The currency, forex, or simply ‘FX’ markets are the largest (by volume) of any in the world, and is continually growing. During 2010, the FX market reached $5 trillion in average daily volume, by comparison in the same period, around $25 billion was traded on the New York Stock Exchange (NYSE).
The market may be huge, but until recently the vast majority of the volumes traded came from Institutions and professional traders, but as currency trading platforms have improved, it has enabled the smaller players to partake in the market and many have found that FX fits in with their investment goals and within their wider portfolio.
The FX market trades 24-hours a day. There are three major sessions: the Asian, European and United States sessions based around the different time zones. Although there is some overlap in the sessions, the main currencies in each market are traded mostly during those market hours. This means that certain currency pairs will be traded more during certain sessions and this has an effect on liquidity.
The FX market has neither a physical location nor a central exchange. The FX market is considered Over-The-Counter or ‘OTC’ due to the fact that the entire market is run electronically. In an OTC market, participants determine who they want to trade with depending on trading conditions, attractiveness of prices, and reputation of the trading counterpart.
The US Dollar is the most traded currency, making up almost half of all transactional volume. The Euro is second at around 20%, while that of the Japanese Yen is third at around 10%.
The chart below shows the seven most t actively traded currencies.
*Because two currencies, known as a ‘currency pair’ are involved in each transaction, the sum of the percentage shares of individual currencies totals 200%, not 100%.
The US Dollar plays a major role in FX. In fact, according to the International Monetary Fund (IMF), it comprises approximately 60% of the world’s official foreign exchange reserves.
Due to the fact almost every investor, business, and central bank have exposure of some kind to the US Dollar, it is the most closely watched currency.
There are also other significant reasons why the US Dollar plays a central role in the forex market:
- The US economy is the largest in the world.
- The US Dollar is the standard ‘reserve’ currency of the world, meaning that other countries hold US Dollars as part of their currency reserves.
- The US has the largest and most liquid financial markets in the world.
- The US is a military superpower.
- The US Dollar is used for many cross-border transactions e.g. oil and other major commodities are priced in US Dollars throughout the world.
It is important to note that while commercial and financial transactions are a large part of trading volume, the majority of currency trading is made up of currency/exposure hedging and speculation.
The trading volume brought about by speculators alone is estimated to be in excess of 70%.
The scale of the FX market means that liquidity (the availability of volumes available for buying and selling at any given time is extremely high. This makes it very easy for anyone to buy and sell currencies. From the perspective of an investor, liquidity is very important because it determines how easily price can change over a given time period. A liquid market environment like forex enables huge trading volumes to happen with very little effect on price, or price action.
Buying and Selling Currencies
FX trading is the simultaneous buying of one currency and selling another. Currencies are traded through a broker or dealer, and are traded in pairs under three letter abbreviated names; for example the Euro and the US Dollar (EUR/USD) or the British Pound and the Japanese Yen (GBP/JPY).
Major Currency Pairs
The currency pairs listed below are considered the “majors”. These pairs all contain the US Dollar (USD) on one side and are the most frequently traded. The majors are the most liquid and widely traded currency pairs in the world.
The most actively traded currency pairs excluding those against the US Dollar are Euro (EUR), Japanese Yen (JPY) and Great British Pound (GBP).
Minor Currency Pairs
Currency pairs that don’t contain the U.S. dollar (USD) are known as cross-currency pairs or simply as the “crosses.” The most actively traded crosses are derived from the three major non-USD currencies: EUR, JPY, and GBP.
Another term for currency pairs would be “Exotic”, these are made up of one major currency paired with the currency of an emerging economy, such as Brazil, Mexico or India.
Advantages of FX trading – There are many benefits and advantages to trading forex. Here are just a few reasons why so many people choose this market:
Simple cost structure – There is no clearing fees or exchange fees, any taxes or government fees. Most brokers are compensated for their services through something called the “bid/ask” or “bid/offer” spread, which is the difference between what a broker quotes they will sell a currency pair for and what they would buy it for. Simply put, the wider the spread, the more expensive it is to trade that currency – The mid-point between the two prices is the ‘spot rate’ – typically the true value of the currency and what a central bank expect the rate to be.
No fixed lot size – In the futures market, contract sizes are determined by the exchanges. A standard-sized contract for a silver future is 5,000 ounces. Trading FX, it is you that determines your trade, or position size. This allows traders to participate with smaller accounts.
Low transaction costs – The average transaction cost (the bid/ask spread) is typically less than 0.1% under normal market conditions. At larger dealers, the spread could be as low as 0.07%. Of course this depends on many factors such as your relationship with the broker and volumes traded etc.
A 24-hour market – There is no waiting for the opening bell. From the Monday morning opening in Australia to the afternoon close in New York, you can practically trade the FX market whenever you want to.
Leverage – In FX trading, a relatively small deposit (posted margin) can control a much larger total contract value. Leverage gives the trader the possibility of making a greater profit than they would be able to trading on a 1:1 basis.
For example, a broker may offer a trader 50:1 leverage on their account, which means simply that a $50 dollar margin deposit would enable a trader to place a trade worth $2,500. Please bear in mind that leverage can be a double-edged sword. Without proper risk management, utilising large amounts of leverage, this can lead to large losses as well as gains.
Highly Liquid – The FX markets size, as mentioned above, means it is extremely liquid. This is an advantage because it means that under normal market conditions, you are able to instantly buy or sell a currency pair as there is usually some other market participant willing to take the other side of your trade. It is extremely rare, if unheard of to get “stuck” in a trade that you can’t buy or sell out of. You can even set your online trading platform to automatically close your position once your desired profit level has been reached, and/or close a trade if a trade is going against you (stop loss).
Why trade FX?
The OTC Forex market does not have a physical location; it trades the majority of the week (excluding the weekend – closes Friday evening and opens Sunday night) virtually via a global network composed of people, businesses, and banks. Time differences around the world do not deter trading as it will begin in New Zealand, move across Asia, to London and then close in New York. This helps to ensure that there is little ‘price gapping’ i.e. when a price jumps with no trading in-between.
You can also take advantage of the fact that the FX is highly leveraged; meaning you only need to put down a fraction of the full value you wish to trade. The result of this is that you can make much larger profits and take much larger losses. This can be controlled however by utilizing strict risk management rules (something we will look at later).
Very important before you start on any journey, it’s crucial to know where you’re going and how you’ll get there. Whether you’re aiming to achieve financial independence or just to generate some extra income, it’s wise to allocate a timeframe and stick to a plan for at least the start of your trading career. Knowing what you constitute as failure and define as success is imperative to gaining the insight necessary for successful trading.
Forex trading is simple to grasp but exceeding difficult to master. Years of practice are required to master the craft but sticking to a simple set of rules, abiding by a plan and being sensible with your trading will ensure you enjoy your trading and hopefully remain profitable!
Disclaimer: Kindly note that the provided information is only for information purpose and does not represent any investment advice. Independent advice should be considered prior to making an investment decision