What Is The Forex Market?
Forex, also known as the foreign exchange or currency market, is where different currencies are traded for one another. Due to the decentralized nature of the market, most trades are done over the counter; this means transactions take place outside formal exchanges such as the New York Stock Exchange (NYSE), London Stock Exchange (LSE), Financial Times Stock Exchange (FTSE) or the National Association of Securities Dealers Automated Quotations (NASDAQ).
Participants in the forex market range from corporations, financial institutions, and nations to regular individuals like you. Let’s say you intend to visit China, you heard a lot about the Great Wall and it’s become a bucket list challenge. So upon making plans you realize that as a citizen of the United States of America all you have is the dollars of the United States (USD) and in order to pay bills like your trip to the Great wall, you will need the yuan, which is the Chinese currency. Next on the agenda would be to Convert your USD to yuan; this could be done at a bureau of exchange at the airport in China or through your bank. By doing this you have successfully participated in the forex market, as you exchanged one currency for another.
The above paragraph explains a currency exchange derived from the movement of a person between two countries, expressing the need for currency exchange to be individual-based. However, the need for currency exchange by nations, corporations and financial institutions is more prevalent as every transfer of goods and services between nations with different currencies requires an exchange in currencies.
Each currency exchange is done at a specific rate; this rate determines how much a currency is worth in relation to another currency, which is referred to as a Currency Pair Price. The exchange rate of a currency can either be floating or pegged. A floating rate changes by a variety of reasons that affect the demand or supply of each currency in the pair and in relation to one another while a pegged currency, as the name suggests, is pegged to another currency so that its changes are parallel to that which it’s pegged to.
Currency Pairs
Currencies generally reflect the state of a nation’s economy and, as established earlier, a currency pair price represents the worth or value of one currency over another. This implies that every currency pair price reflects a comparison between the economies of the underlining countries.
Currencies are grouped into two parts, the majors and the minors. We will be focusing only on the major currencies as they are the most liquid. Below is a list of all the major currencies, their names, symbols, and country.
Country, Currency, and Forex Symbols
An example of a currency pair derived off these majors would be the pound and the United States dollar (GBP/USD) or the New Zealand dollar against the Canadian dollar (NZD/CAD). Given that the United States dollar is the world’s reserve currency, all pairs including the USD are the most liquid pairs traded in the forex market.
US Dollar Pairs & Prices
Example 1.a,
Tony, who lives in the United States, is interested in purchasing a Rolls Royce from the United Kingdom (Great Britain) for 180,000 pounds including shipping. How many USD does he need to make this purchase?
Since, 1 GBP = 1.2790 USD (based on GBP/USD)
180000 GBP = 180000 * 1.2790
= 230,220 USD.
Currency pair prices are constantly changing and these changes come as a result of multiple factors, which all boil down to economic strength. So a move of GBP/USD from 1.2790 to 1.3000 would imply Tony would need a lot more US dollars to purchase the same amount of pounds. This movement in price essentially means the pound has gained in value over the US dollar.
Forex Market Size
The forex market is the largest financial market in the world with a daily trading volume of 5.1 trillion USD (Triennial Central Bank survey 2016) and the USD remains the most dominant currency. The chart below shows the percentage of currency composition.
Figure 1
The forex market is significantly larger than the New York Stock Exchange, which is the largest equity market in the world at $40 billion in daily turnover. The United States bond market also falls short and it is the largest bond market in the world at $530 billion in daily trading volume. Below is a chart that clearly depicts these facts.
Figure 2
Benefits Of Trading Forex
Availability of Trading Information
In order to make quality decisions in trading any financial market, relevant information on supply and demand is needed. As established earlier, currency trading involves the economic strength of the countries whose currencies are in question. So in order to determine liquidity flow of one currency over another, the economic data affecting these currencies has to be readily available.
Thanks to scheduled news reports/events such as the growth reports (gross domestic product, inflation and employment data), monetary policy reports (interest rate data and Central Bank forecasts) are readily and publicly available. Unlike the equity market, the likelihood of insider information giving any market participants an unfair advantage over others is significantly low.
Market Size
As established earlier, the forex market is the largest financial market in the world. This means more liquidity, which translates to quick and instant execution of orders. In other words, you will never have to wait more than a single second for your order to be placed. Some markets face execution delays, where a market order is placed at a particular price but, due to delays, an alternative price is executed instead.
Leverage
This can also be referred to as debt trading. Most forex brokers provide traders with leverage proportional to the capital provided by the trader. This is a system that allows trading with more money than deposited by the trader. Leverage creates a case of “more risk more reward”. This means the more money you have the higher the positions you can take, resulting in more profits.
While more capital increases the size of your wins using leverage, it also increases losses but there is a cap point. This point is called the “margin call”; at this point your broker is likely to close out all open trades or restrict new trades as you may have lost all your initial deposit. The advantage here is you only get to lose your initial capital while your upside is unlimited. More on leverage will be discussed later in this chapter.
Round-the-Clock Market Participation
Yes! The forex market is open 24 hours. Due to the world’s participation in the forex market, there is always at least one market open. This allows traders the ability to manage their trades across different time zones.
Transaction Cost
Besides a few exceptions, the cost of trading in the forex market is significantly low, ranging from $0.5 to $4 in commission for a single contract. In most cases, the cost of trading is built into the trade in the form of a “spread”, which is the difference between the buy and the sell price of a currency pair.
Trading Applications/Mobile Trading
The forex market is one of the very few financial markets where retail traders have access to a lot of online trading platforms. These include Trade Station, Trading View, Ninja Trader and the most popular trading platform of all, MetaTrader 4 & 5 (MT4 & MT5), which we will go into detail about in later chapters. Some of these platforms have mobile applications that allow you the possibility to manage your trades while on the move.
Trading Terms And Definitions
What is a Pip?
Definition: A pip represents the smallest unit measurement of a currency pair, also known as a “point in percentage”.
This should be the most commonly used term in forex trading as it is the standardized unit used to measure the distance between two price points within a currency pair. Example: EUR/USD at 1.1407, the smallest unit would be 0.0001 (this is equal to one pip). Therefore, a change in EUR/USD by 0.0001 would be a change by one pip. This means if the price moved from 1.1407 to 1.1507, EUR/USD would have moved up a total of 100 pips.
In the case of certain currency pairs that are priced differently, the same logic still applies. The smallest unit of the price represents one pip. An example of this would be USD/JPY at 87.95, where the smallest unit of the pair is 00.01. Therefore, a change in USD/JPY by 0.01 would be a change by one pip.
NOTE: Some brokers display certain currency prices over the standardized number of digits, which is five. An example of this would be EUR/USD at 1.14075 instead of just 1.1407. This last digit represents a 10th of a pip, meaning a pip broken down into 10 parts.
Forex Quote
Definition: This is the latest price at which the currency pair traded.
Basically, the last trades both by the buyers and sellers were done at the quoted price. The quotes are always in pairs called the BID and ASK prices.
Bid And Ask Prices
Definitions: A bid is the last price where buyers accept to purchase the pair while the ask price refers to the price where sellers accept to sell the pair.
Traditionally the above would describe what bid and ask mean perfectly, but in the forex market and as retail traders it is slightly different. This is because bid and ask prices are lodged from the perspective of the broker, which means as a buyer the broker offers to sell the currency pair using the ask price and buys from the trader using the bid price.
Example: Bid and ask price for EUR/USD =1.1412/1.1414.
The lower price is bid and the higher price is ask. This means the broker is selling to traders at a higher price, representing the trader’s buy price and buying at the lower price, representing the trader’s sell price.
The moral of this story is that market makers always have the upper hand over retail traders in the case of quotes as traders will always get the worse price.
Market Spreads
Definitions: A spread represents the difference between the bid and the ask price.
Example: Given a quote on the EUR/USD at 1.1412/1.1414.
Spread: 1.1414 – 1.1412 =2
Base & Quote Currency
Definition: A base currency is a currency the exchange rate is derived off, while the quote is the measure of the base.
Take the EUR/USD @1.3660. This means for every one euro you need 1.3660 USD, establishing USD as the quote derived from a single euro. A simpler way to put it would be the currency that appears first in the pair is the base currency while the latter is the quote.
Lots
Definition: This is the unit measurement of a forex contract. It can also be referred to as a contract size.
Forex lots are categorized differently, the largest being the “standard lot” where a lot is 100,000 units of the currency in question and is represented as 1.00 lots. Below is a table showing the different categories of lots in the forex market and their unit symbols.
Table 3
Profits in the forex market are gotten by accurately predicting the change in a currency pair price. This change, as previously described, is measured in pips. To convert this pip to actual US dollar figures a certain calculation needs to be made.
For currency pairs with USD as the quote currency use the formula in the table below:
The above table suggests that a single pip on a dollar quote currency is 10 USD on a Standard lot, 1 USD on a Mini lot, 0.1 USD on a Micro lot and 0.01 USD on a Nano lot.
For pairs with the USD as the base currency, the formula is slightly different. Let’s calculate the 1 pip of the USD/CAD
1 pip = 0.0001 on the USD/CAD
At one standard lot; 1 pip = 100,000 * 0.0001
= 10 CAD (As the contract is quoted in Canadian dollars)
To get one pip of USD/CAD in United States dollars, you have to convert 10 CAD to USD by dividing the 10 CAD by the current USD exchange rate (1.32).
10 CAD / 1.3200 = 7.6 USD.
Note: To calculate a pip value for the other contract categories, just replace the contract.
Therefore, one pip of the USD/CAD is worth 7.6 USD on a single standard lot.
Another USD pair with a slightly different calculation is the USD/JPY mainly because one pip is 0.01. The table below will show a comparison in the calculation of the value of a pip in the USD/CAD and the USD/JPY.
Lastly, the value of one pip of a non-USD pair is calculated similarly to the above method. Let’s use the EUR/GBP. The quote currency here is the pound (GBP) @ 0.8556 and contract size is standard (1.00).
1 pip in GBP = 100000* 0.0001
= 10 GBP
1 pip In USD = 10 GBP * 1.329 (GBP/USD price)
= 13.29 USD per 1 standard lot
Note: Non-USD pairs paired with the yen (JPY) have the same calculation with one difference being the value of a single pip, which is 0.01, whereas other pairs are 0.0001.
Long And Short Position
Definition: A long position, also known as a BUY position, is a trade triggered with the goal of the price moving HIGHER than the price at which the trade was entered while a short position, also known as a SELL position, is the opposite, a trade entered where the goal is for the price to go LOWER than the current prices.
Basically, if you get into a long trade, you’re anticipating the currency pair price will go UP while if you go short, you hope prices go down. In the event that the price goes in the opposite direction of your anticipated move, your trade will go negative.
Market And Pending Orders
Definition: These are the methods of entering trades in the forex market. A market order allows the trader to enter a trade at the current market price while the pending order offers the ability to place a trade at price above or below the current market price. This, in turn, allows the trade to trigger automatically when the market gets to the intended order price.
There are four kinds of Pending Orders:
· Buy Limit
This order is used when the intention is to buy at a price lower than the current market price. Assuming the market price of EUR/USD is 1.1322 heading lower but your analysis suggests a reversal is likely around 1.1300–1.2980, you then set a “buy limit” at your preferred price within that range. Since this preferred price is lower than 1.1322, a buy limit guarantees you an entry as soon as the price gets to your level. Hopefully, a reversal then occurs and you go smiling to the bank.
· Sell Limit
If the intention is to enter a short trade at a price higher than the market price, a “sell limit” order is placed to guarantee a sell trade is activated as soon as the market gets to the higher price.
· Buy Stop
This order is used to enter long trades above the market price. This is mostly used in breakout strategies; here the aim is to catch aggressive price moves to the upside.
· Sell Stop
Similar to the buy stop, the sell stop is used to enter short trades at a price lower than the market price. It’s also used to catch aggressive moves to the downside.
Below is a diagram describing the above concepts:
Leverage
Definition: This represents the ratio of total trading capital to the deposit amount provided by the trader.
Leverage in general business terms suggests the infusion of borrowed funds in an investment. This is basically the same in forex but expressed in terms of ratios, commonly written as 500:1. This means for every 500 USD traded the trader is required to provide 1 USD (margin), thereby borrowing 500 USD on every 1 USD trading capital.
Margin
Definition: This is an amount stipulated by individual brokers to be provided by traders as a good faith deposit for specific trading position size.
As explained above, the margin represents the total required amount deposited by the trader to give access to the leveraged sum. The margin is usually represented in percentages (2%, 1%, 0.25, etc.), describing the percentage of the total trading capital required by the trader on specific leverage size.
Example: If a trader intended to open a position of 100,000 USD, a 1% margin would require the trader to provide 1000 USD in deposit to trade in such a size.
When Can You Trade?
We have established the fact that the forex market is a 24-hr market but this does not describe in detail how that is possible. The forex market may be open 24 hrs but only in select regions around the world and at certain times of the day. The tables below show the different trading sessions and their open and close times, also adjusted for daylight savings.
As displayed above, there are four major sessions for the forex market—Sydney, Tokyo, London, and the New York session—all of which have both unique and similar characteristics. You can also see that some sessions cross over in time; these portions of time give rise to certain market behavior. So it’s important to take note of the trading session you’re working on and their open and close times because this could mean the difference between a winning or losing trade.
Let’s look at the different characteristics in each trading session:
Tokyo Session
- Has the least market volatility with the exception of Asia Pacific pairs, which are the Aussie and yen pairs. This is also due to the fact that the two largest forex hubs in the world (London and New York) are mostly inactive during this session, resulting in thin liquidity and causing a really boring trading experience.
- Market activity during this session could serve as a leading indicator for the rest of the day’s price action as low volume leads mostly to range-bound moves, which then is likely to break out into a trend in the next session. In some cases, a volume accumulation is formed, which could serve as a key area of market reversal in the future.
- The main market participants during this session are not limited to just Tokyo or Sydney, but they include major financial hubs such as Hong Kong, Singapore and high-import-dependent nations like the People’s Republic of China.
- Most of the economic data are usually released in the early hours of this session; as a result, the session has its highest level of market activity during these hours.
London Session
- London is the forex capital of the world and as it shares a good chunk of this session with the New York session and a little with the Asian session. It is the most liquid forex trading session of all.
- Due to high-level trading activity, brokers have the luxury of offering a lower “transaction cost” to their clients (lower spreads).
- Trends tend to begin during this session as you get aggressive breakouts of consolidations created during the Tokyo session.
- Has the highest volatility of all sessions.
NY Session
- As we already established, the United States dollar is the highest-traded currency in the world and New York is its financial capital. This makes this session a highly liquid session as well.
- The early hour are when most macroeconomic data are released, adding to increased volatility during this period.
- Activity slows down after the close of the London session. This is especially the case on Fridays as most other session participants are closing for the week. Most traders tend to unwind positions just before the weekends.
- This unwinding of open trades sometimes leads to major reversals in the markets as well.
