Introduction to Forex Basics
In this article, we’ll build on your introduction to financial markets by focusing specifically on the forex market and how professionals trade it. We’ll explore what forex is, why we trade it, different market participants, and how they trade. By the end of this article, you’ll be ready to begin learning about how to analyze and trade this market in much more depth. So, let’s begin with what Forex trading is.
What is Forex Trading?
The forex markets, or FX markets as they’re commonly called by professionals, are where currencies of different nations around the world are traded and exchanged. The FX market is the world’s largest, with a daily traded volume of around seven trillion dollars. This immense volume means it’s less vulnerable to interventions and manipulation by any single entity over a sustained period. The spot market, which is what we’ll predominantly trade, is worth about 2.5 trillion dollars per day, still larger than any other related market on its own.
Trading in FX Markets
When trading FX markets, we’re essentially buying and selling money. This can be likened to the stock market, where buying a currency is like buying a share in a particular country. The price of the currency reflects the market’s view of the current and future health of that nation’s economy. For example, buying US dollars means you’re betting on the future success of the US economy, with the goal of selling those dollars back to the market for a net profit.
Currency symbols in FX consist of three letters. The first two letters identify the nation behind the currency, and the last letter identifies the currency itself. For instance, USD stands for United States Dollar. When buying a physical product like a share in a company or a commodity, we exchange money for the item. In FX, however, you can’t buy a dollar with dollars, so currencies are bought and sold in pairs, such as EUR/USD (Euro/US Dollar).
Currency Pairs
When trading FX, you’re always dealing in currency pairs. The currency on the left is the product, and the one on the right is the price. For example, if you buy the EUR/USD pair, you’re buying euros (the product), and the price displayed is how much a euro costs in US dollars. If EUR/USD is trading at 1.25, it means one euro costs 1.25 US dollars.
Major currencies have the best trading conditions due to higher liquidity, making buying and selling relatively simple. These include the US dollar, euro, Canadian dollar, British pound, Swiss franc, Japanese yen, Australian dollar, and New Zealand dollar. Minor currencies, often from emerging economies like Brazil, Russia, and Mexico, have less liquidity and are harder and more expensive to trade.
FX Market Structure
The FX market is decentralized, operating over the counter (OTC) within a network of banks continuously over a 24-hour period. This allows trading from virtually anywhere in the world. The most actively traded currency is the US dollar, followed by the euro and Japanese yen. The dominance of the US dollar is due to several factors, including the US being the world’s largest economy and having the largest and most liquid markets, a stable political system, unmatched military power, and the dollar being the medium for most cross-border transactions, like oil.
Importance of the US Dollar
According to the IMF, the US dollar comprises around 60% of the global currency reserves. This dominance means that the market pays close attention to US dollar-related data and indicators, regardless of the currencies being traded.
Market Participants
Speculators, who trade for profit, account for 90% of the daily FX market volume. Despite negative press, speculative trading is crucial for the smooth running of the financial system. The FX market also includes large banks, commercial companies, central banks, and governments. These entities engage in FX trading for various reasons, including conducting business, adjusting currency reserves, and stabilizing their currencies.
Different Ways to Trade Currencies
There are multiple ways to trade currencies in the FX market:
- Spot Market: Currencies are traded immediately at the current market price. This is the simplest and most liquid way to trade FX, allowing around-the-clock trading.
- Futures Market: Futures contracts are standardized agreements to buy or sell a certain asset at a specific price on a future date. Currency futures are traded on central exchanges, offering transparency and regulation.
- Options: Options give the buyer the right, but not the obligation, to buy or sell an asset at a specified price before the expiry date. Currency options are traded on central exchanges but have limited market hours and liquidity.
- ETFs (Exchange Traded Funds): ETFs allow trading of various assets, including currencies, in a more liquid market. They help diversify exposure but are subject to additional trading commissions and transaction costs.
Advantages of Trading Spot FX
Trading spot FX offers several advantages:
- Lower Commissions: FX trading is not centralized, eliminating traditional costs like clearing fees, exchange fees, and government fees.
- No Fixed Lot Sizes: Traders can set their own trade sizes, minimizing risk exposure.
- High Liquidity: Trades can be executed at virtually any time, ensuring fairness and preventing market manipulation.
Structure of the FX Market
The FX market’s structure is hierarchical. At the top are major banks like Goldman Sachs, followed by electronic dealing platforms (Reuters, Bloomberg), smaller banks, ECN brokers, market makers, hedge funds, and finally retail traders. Major banks deal directly with each other in the interbank market, where the best prices are found. Hedge funds, corporations, market makers, and ECN brokers deal through commercial banks, while retail traders often get slightly higher prices due to their position in the hierarchy.
Types of Brokers
There are two main types of brokers:
- ECN (Electronic Communications Network) Brokers: These brokers match buyers and sellers automatically and transparently, taking a small commission for their services.
- Market Makers: These brokers create their own market for clients to trade in. They can break larger contracts into smaller pieces but generally have higher costs and less transparent pricing.
As traders, ECN brokers are usually preferred for their transparency and cost-effectiveness.
Conclusion
We have explored the basics of FX trading, including the structure of the FX market, different market participants, and various ways to trade currencies. Understanding these fundamentals provides a solid foundation for engaging in the FX market and making informed trading decisions.