country, it must pay in the local currency.
For instance, if a Japanese company buys a German company, it has to pay for the transaction in euros. For that, it will turn to the FX market to exchange JPY for EUR, influencing the demand for the two.
Recent years have seen many industries consolidating, with giants merging to form a new, stronger entity. The transaction between such corporations is strong enough to change trends in the FX market.
The Professional Trading Community
This community is the envy of retail traders. All retail traders aspire to become professional traders, but the only thing they're missing is the funds to trade.
Retail traders have limited funds, with most speculating with their savings. However, professional trading community members trade with pooled funds, for instance.
Also, while the purpose remains the same (making a profit), the approach differs as well. In this category, for instance, we find algorithmic traders and proprietary trading desks at banks, hedge funds, and commodity trading advisors.
The professional trading community is responsible for most of the daily FX turnover. They have different trading strategies to speculate about future market moves, from technical to fundamental ones.
Sovereign Wealth Funds
A sovereign wealth fund (SWF) is an entity representing a country with a financial surplus. Typically, countries with large commodity resources (e.g., Norway, the United Arab Emirates) create SWFs and invest the proceeds for future generations.
The derived FX flows are enough to move the market on any given day, with a substantial impact on the market's volatility.
Anyone that uses an Internet browser and looks for a Forex broker is a retail trader. Retail traders have the smallest part of the FX market compared to all other Forex market players discussed so far.
However, they are a rising demographic. Trends suggest that beyond 2020, the proportion of retail traders on the daily FX market will increase significantly.
This is not by chance, as volume dictates the numbers. With more and more people joining the market every day, small accounts add to the essential numbers.
At the moment, though, the volume belonging to the retail traders has a minimal impact on the market. Just watch the FX market on a public holiday and see that the prices barely move. This shows that the actions of retail traders aren't enough to influence the FX market's volatility.
This is an area of the FX market little known to FX retail traders. National governments are responsible for large FX flows, as their needs often create disruptions in the market.
For instance, to maintain a military force in a foreign country, a national government needs the FX. In some cases, governments create entities directly responsible for managing FX liquidities.
The perfect example comes from Canada, where a financial entity set up by the province of Quebec manages public pension funds. With over 200 billion Canadian dollars in assets, the entity is an active player in the global FX market.
UBS, HSBC, and Citigroup are just some of the names involved in the dealing business. The FX turnover of these entities is enormous.
Being a dealing bank is expensive. One needs a global presence and a massive investment in the electronic technology required to offer competitive FX pricing.
When central banks change the interest rate level, they directly affect commercial banks too. For instance, let's assume a central bank increases the interest rate for its overnight facility deposit.
Its aim is to attract the excess reserves commercial banks may have. By placing excess liquidity with the central bank, commercial banks receive interest, adding to their profitability. In exchange, the central bank conducts monetary policy, tightening the monetary conditions, because such a move drains the liquidity in the economy.
But commercial banks want to make a profit. Therefore, they don't keep their excess reserves in cash and in local currency only. All commercial banks have a treasury department responsible for executing clients' instructions and for managing the bank's reserves.
Thus, to park funds with the central bank, commercial banks need funds in the local currency, thus influencing the overall FX flows.
Other Things to Consider When Trading on the Currency Market
So far, we've covered the size of the FX market as well as its leading players. The idea is for retail traders to assess the true nature of the currency market and be aware of what moves the prices.
Many retail traders fail. They fall prey to false advertising, to brokers that promote trading on the FX markets as the easiest thing on Earth and a sure path to financial freedom.
The reality begs to differ. Most retail traders fail, and one of the reasons is that they lack the proper trading education.
A quick look at the FX forums reveals that many traders blame the market. To be clear, the market has nothing to do with you and your actions. It merely reflects the other market players buying or selling.
For this reason, one way to consistently beat the FX market is to align your interests with those of the other market participants. Another way is to devise your own strategy that offers a competitive advantage ahead of the other market players.
This is how, for instance, the high-frequency trading industry appeared. Quant firms built algorithms based on mathematical formulas to buy and sell on the currency market.
Helped by powerful computers, the trading activity takes place at the sixth or seventh decimal place. Thus, the HFT operates on a niche for tiny market moves.
We can even say that the HFT industry doesn't really move the market. Because trading takes place at such a micro level, with thousands of trades per second, the actual quote on the fourth or fifth decimal place doesn't change much.
- Illogical Market
The FX market's moves often seem irrational. Retail traders often try to find the reason why the market is moving in a particular direction.
Encouraged by financial analysts and TV shows, everyone tries to justify why USD has risen, why JPY has depreciated in the last week, or why traders have dumped CAD. In reality, no one knows.
With such a wide variety of FX market participants, it is difficult to find the reason behind the move of a currency pair. At best, we can have an idea but can't know precisely why the market makes any given move.
Sometimes it moves without a logic. For instance, traders using the economic calendar for news trading often see surprising market reactions.
Using the economic calendar is straightforward. There's the previous release and the forecast, both known in advance.
Then, there's the standard interpretation of what a currency might do based on economic news — whether it will beat expectations or not. Let's use NFPs (non-farm payrolls) as an example.
NFPs are some of the most relevant economic releases in the United States. They show the strength of the U.S. labor market, and the Fed has a mandate of creating jobs. Thus, NFPs have a tremendous impact on USD's volatility.
If an NFP release beats expectations, USD moves to the upside. That means that on the FX dashboard, EURUSD, GBPUSD, NZDUSD, AUDUSD, and so on will fall, while at the same time, USDCAD, USDJPY, USDCHF will rise.
That's the standard and logic reaction. But in reality, many times the market reacts differently.
The initial reaction may be the correct one, but a few minutes later, the entire move might reverse, and the market might move in the opposite direction.
What should you make of such moves? Well, that's the beauty of trading on the FX market: No day is the same, and the market can discount anything in a blink of an eye.
- Correlations – Majors and Crosses
Another Forex market particularity is that it moves in a correlated fashion. That's especially true in the case of majors and crosses.
A major pair is one that has USD in its componence. As the world's reserve currency, USD splits the Forex dashboard into two distinct categories: majors and crosses.
Naturally, any currency pair that doesn't have USD in its componence is not a major. Instead, it is called a cross pair.
For every cross, there are two major pairs. The CADJPY cross, for example, has the USDCAD and USDJPY majors. Similarly, EURGBP has the EURUSD and the GBPUSD majors.
As a result, the three pairs move in a correlated fashion. Imagine that an NFP beats expectations, so USD surges. It does so both against EUR and GBP.
If EURUSD and GBPUSD fall by the same percentage, the cross remains flat. If not, the difference between the two is reflected in the cross's move.
Other correlations also exist, but we'll look at all of them in a future article dedicated to the subject.
FX Market Volume
The FX market volume is a sensitive subject for many FX retail traders. Because online trading has increased in popularity, traders participate in other markets too, like the stock market.
As such, they have learned to use volume-based strategies like VSA (volume spread analysis). Such strategies use volume information to spot big players entering and exiting the market. Therefore, retail traders want to trade in the same direction to discover the market's path of least resistance.
The problem on the FX market is that the volume information provided by the broker isn't accurate — or, rather, it is accurate, but it reflects only the volume traded by the broker's customers.
Therefore, when using the FX market volume as a base for trading decisions, keep in mind that it doesn't reflect the overall volume but only a fraction of it.
As we go deeper into this trading academy, it becomes evident that trading on the Forex market requires both knowledge and expertise, as well as funds and time. By now, you have an idea about what this market is, what money is, and, most importantly, what trading on the FX market is.
The Forex market particularities presented here don't cover everything there is to know about the currency market. Instead, we merely highlighted some critical aspects to consider before trading currencies.
Other market players besides the ones mentioned here also trade actively on the FX market. Also, the functions of the FX market go deeper into global trade and the resulting international flows.
Moving forward, the next article deals with the elements of a trading account, which may seem like a subject unworthy of a full article in this academy. But, as you're about to find out, knowing what a trading account stands for is important for setting up an overall strategy. Opening and funding a trading account these days isn't a hustle anymore. However, knowing how to make the most of it is relevant for your overall profitability.