How does Forex work?
The Forex market (Forex or FX for short) is one of the most exciting and fast-moving markets. Until a few years ago, foreign exchange trading was the domain of large financial institutions, corporations, central banks, hedge funds and extremely wealthy individuals. The emergence of the Internet has changed all this and now average investors can buy and sell currencies through online brokerage accounts with the single click on a mouse.
Daily currency fluctuations are usually very small. Most currency pairs move less than a cent a day, which is less than a 1% change in the value of the currency. This makes the currency market one of the least volatile financial markets. Therefore, many currency speculators rely on the availability of an enormous leverage effect to increase the value of potential movements. In the Forex market, the leverage can be up to 400:1, but ESMA (European Securities and Markets Authority) has pushed to reduce the leverage to a maximum of 30:1 recently with other geographic regulators likely to follow. Higher leverage can be risky, but due to round-the-clock trading and low liquidity, forex brokers could make high leverage an industry standard to make movements meaningful for forex traders.
Extreme liquidity and high leverage have helped to drive the market’s rapid growth and make it the ideal place for many traders. Positions can be opened and closed in seconds or held for months. Currency prices are based on objective supply and demand considerations and are not easy to manipulate, as the size of the market does not allow even the largest players, such as central banks, to move prices at will.
The foreign exchange market offers many opportunities for investors. However, to be successful, a forex trader must understand the fundamentals of currency movements.
Forex is an OTC market
The foreign exchange market is the “place” where currencies are traded. Currencies are important to most people around the world, whether they recognize it or not, because currencies need to be exchanged in order to do foreign trade and business. If you live in Germany and want to buy cheese from Switzerland, you or the company from which you buy the cheese must pay the Swiss seller for the cheese in Swiss francs (CHF). This means that the German importer would have to exchange the equivalent of Euro into CHF. The same applies to travel. A French tourist in Egypt cannot pay in euros to see the pyramids because it is not the locally accepted currency. The tourist must therefore exchange the euro for the local currency, in this case the Egyptian pound, at the current exchange rate.
The need to change currencies is the main reason why the currency market is the largest and most liquid financial market in the world. It surpasses other markets in their size, even the stock market, with an average trade value of around $5 billion per day.
A unique aspect of this international market is that there is no central marketplace for foreign exchange. Rather, foreign exchange trading is conducted electronically over the counter (OTC), meaning that all transactions are conducted over computer networks between traders around the world and not at a central exchange like the Wall Street. 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 – in almost every time zone. This means that after the end of the trading day in the USA, the foreign exchange market in Tokyo and Hong Kong will start anew and trading volume will shift. This means that the forex market can be extremely active at any time of day, with price quotations constantly changing.
Spot market and futures markets
There are actually three ways for institutions, companies and individuals to trade foreign exchange: the spot market, the futures market (Futures) and the futures market (Forwards). Forex trading on the spot market has always been the largest market because it is the “underlying” real value on which the futures markets are based. In the past, the futures market was the most popular place for traders as it was available to individual investors over a longer period of time. However, with the advent of electronic trading and numerous forex brokers, the spot market has experienced an enormous surge 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 refer to the spot market. Futures markets are usually more popular with companies that need to hedge their foreign exchange risks at a certain point in the future. That is usually done by Forwards (fix or window).
What is the spot market?
Specifically, the spot market (cash market) is the place where currencies are bought and sold at the current price. This price, which is determined by supply and demand, reflects many things, including current interest rates, economic performance, sentiment towards current political situations (both local and international) and the perception of the future development of one currency against another. When a deal is closed, it is referred to as a “spot deal”. It is a bilateral transaction in which one party delivers an agreed currency amount to the other party and receives a certain amount of another currency at the agreed exchange rate value. After a position has been closed, the settlement takes place in cash. Although the spot market is generally known as one that deals with transactions in the present (and not the future), these transactions actually take two days to settle.
What are the forward and futures markets?
In comparison to the spot market, the forward and futures markets do not trade in actual currencies. Instead, they are contracts that claim a particular currency type, a particular unit price, and a future settlement date.
In the futures market, contracts are bought and sold OTC between two parties that determine the terms of the contract.
In the futures market, futures contracts are bought and sold on the basis of a uniform size and settlement date in public commodity markets such as the Chicago Mercantile Exchange (CME). In the USA, the National Futures Association regulates the futures market. Forward contracts contain specific details, including the number of units traded, the delivery and settlement date and minimum price increases, which cannot be adjusted. The Exchange acts as a counterpart to the trader and ensures settlement.
One of the biggest confusions for beginners to the foreign exchange market is the standard for quoting currencies. In this section, we will look at currency quotes and how they work in currency pair trading.
Read a quote
When a currency is shown, it is quoted in relation to another currency so that the value of one currency is reflected by the value of another. So if you try to determine the exchange rate between the US dollar (USD) and the Japanese yen (JPY), the exchange rate would look like this: USD/JPY = 119.50
This is called a currency pair. The currency to the left of the slash is the base currency, while the currency to the right is the quote or counter currency. The base currency (in this case the US dollar) is always one unit (in this case 1 US dollar), and the quoted currency (in this case the Japanese yen) is what that one base unit is in the other currency. The rate means that US$1 = 119.50 Japanese Yen. In other words, US$1 can buy 119.50 Japanese yen. The currency quotation contains the currency abbreviations for each currency.
Direct currency quotation vs. indirect currency quotation
There are two ways of quoting a currency pair directly or indirectly. A direct currency quote is simply a currency pair in which the local currency is the quoted currency; while an indirect quote is a currency pair in which the local currency is the base currency. So if you were to consider the Canadian dollar as the national currency and the US dollar as the foreign currency, a direct quote would be USD/CAD, while an indirect quote would be CAD/USD. The direct rate varies the local currency, and the base or foreign currency remains fixed at one unit. In the indirect rate, however, the foreign currency is variable and the local currency is fixed at one unit.
For example, if Canada is the local currency, a direct quote would be 1.18 USD/CAD and means that USD$1 will buy C$1.18. The indirect quotation marks for this are the inverse (1/1.18), 0.85 CAD/USD, which means you can buy US$0.85 with C$1.
In the forex spot market, most currencies are traded against the US dollar and the US dollar is often the base currency in the currency pair. In these cases we speak of a direct offer. This would apply to the USD/JPY currency pair above, which means that 1 US dollar = 119.50 Japanese yen.
However, not all currencies are based on the US dollar. The queen’s currencies – those currencies that have historically been associated with Britain, such as the British pound, the Australian dollar and the New Zealand dollar – are all quoted as the base currency against the US dollar. The relatively new euro is also quoted in the same way. In these cases, the US dollar is the counter currency and the exchange rate is referred to as the indirect quote. For this reason, the EUR/USD quote, for example, is 1.20 because this means that one euro is the equivalent of 1.20 US dollars.
Most exchange rates are quoted with four (plus a 5th) decimal places, with the exception of the Japanese yen (JPY), which is quoted with two (plus a 3rd) decimal places. The 4th (2nd for Yen pairs) decimal number is called pip.
If a currency quotation is given without the US dollar as one of its components, this is referred to as a foreign currency. The most common currency pairs are EUR/GBP, EUR/CHF and EUR/JPY. These currency pairs expand trading opportunities in the forex market, but it is important to note that they do not have as many followers (e.g. not as actively traded) as pairs containing the US dollar, also known as majors.
Bid and Ask
As with most trading transactions on the financial markets, when trading a currency pair there is a bid price (buy) and an offer price (sell). Here, too, these refer to the base currency. When buying a currency pair (long), the ask price refers to the amount of the quoted currency that must be paid to buy a unit of the base currency, or how much the market will sell for a unit of the base currency relative to the quoted currency.
The bid rate is used when selling a currency pair (short) and reflects how much of the quoted currency will be obtained when selling a unit of the base currency or how much the market will pay for the quoted currency relative to the base currency.
The offer before the slash is the bid rate, and the two digits after the slash represent the ask rate (only the last two digits of the full price are normally offered). Note that the bid price is always lower than the ask price. Let’s look at an example:
USD/CAD = 1.2000/05
Bid = 1.2000
If you want to buy this currency pair, it means that you want to buy the base currency and therefore look at the ask rate to see how much (in Canadian dollars) the market will charge for US dollars. According to the ask rate, you can buy one US dollar at 1.2005 Canadian dollars.
However, to sell this currency pair or sell the base currency in exchange for the quoted currency, you would look at the offer price. It tells you that the market will buy 1 US dollar base currency (you will sell the base currency to the market) for a price of 1,2000 Canadian dollars, which is the quoted currency.
The currency that is quoted first (the base currency) is always the one in which the transaction is carried out. You buy or sell the base currency. Depending on the currency in which you want to buy or sell the base currency, you refer to the corresponding spot rate for the currency pair to determine the price.
Spread and pips
The difference between the bid price and the ask price is called the spread. If we were to look at the following quote: EUR/USD = 1.2500/03, the spread would be 3 pips, also known as points when looking at not-currency markets like indices or commodities. A pip is therefore the fourth decimal place, or the second for JPY pairs. In recent years, brokers and banks have added the fifth decimal place (and third for YEN pairs). This should allow a more accurate calculation.
Although these movements may seem insignificant, even the smallest point change can lead to thousands of dollars being made or lost through leverage. This, too, is one of the reasons why speculators are so attracted to the currency market; even the smallest price move can lead to huge profits.
The pip is the smallest amount a price can move in any currency. In the case of the US dollar, euro, British pound or Swiss franc, a pip would be 0.0001. In the case of the Japanese yen, a pip would be 0.01, as this currency is quoted to two decimal places. For a currency quote of USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies trade in the range of 100 to 150 pips per day.
Differences between foreign exchange and equities
A major difference between the foreign exchange market and the equity market is the number of instruments traded: The foreign exchange market has very few compared to the thousands on the stock market. The majority of forex traders focus their efforts on seven different currency pairs: the four main currencies (EUR/USD, USD/JPY, GBP/USD, USD/CHF) and the three commodity pairs (USD/CAD, AUD/USD, NZD/USD). All other pairs are just different combinations of the same currencies, also known as cross-currencies. This makes forex trading easier, because instead of having to choose between 10,000 stocks to find the best value, forex traders only have to “keep up to date” with the economic and political news from eight countries.
Equity markets can often suffer a slump, leading to a decline in volume and activity. As a result, it can be difficult to open and close positions if desired. Moreover, in a declining market, an equity investor can only make a profit with extreme ingenuity. It is difficult to short sell in the US equity market as strict rules and regulations apply to this process. On the other hand, the Forex market offers the opportunity to benefit in both rising and falling markets, as you buy and sell simultaneously with each trade and short selling is inherent in each transaction. Because the Forex market is so liquid, it is not necessary for traders to wait for an uptrend before entering a short position – just like in the stock market.
Due to the extreme liquidity of the forex market, the margin is low and the leverage is high. It is simply not possible to find such low margin rates in the equity markets; most margin traders in the equity markets require at least 50% of the value of the investments available as margin. In addition, commissions on the stock market are much higher than on the foreign exchange market. Traditional brokers charge commissions on the spread and fees payable on the exchange. Spot forex brokers only take the spread as a fee for the transaction.