The foreign exchange market (Forex or FX) is one of the most exciting, fast-paced markets around.
FX, forex, foreign-exchange market, currency market are all synonymous and all refer to the forex market.
Until recently, forex trading in the currency market had been the domain of large financial institutions, corporations, central banks, hedge funds and extremely wealthy individuals.
The emergence of the internet has changed all of this, and now it is possible for average investors to buy and sell currencies easily with the click of a mouse through online brokerage accounts.
Forex is one of the least volatile financial markets around.
Therefore, many currency speculators rely on the availability of enormous leverage to increase the value of potential movements.
In the retail forex market, leverage can be as much as 250:1. Higher leverage can be extremely risky, but because of round-the-clock trading and deep liquidity, foreign exchange brokers have been able to make high leverage an industry standard in order to make the movements meaningful for currency traders.
Extreme liquidity and the availability of high leverage have helped to spur the market’s rapid growth and made it the ideal place for many traders.
Positions can be opened and closed within minutes or can be held for months.
Currency prices are based on objective considerations of supply and demand and cannot be manipulated easily because the size of the market does not allow even the largest players, such as central banks, to move prices at will.
The forex market provides plenty of opportunity for investors.
However, in order to be successful, a currency trader has to understand the basics behind currency movements.
What Is Forex?
The foreign exchange market is the “place” where currencies are traded.
The forex market is the largest, most liquid financial market in the world.
It dwarfs other markets in size, even the stock market, with an average traded value of around U.S. $2,000 billion per day.
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.
This means that when the trading day in the U.S. ends, the forex market opens in Tokyo and Hong Kong.
Spot Market and the Forwards and Futures Markets
There are actually three ways that institutions, corporations and individuals trade forex:
- the spot market
- the forwards market
- the futures market
The forex trading in the spot market always has 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.
What is the spot market?
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, which usually takes two days.
What are the forwards and futures markets?
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 for 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.
Reading a Quote
When a currency is quoted, it is done in relation to another currency, so that the value of one is reflected through the value of another.
Therefore, if you are trying to determine the exchange rate between the U.S. dollar (USD) and the Japanese yen (JPY), the forex quote would look like this:
USD/JPY = 118.50
Direct Currency Quote vs. Indirect Currency Quote
This is referred to as a currency pair.
The currency to the left of the slash is the base currency, while the currency on the right is called the quote or counter currency.
The base currency (in this case, the U.S. dollar) is always equal to one unit (in this case, USD 1), and the quoted currency (in this case, the Japanese yen) is what that one base unit is equivalent to in the other currency.
The quote means that US$1 = 118.50 Japanese yen. In other words, US$1 can buy 118.50 Japanese yen.
The forex quote includes the currency abbreviations for the currencies in question.
There are two ways to quote a currency pair, either directly or indirectly.
A direct currency quote is simply a currency pair in which the domestic currency is the quoted currency.
An indirect quote, is a currency pair where the domestic currency is the base currency.
So if you were looking at the Canadian dollar as the domestic currency and U.S. dollar as the foreign currency, a direct quote would be USD/CAD, while an indirect quote would be CAD/USD.
The direct quote varies the domestic currency, and the base, or foreign currency, remains fixed at one unit.
In the indirect quote, on the other hand, the foreign currency is variable and the domestic currency is fixed at one unit.
For example, if Canada is the domestic currency, a direct quote would be 1.1600 USD/CAD and means that USD$1 will purchase C$1.16.
The indirect quote for this would be the inverse (1/1.1600), 0.8621 CAD/USD, which means with C$1, you can purchase US$0.8621.
In the forex spot market, most currencies are traded against the U.S. dollar, and the U.S. dollar is frequently the base currency in the currency pair.
In these cases, it is called a direct quote.
This would apply to the above USD/JPY currency pair, which indicates that US$1 is equal to 118.50 Japanese yen.
However, not all currencies have the U.S. dollar as the base.
The Queen’s currencies, the British pound, Australian Dollar and New Zealand dollar, are all quoted as the base currency against the U.S. dollar.
The Euro is quoted the same way as well. In these cases, the U.S. dollar is the counter currency, and the exchange rate is referred to as an indirect quote.
This is why the EUR/USD quote is given as 1.1500, for example, because it means that one euro is the equivalent of 1.1500 U.S. dollars.
Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of the Japanese yen (JPY), which is quoted out to two decimal places.
Bid and Ask
As with most trading in the financial markets, when you are trading a currency pair there is a bid price (buy) and an ask price (sell).
Again, these are in relation to the base currency.
When buying a currency pair (going long), the ask price refers to the amount of quoted currency that has to be paid in order to buy one unit of the base currency, or how much the market will sell one unit of the base currency for in relation to the quoted currency.
The bid price is used when selling a currency pair (going short) and reflects how much of the quoted currency will be obtained when selling one unit of the base currency, or how much the market will pay for the quoted currency in relation to the base currency.
The quote before the slash is the bid price, and the two digits after the slash represent the ask price (only the last two digits of the full price are typically quoted).
Note that the bid price is always smaller than the ask price.
Let’s look at an example:
USD/CAD = 1.2000/05
Bid = 1.2000
Ask= 1.2005
However, in order to sell this currency pair, or sell the base currency in exchange for the quoted currency, you would look at the bid price 1.20000.
It tells you that the market will buy US$1 base currency (you will be selling the market the base currency) for a price equivalent to 1.2000 Canadian dollars, which is the quoted currency.
If you want to buy this currency pair, this means that you intend to buy the base currency and are therefore looking at the ask price to see how much (in Canadian dollars) the market will charge for U.S. dollars.
According to the ask price, you can buy one U.S. dollar with 1.2005 Canadian dollars.
Whichever currency is quoted first (the base currency) is always the one in which the transaction is being conducted.
You either buy or sell the base currency.
Depending on what currency you want to use to buy or sell the base with, you refer to the corresponding currency pair spot exchange rate to determine the price.
Spreads and Pips
The difference between the bid price and the ask price is called a spread.
If we were to look at the following quote: EUR/USD = 1.2500/03, the spread would be 0.0003 or 3 pips, also known as points.
Although these movements may seem insignificant, even the smallest point change can result in thousands of dollars being made or lost due to leverage.
Again, this is one of the reasons that speculators are so attracted to the forex market; even the tiniest price movement can result in huge profit.
The pip is the smallest amount a price can move in any currency quote.
In the case of the U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001.
With the Japanese yen, one pip would be 0.01, because this currency is quoted to two decimal places.
So, in a forex quote of USD/CHF, the pip would be 0.0001 Swiss francs.
Most currencies trade within a range of 100 to 150 pips a day.
To summarize
- USD/CAD = 1.2232/37
- Base Currency to the left (USD)
- Quote/Counter Currency to the right (CAD)
- Bid Price 1.2232 : price at which the market maker will buy the base currency and the retail trader (you) will sell the base currency
- Ask Price 1.2237 : price at which the market maker will sell the base currency and the retail trader (you) will buy the base currency
- Spread : difference between bid and ask price (1.2237-1.2232), is 5 pips/points;
- Pip is .0001 and 1 point change would be from 1.2231 to 1.2232
Currency Pairs in the Forwards and Futures Markets
One of the key technical differences between the forex markets is the way currencies are quoted.
In the forwards or futures markets, foreign exchange always is quoted against the U.S. dollar.
This means that pricing is done in terms of how many U.S. dollars are needed to buy one unit of the other currency.
Remember that in the spot market some currencies are quoted against the U.S. dollar, while for others, the U.S. dollar is being quoted against them.
As such, the forwards/futures market and the spot market quotes will not always be parallel one another.
For example, in the spot market, the British pound is quoted against the U.S. dollar as GBP/USD.
This is the same way it would be quoted in the forwards and futures markets.
Thus, when the British pound strengthens against the U.S. dollar in the spot market, it will also rise in the forwards and futures markets.
On the other hand, when looking at the exchange rate for the U.S. dollar and the Japanese yen, the former is quoted against the latter.
In the spot market, the quote would be 115 for example, which means that one U.S. dollar would buy 115 Japanese yen.
In the futures market, it would be quoted as (1/115) or .0087, which means that 1 Japanese yen would buy .0087 U.S. dollars.
As such, a rise in the USD/JPY spot rate would equate to a decline in the JPY futures rate because the U.S. dollar would have strengthened against the Japanese yen and therefore one Japanese yen would buy less U.S. dollars.
Now that you know a little bit about how currencies are quoted, let’s move on to the benefits and risks involved with trading forex.
Commissions and Fees
Another major benefit of forex accounts is that trading within them is done on a commission-free basis.
This is unlike equity accounts, in which you pay the broker a fee for each trade.
The reason for this is that you are dealing directly with market makers and do not have to go through other parties like brokers.
This may sound too good to be true, but rest assured that market makers are still making money each time you trade.
Remember the bid and ask from the previous section?
Each time a trade is made, it is the market makers that capture the spread between these two.
Therefore, if the bid/ask for a foreign currency is 1.5200/50, the market maker captures the difference (50 basis points).
If you are planning on opening a forex account, it is important to know that each firm has different spreads on foreign currency pairs traded through them.
While they will often differ by only a few pips (0.0001), this can be meaningful if you trade a lot over time.
So when opening an account make sure to find out the pip spread that it has on foreign currency pairs you are looking to trade.
How to Trade Forex
Now that you know some important factors to be aware of when opening a forex account, we will take a look at what exactly you can trade within that account.
The two main ways to trade in the foreign currency market is the simple buying and selling of currency pairs, where you go long one currency and short another.
The second way is through the purchasing of derivatives that track the movements of a specific currency pair.
Both of these techniques are highly similar to techniques in the equities market.
The most common way is to simply buy and sell currency pairs, much in the same way most individuals buy and sell stocks.
In this case, you are hoping the value of the pair itself changes in a favorable manner.
If you go long a currency pair, you are hoping that the value of the pair increases.
For example, let’s say that you took a long position in the USD/CAD pair – you will make money if the value of this pair goes up, and lose money if it falls. This pair rises when the U.S. dollar increases in value against the Canadian dollar, so it is a bet on the U.S. dollar.
The other option is to use derivative products, such as options and futures, to profit from changes in the value of currencies.
If you buy an option on a currency pair, you are gaining the right to purchase a currency pair at a set rate before a set point in time.
A futures contract, on the other hand, creates the obligation to buy the currency at a set point in time.
Both of these trading techniques are usually only used by more advanced traders, but it is important to at least be familiar with them.
Types of Orders
A trader looking to open a new position will likely use either a market order or a limit order.
The incorporation of these order types remains the same as when they are used in the equity markets.
A market order gives a forex trader the ability to obtain the currency at whatever exchange rate it is currently trading at in the market, while a limit order allows the trader to specify a certain entry price.
Forex traders who already hold an open position may want to consider using a take-profit order to lock in a profit.
Say, for example, that a trader is confident that the GBP/USD rate will reach 1.7800, but is not as sure that the rate could climb any higher. A trader could use a take-profit order, which would automatically close his or her position when the rate reaches 1.7800, locking in their profits.
Another tool that can be used when traders hold open positions is the stop-loss order.
This order allows traders to determine how much the rate can decline before the position is closed and further losses are accumulated.
Therefore, if the GBP/USD rate begins to drop, an investor can place a stop-loss that will close the position (for example at 1.7787), in order to prevent any further losses.
As you can see, the type of orders that you can enter in your forex trading account are similar to those found in equity accounts.
Leverage
Leverage is basically the ability to control large amounts of capital, using very little of your own capital; the higher the leverage, the higher the level of risk.
The amount of leverage on an account differs depending on the account itself, but most use a factor of at least 50:1, with some being as high as 250:1.
A leverage factor of 50:1 means that for every dollar you have in your account you control up to $50.
For example, if a trader has $1,000 in his or her account, the broker will lend that person $50,000 to trade in the market.
This leverage also makes your margin, or the amount you have to have in the account to trade a certain amount, very low.
In equities, margin is usually at least 50%, while the leverage of 50:1 is equivalent to 2%.
Leverage is seen as a major benefit of forex trading, as it allows you to make large gains with a small investment.
However, leverage can also be an extreme negative if a trade moves against you because your losses also are amplified by the leverage.
With this kind of leverage, there is the real possibility that you can lose more than you invested – although most firms have protective stops preventing an account from going negative.
For this reason, it is vital that you remember this when opening an account and that when you determine your desired leverage you understand the risks involved.
Market Participants
Unlike the equity market, where investors often only trade with institutional investors (such as mutual funds) or other individual investors, there are additional participants that trade on the forex market for entirely different reasons than those on the equity market.
Therefore, it is important to identify and understand the functions and motivations of the main players of the forex market.
Governments and Central Banks
Arguably, some of the most influential participants involved with currency exchange are the central banks and federal governments.
In most countries, the central bank is an extension of the government and conducts its policy in tandem with the government.
However, some governments feel that a more independent central bank would be more effective in balancing the goals of curbing inflation and keeping interest rates low, which tends to increase economic growth.
Regardless of the degree of independence that a central bank possesses, government representatives typically have regular consultations with central bank representatives to discuss monetary policy.
Thus, central banks and governments are usually on the same page when it comes to monetary policy.
Central banks are often involved in manipulating reserve volumes in order to meet certain economic goals.
For example, ever since pegging its currency (the yuan) to the U.S. dollar, China has been buying up millions of dollars worth of U.S. treasury bills in order to keep the yuan at its target exchange rate.
Central banks use the foreign exchange market to adjust their reserve volumes.
With extremely deep pockets, they yield significant influence on the currency markets.
Banks and Other Financial Institutions
In addition to central banks and governments, some of the largest participants involved with forex transactions are banks.
Most individuals who need foreign currency for small-scale transactions deal with neighborhood banks.
However, individual transactions pale in comparison to the volumes that are traded in the interbank market.
The interbank market is the market through which large banks transact with each other and determine the currency price that individual traders see on their trading platforms.
These banks transact with each other on electronic brokering systems that are based upon credit.
Only banks that have credit relationships with each other can engage in transactions.
The larger the bank, the more credit relationships it has and the better the pricing it can access for its customers.
The smaller the bank, the less credit relationships it has and the lower the priority it has on the pricing scale.
Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the bid/ask price.
One way that banks make money on the forex market is by exchanging currency at a premium to the price they paid to obtain it.
Since the forex market is a decentralized market, it is common to see different banks with slightly different exchange rates for the same currency.
Hedgers
Some of the biggest clients of these banks are businesses that deal with international transactions.
Whether a business is selling to an international client or buying from an international supplier, it will need to deal with the volatility of fluctuating currencies.
If there is one thing that management (and shareholders) detest, it is uncertainty.
Having to deal with foreign-exchange risk is a big problem for many multinationals.
For example, suppose that a German company orders some equipment from a Japanese manufacturer to be paid in yen one year from now.
Since the exchange rate can fluctuate wildly over an entire year, the German company has no way of knowing whether it will end up paying more euros at the time of delivery.
One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go into the spot market and make an immediate transaction for the foreign currency that they need.
Unfortunately, businesses may not have enough cash on hand to make spot transactions or may not want to hold massive amounts of foreign currency for long periods of time.
Therefore, businesses quite frequently employ hedging strategies in order to lock in a specific exchange rate for the future or to remove all sources of exchange-rate risk for that transaction.
For example, if a European company wants to import steel from the U.S., it would have to pay in U.S. dollars.
If the price of the euro falls against the dollar before payment is made, the European company will realize a financial loss.
As such, it could enter into a contract that locked in the current exchange rate to eliminate the risk of dealing in U.S. dollars. These contracts could be either forwards or futures contracts.
Speculators
Another class of market participants involved with foreign exchange-related transactions is speculators.
Rather than hedging against movement in exchange rates or exchanging currency to fund international transactions, speculators attempt to make money by taking advantage of fluctuating exchange-rate levels.
The most famous of all currency speculators is probably George Soros.
The billionaire hedge fund manager is most famous for speculating on the decline of the British pound, a move that earned $1.1 billion in less than a month.
On the other hand, Nick Leeson, a derivatives trader with England’s Barings Bank, took speculative positions on futures contracts in yen that resulted in losses amounting to more than $1.4 billion, which led to the collapse of the company.
Some of the largest and most controversial speculators on the forex market are hedge funds, which are essentially unregulated funds that employ unconventional investment strategies in order to reap large returns.
Think of them as mutual funds on steroids. Hedge funds are the favorite whipping boys of many a central banker.
Given that they can place such massive bets, they can have a major effect on a country’s currency and economy.
Some critics blamed hedge funds for the Asian currency crisis of the late 1990s, but others have pointed out that the real problem was the ineptness of Asian central bankers.