The foreign exchange market, also known as FOREX or FX, is a global marketplace which facilitates the simultaneous buying of one currency and selling of another. Considered the world’s most liquid financial market with average daily volume peaking at $6 trillion (in 2014), FOREX market participants include governments and central banks, institutional investors (such as large international banks and hedge funds), speculators, commercial corporations as well as individual retail traders.show more
With the major FOREX trading centres located in Sydney, London, New York, Tokyo, Singapore and Hong Kong intermediating approx. 77-percent of trading, the FOREX market is unique in that it is a decentralised over-the-counter (OTC) trading market. That is, there is no central marketplace for currency exchange, rather currencies are exchanged directly between parties.
Traded through a broker or a dealer, FOREX currencies are traded against one another in pairs; with one currency being quoted in terms of the other.
Dating back to its earliest days in 1875 and the formation of the Gold Standard monetary system whereby governments would guarantee the conversion rate of currency into a specific amount of gold and silver (and vice versa) and the Bretton Woods System in 1944 which saw fixed exchange rates between countries whose currency values were pegged to the US Dollar, and the US Dollar’s exchange-to-gold at a fixed rate of $35 per ounce, modern FOREX was born in 1973 when floating and relatively free market conditions were adopted by developing nations.
In the mid-1980’s, Reuters released ‘Reuters Dealing’ – the first electronic form FOREX trading. The dot-com age of the 1990’s and the internet reduced barriers to entry and saw an explosion of retail FOREX traders flood the currency market and institutional dealers (such as banks and brokers) developing internet based trading platforms automatically matching traders buy and sell orders with market counterparties.
Today, with more than $5.3 trillion daily turnover (2016) and hundreds of millions of daily trades, the FOREX market is the world’s largest and most liquid financial market.
FOREX transactions take place on either a spot, forward or future basis. FOREX options are also popular trading instruments.
A spot FOREX transaction is for immediate delivery (or settlement within two-business days as defined by standard settlement timeframes). It is an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on the spot date. The agreed exchange rate is known as the spot exchange rate. Accounting for almost 40-percent of average daily turnover, spot FOREX transactions are easily facilitated with global electronic currency trading.
A forward FOREX transaction is a non-standardised contract settles on a date later than a spot transaction. It is an agreement to purchase (or sell) a set amount of a currency at a predetermined price at an agreed date in the future. Similar to a futures transaction (which is a standardised contract), forward transactions are used to hedge against currency rate risk.
A FOREX option is an instrument that gives the right, but not the obligation to buy or sell a currency pair at a predetermined price (known as the strike price) on a prespecified date (called the expiry date). A call option gives you the right to buy, a put option gives you the right to sell. FOREX options are primarily used by traders for short-term hedges of spot FOREX market positions.
Spot, forward or future transactions as well as FOREX options are typically used for speculating and/or hedging purposes.
FOREX pairs are classified either ‘major’, ‘minor’ or ‘exotic’.
Major currency pairs contain the US Dollar on one side; either the base side or the quote side and are the most frequently traded FOREX pairs accounting for approx. 85% of FOREX trading volume. Characterized by massive liquidity and a tight bid/ask spread, major FOREX pairs include: EUR/USD, USD/JPY, GBP/USD, AUD/USD, USD/CHF, NZD/USD and USD/CAD. In 2016, the USD was the primary currency for 88-percent of all FOREX transactions with the USD/EUR the most traded currency pair (23.1-percent of all FOREX trades in 2016).
Minor currency pairs do not include the US Dollar. Also known as cross-currency pairs, minor FOREX pairs are relatively less popular trading pairs and exhibit considerably less trading liquidity. Most minors FOREX pairs include one of the three major non-US Dollar currencies (Euro, Pound and/or Yen) including: EUR/CHF, EUR/NZD, GBP/AUD, GBP/JPY and CAD/JPY.
Exotic currency pairs are generally paired with a major currency such as the US Dollar and are issued by countries with small economies. Typified by large bid/ask spreads, illiquidity and low trading volume, exotic currencies include: the Brazilian real, the Afghanistan Afghani, the Indonesian Rupiah or the Thai baht.
Using a country’s assigned three letter currency symbol whereby the first two letters represent the country’s name and the third letter identifies that country’s currency, the first currency in the FOREX pair is referred to as the ‘base currency’ while the second currency is the ‘counter currency’ or ‘quote currency’.
The value of the base currency is always equal to 1.
EXAMPLE: The Australian Dollar and the US Dollar (AUD/USD); the base currency is the AUD while the quote currency is the USD. In the example of the AUD/USD, this is the price of the AUD in US Dollars and if the AUD/USD is trading at 0.79213, this means that 1 Australian Dollar will buy 0.79213 US Dollars.
Because a standard FOREX quote lists two currencies as a rate and free market conditions mean the currency price is set by the market based on supply and demand, the exchange rate fluctuates. That is, when the value of a currency increases in terms of another, it is known as appreciation. Conversely, when the value of a currency decreases compared to another currency, this is known as depreciation. FOREX speculators and hedgers buy and sell based on whether a currency will increase (appreciate) or decrease (depreciate) in value for profit.
FOREX trading is the purchase of one currency and the simultaneous sale of another.
When reading a FOREX quote, a pip (percentage in point) is the smallest unit of measurement used in a price quote to represent the change in value between two currencies. It is the last decimal place of a price quotation. Most FOREX pairs are quoted to 4-decimal places. For example, if the AUD/USD moves from 0.79213 to 0.79214, that .0001 USD rise in value is one-pip.
When trading a FOREX pair there is a ‘bid’ price and an ‘ask’ price quoted. The bid and ask price is always quoted in relation to the base currency.
The bid price is the price at which the market is prepared to buy a currency pair in the FOREX trading market. That is, it is the price at which a trader can sell the base currency. In a price quote, the bid price in on the left of the FOREX quote.
The ask price (sometimes known as the offer price) is the price at which the market is willing to sell a currency pair in the FOREX trading market. That is, it is the price that a trader buys in at. The ask price appears in the right of the FOREX quote.
The bid price will always be lower than the offer price.
The difference between the bid and the ask price in a FOREX quote is known as the ‘spread’ and represents the market makers profit (or commission). Generally, the more liquid the FOREX pair, the narrower the bid/ask spread. Conversely, the less liquid the FOREX pair, the wider the spread.
EXAMPLE: The AUD/USD has a current price quote of 0.7935/0.7938. That is, a trader who is seeking to sell one AUD could do so at the bid price 0.7935. A trader wanting to buy the one AUD could at the ask price 0.7938. The bid ask spread is .0003 or 3 pips.
In FOREX trading, lot size is used to describe the trade size in amounts of the currency pair.
A standard lot of the base currency is 100,000 units and is assigned a trading size of 1.0.
A mini lot is one-tenths of a standard lot or 10,000 units of the base currency. Assigned a size of 0.1, a mini lot trade may range from 0.1 – 0.99 lots.
A micro lot is one-hundredths of a standard lot or 1,000 units of the base currency. Assigned a size of 0.01, a micro lot trade may range from 0.01 – 0.099 lots.
One of the benefits of FOREX trading is the availability to leverage a trade using a margin account.
Leverage is a loan provided to a FOREX trader by the broker and is used to control larger trade sizes and magnify returns. Typically, the amount of leverage (expressed as a ratio) provided to the trader is either 50:1, 100:1 or 200:1, depending on the broker and the size of the position they are trading.
Expressed as a percentage, margin is the amount of money (or deposit) given to the broker to open (or maintain) the leveraged market position/s. Margins are required in order to use leverage. Expressed as a percentage of the full amount of the position such as 2%, 1%, 0.5% or 0.25%, a margin account allows a FOREX trader to leverage a position that is larger than the actual account balance.
FOREX traders using leverage and a margin account should always consider the risks.
EXAMPLE: If a FOREX trader has $1,000 cash in a margin account that requires 1% initial margin (or deposit) and allows 100:1 leverage, up to $100,000 worth of currency can be traded.
Calculating the profit (or loss) of a FOREX transaction requires (a) the position size and (b) how many pips price has moved for (or against) the position. Simply, profit or loss is equal to the position size multiplied by the amount of pips moved.
EXAMPLE: Assuming a trader holds a 100,000 GBP/USD position currently trading at 1.6240. If price rises from GBP/USD 1.6240 to 1.6255, then price has appreciated by 15 pips. For a 100,000 GBP/USD position, the 15 pips movement equates to USD 150 (100,000 x 0.0015) profit.
It is estimated that up to 90-percent of FOREX trading volume is based on speculation. A ‘speculator’ is a FOREX trader who buys and sells for short or long-term gain in anticipation of future directional price movements. More than 75-percent of speculation takes place on major currencies where liquidity or trading volume is high. FOREX speculators include hedge funds, commercial companies and individual retail clients.
FOREX traders who buy and sell currencies as a risk management tool are ‘hedgers’. Used to eliminate or reduce risk, hedging is employed by Governments, banks, corporations, pension funds, exporters and importers all of who may need to protect against foreign currency fluctuations to facilitate international trade or to insure against an adverse price movement in an underlying asset.
The FOREX market operates 24-hours a day, five-days a week with three primary trading sessions which form the market; the Asian session, the US session and the European session. During these trading sessions, an overlapping of trading hours occurs. During this overlap, the highest volume of trades take place resulting in a greater number of opportunities to profit.
Market open hours begin in Sydney, 7:00am – 4:00pm AEST; at 9:00am the Asian market in Tokyo opens but before it closes at 5:00pm, the London market comes online at 5:00pm. The New York trading session opens at 10:00pm (AEST) and closes at 7:00am when once again, the Sydney FOREX market reopens for daily trading.
Because a floating exchange rate system means that currency rates are free to appreciate and depreciate according to market forces, demand for a country’s currency on the FOREX market is determined by a number of political, economic and financial influences which can result in either an appreciation or depreciation of the country’s currency.
Used by traders to determine a country’s level of economic health, FOREX rates are affected by a country’s; interest rate level and monetary policy, economic growth and inflation, political policies (including election results), trade conflicts and terror related attacks as well as major movement in financial markets (such as a stock market crash) .
Demand and supply for imports and exports including current levels of foreign investment will also affect the valuation for a country’s currency.
For traders, the FOREX market offers many advantages relative to other financial markets. Not only is the FOREX market 24-hour, liquidity is high and transaction costs are considerably lower than other markets. Because of the magnitude of buyers and sellers the market itself is transparent and difficult to manipulate. There is no fixed lot size and traders can potentially profit in all market condition – bull, bear or sideways markets – with long or short positions. FOREX Traders can access margin facilities and using leverage, multiply returns on their investment. However, traders should always balance those benefits with some of the risks involved.