Foreign Exchange is the largest and most liquid market in the world with a daily turnover of about $ 4 trillion. The daily transactions volume exceeds the total turnover of the world's stock and futures exchanges combined. Forex is attractive for traders because of its high liquidity and around the clock trading.
Forex is over the counter market (OTC) - it has no central exchange for currency trading. Market participants are banks, brokers, dealers, financial institutions and individual traders worldwide. About 90% of the transactions are made in investment and speculative purposes, and only a small part of them is an actual currency conversion.
Currency trading is done in the major financial centers - Wellington, Sydney, Tokyo, Singapore, Moscow, Frankfurt, Zurich, London, New York, Chicago, San Francisco. Together these financial centers form a continuous circle, allowing to trade currencies around the clock. Choosing the appropriate session for trading is important for the trader as each session is different in its dynamics.
There are four major trading sessions:
Sydney 22:00 - 7:00 GMT
Tokyo 0:00 - 9:00 GMT
London 8:00 - 17:00 GMT
New York 13:00 - 22:00 GMT
The currency is most liquid when trading takes place during its "home" session. The Japanese yen is most liquid during Tokyo session, and the British pound during the working hours of London exchanges.
Traders continuously follow economic calendars and releases of economic data because of the large impact of macroeconomic factors, political events and monetary decisions of central banks on the Forex market.
Similar to other markets, the currency market’s participants are broadly divided into speculators and hedgers. Whereas speculators profit from the price changes, hedgers, on the other hand, are indifferent to changes in price because they own the physical assets.
Consider the following currency risk hedging example. If an investor owns production facilities in Germany, and sells the produced goods in the U.S., he will benefit from the strengthening of U.S. dollar and the weakening of the euro. In this case, after selling the goods in the U.S., the investor will receive more euros than expected. If the EUR/USD goes up (the euro appreciates, the dollar depreciates), the producer will suffer losses because he will receive less EUR, than planned.
Using Forex the investor can hedge the currency risk by going long the EUR/USD. If the exchange rate goes down, the investor loses on Forex, but earns more on the produced goods. With precise hedging currency risks can be greatly reduced.
The most liquid currencies are the U.S. dollar (USD), euro (EUR), British pound (GBP), Japanese yen (JPY), Swiss Franc (CHF) and the Canadian Dollar (CAD). These currencies account for more than 80% of all volume traded.
There are major pairs EUR/USD, GBP/USD, USD/CHF, USD/JPY and "commodity" pairs - NZD/USD, AUD/USD and USD/CAD. The last three pairs may be of interest to the metals and oil traders, as they highly depend on the price changes of these resources. It is commonly known that Australia and New Zealand are major miners of industrial metals, and Canada is the largest exporter of oil to the U.S.
Unlike the stock market, foreign exchange does not offer traders opportunities to diversify their portfolio. The long position on EUR/USD, GBP/USD and short on USD/JPY and USD/CHF give the trader about the same exposure because he is profiting from the weakening of the U.S. dollar.
Cross rates enable traders to diversify their strategy by including several currency pairs in their portfolio reducing the dependence on the U.S. dollar, which is used as a reserve currency for central banks. In addition, cross rates offer a more precise bet on the release effect of various economic data in a selected country.
Available for trading are such currencies as DKK, SGD, PLN, RUB, SEK, ZAR, MXN, CZK, HUF, NOK, ILS, collectively called “exotics” because of their low liquidity. Because of the difference in interest rates they are also of interest to the trader.
Exchange rates are expressed through the relation of one currency to another. For example: USD/JPY = 84.50. In this case, the U.S. dollar is the base currency and the yen is a counter currency - the equivalent of a base currency in yen. This quote means that one dollar can buy 84.5 yen.
As in other markets, there are «bid» prices, at which participants are willing to buy and «ask» prices, at which they are willing to sell. Spread is the difference between the two and is most narrow in normal market conditions. A wider spread is possible during the releases of economic data and the European night time.
If the trader is willing to buy this currency pair at market, the transaction will occur at «ask» prices, if he is willing to sell, then «bid» prices are used. When buying GBP/USD at the rate of 1.6202, the trader is buying 100 000 GBP, while simultaneously selling 162 020 USD.
Pip is the smallest change in price. For example, one pip on the EUR/USD pair is 0.0001, and for XAG/USD it is 0.01. Basically all currency pairs have four characters after a decimal point. Exceptions are pairs with JPY, RUB, and metals, which are listed with the two digits after the decimal point.
The cost of borrowing a currency depends on interest rates set by the central banks. By opening a currency pair position, the trader has the exposure to both currencies. Depending on the difference between the currencies’ interest rates trader earns or pays for the position rollover to the next day.
For example, after buying NZD/USD, the trader is long NZD and short USD. In other words, NZD is placed on deposit, and USD is taken on credit. The investor receives New Zealand dollar interest rate and pays the U.S. dollar rate. The difference between the two rates adding the commission is a position rollover fee (swap).
Most currency pairs have a delivery date (value date) t+2. To prevent the actual delivery to take place the position is closed and then reopened at the near same price if left overnight. In case the value date falls on a holiday, the position is rolled to the next working day, and the swap is charged for a few days in advance.
Most currencies move less than 1% a day, but high leverage more than compensates this small volatility. The advantage of the Forex market is that leverage allows to profit from a relatively small price changes. However, the risk of losses also increases in proportion to income opportunities.
Forex trading is done on margin, so the nominal size of the trader’s open positions can substantially exceed his account balance. Forex brokers offer high leverage to their clients (1:50 and 1:100). For example, when using leverage 1:100, to place a trade the trader must have at least 1% of the total exposure of his intended position. Trader's position is automatically liquidated when the current account balance falls below the amount necessary to maintain his open position.
Some currency pairs move in the same direction, and some in the opposite. Statistically, this relationship is called the correlation and is measured from -1 to +1. In the case of a perfect positive correlation currency pairs will move in the same direction 100% of the time. In case of a negative correlation – they will move in opposite direction. This information is useful to traders who are trading multiple currency pairs at once since the total risk exposure depends on it.
Two currency pairs show a strong correlation, if the absolute value is 0.7 or above. The EUR/USD and GBP/USD or AUD/USD and EUR/USD often move in the same direction. A currency pair example with a strong negative correlation is EUR/USD and USD/CHF, AUD/USD and USD/CAD.
The information presented in this article is provided for informational purposes only. It is not a recommendation to perform any operations on the currency market.
Trading currencies is risky and requires the appropriate knowledge and experience. Any of your investment decisions should be based entirely on an assessment of your personal financial circumstances and investment objectives.