Introduction to The Forex Market
- The Forex Market
- Main Forex Participants
- Benefits of Trading Forex
- Summary Report
Welcome to this, your first lesson in our Free Forex Course. We hope you find the content interesting,
informative and helpful to your trading future.
In this first lesson you will learn about all the basic information regarding the Forex market. While these following lessons will cover a large number of concepts and ideas in great depth, more detail and advanced trading ideas are available in our academy
In any kind of business, it is important to understand every aspect of the market, from the very essentials to the most complex issues that affect it.
Trading have many aspects and requires knowledge to make educated choices . I’ve seen many traders getting a margin call (MC) without being aware what kind of leverage was being used when the MC happened and some other traders without even knowing what a margin call was!! (If you are not familiar with these terms, don’t worry about it, we will go through them in the following lesson).
In this lesson, we will analyze every aspect of Forex trading, from how it was formed, the main participants, advantages and disadvantages of trading the Forex market, how the Forex market compares to futures and equity markets and all concepts related to Forex trading.
What is The Forex Market?
The Forex market is an acronym of The Foreign Exchange Market also called The Currency Market.
What is traded in the Forex Market?
Money, as simple as that!
Currencies are bought and sold freely. This is the simultaneous buying of one currency and the selling of another.
For instance, you have some inside information that leads you to think that the Euro will go up, you want to buy the Euro pair (or EUR/USD). When you buy the EUR/USD pair you are actually buying the EUR and selling the US dollar. When you buy the EUR it is also said that you are “long” the EUR. When you sell the EUR it is also said that you are “short” the EUR.
More than 80% of the volume is generated by what we call the seven major currencies:
The US dollar (USD)
The Euro (EUR)
The British Pound (GBP)
The Swiss Franc (CHF)
The Canadian dollar (CAD)
The Australian dollar (AUD)
The Japanese Yen (JPY)
When did it at all start?
You could not say it all started after a sole event. A series of events happened and in the end it resulted in the Forex market, as we know it today.
It all started when the Bretton Woods agreement was finally abandoned around 1971.
In this agreement, participating countries had their currency pegged to either the gold or the US dollar. By 1973 the most powerful countries around the globe introduced a free exchange rate regime where they let their currencies fluctuate driven by the market or more precisely by the forces of supply and demand. It was then when the Forex market was available to speculate, hedge as well as other reasons.
It was not until 1997 when the Forex market became available to individual investors and traders through online trading capabilities and leverage (margin trading), offering traders around the world great opportunities to profit from the Forex market.
The Forex market is now the most liquid financial market of the world, with a generated volume of nearly 2 trillion US dollars (source: BIS) on a daily basis (more than all other US financial markets combined).
Where is the Forex Market located?
The Forex Market, unlike other financial markets, has no physical location where all trades take place. The transactions are relayed via telecommunications (phone, online platforms, etc.) between banks, institutions, investors, traders, and so forth. This trade is called Over the Counter market or OTC.
In the Stock Market, all transactions are done through the NYSE (in New York for example), or through the LSE (in London for example). In the Forex Market there is no one single location that funnels all the activity. You must be wondering how all these worldwide transactions are accounted for? Or maybe it’s not even possible to measure the volume of all transactions in the Forex Market?
What are the advantages of Trading Forex?
When trading in the Forex Market, there are several benefits that it has over the regular financial markets. A few advantages place the Forex Market high up on the trading list such as: liquidity, the fact that it works 24/5, low transaction fees, the ability to leverage trade (margin), specialized trading, low minimum investment and you can trade from anywhere in the world.
Trading almost 2 trillion dollars on a daily basis, the Forex market is by far the most liquid financial market in the world. Liquidity is important for the following reasons:
– The number one reason is that liquidity equals price stability. Being that the Forex market is so vast, it is likely that there will always be a buyer or a seller of any currency at the price quoted allowing for trades to open and close all the time, day and night. Keep in mind that there are times of high volatility, where trading may present difficult.
– Due to the large amount of liquidity, we can find ourselves entering and exiting the market quite quickly with good results, however, times that are more unstable may prove difficult to do so.
– Large liquidity doesn’t allow for controlled manipulation of the market – if you try to manipulate the market you would need huge amounts of money (I’m talking billions here) in order to make an effect, which would render this impossible.
As you already know, the Forex market is great for Insomniacs. This market works around the clock, which means that even as the NY market closes, the Sydney one opens. You can open or close a position whenever you want, whether you started trading while the Sydney market opened and closed when the London market closed. Since the market is not located anywhere, the trading is endless and continuous.
In the Forex market, a participant has substantial buying/selling power. This power allows the trader to control larger transactions with rather small margin deposits. Brokers understand this as they offer 400:1 leverage allowing you to control for example 100,000 US dollar transaction for a minimal 25% or $250 US. Basically, you keep your capital risk low as you make money.
But, and here comes the but, leverage is not all fun and games. If you don’t know how to use this leverage, it may be used against you. The more leverage used, the more your whole account is at risk.
For example, take Mike and John. They are two traders with the same capital who decided to go for different leverage:
Mike: used 400:1 with a US$2,000 trading account
John: used 100:1 with a US$2,000 trading account
Now what happens as they open a trade? They start with a standard trade (100,000 units)- Mike will have at risk US$1,750 (2,000 – 250 = 1750) while John will only have at risk US$1,000 (2000 – 1000 = 1000)*.
*Later we will teach you some risk management techniques that are meant to avoid taking this risk at all. Have patience.
So, yes, we recommend not using leverage greater than 100:1 (Don’t forget the margin is just a deposit, and the rest of the account is also at risk…).
Low Transaction costs
The Forex market is considered one of the markets with the lowest costs of trading. Most brokers collect their fees based on two schemes:
Spread – Brokers collect their fees by charging a different price for long and short positions. The difference is what is collected by the broker.
Spread and Commissions – Most brokers under this scheme charge a commission but usually the spread is tighter and transaction costs can even fall below brokers under the spread “only” scheme.
Low minimum investment – The Forex market requires less capital to start trading than any other markets. Some brokers allow traders to open trading accounts with an investment that could go as low as US$1 (yes, you read that right, that is one US dollar.) On average however, brokers allow traders to open accounts with around US$250.
Of course, you can’t expect to make a fortune with that investment but it will get your feet wet before you start risking a larger amount of capital or you can try to slowly start growing your account from there.
Specialized trading – The liquidity of the market allows us to focus on just a few instruments (or currency pairs) as our main investments (85% of all trading transactions are made on the previously mentioned seven major currencies). This allows us to keep track of, monitor and get to know each instrument better.
Trading from anywhere – Not having a physical location where all transactions take place (OTC), allows us to trade from anywhere in the world. We only need either a phone line (where you can have direct access to the brokers dealing desk) or an internet connection (through an online platform).
Below, comparative tables between the Forex market and other financial markets.
Main Forex Participants
A few decades ago, the main participants in the Forex market were the commercial banks that would take positions against other banks for a wide variety of reason (speculation, hedging, etc.), and firms (exporters and importers of goods and services) that would use banks for their foreign exchange transactions. All this activity accounted for about 70% of the overall volume generated in the Forex market.
These days however, the market has changed, with technological development and the ability to conduct transactions overseas with more ease, other financial / non-financial institutions are able to participate in the foreign exchange market, as well as individual investors and traders.
These days speculation accounts for more than 80% of the overall daily activity. These transactions are conducted from commercial banks to individual traders.
The main participants in the Forex market are: banks, central banks, commercial companies, individual investors and traders and brokers and the main reasons they participate in the Forex market are:
Profit from fluctuations in currency pairs, speculating (close to 80% of the volume)
Protection from fluctuating currency pairs, derived from trading goods and services, hedging
Profit from the rollover generated by differences on interest rates
Banks are the greatest participant of the Forex market. Large transactions are conducted by these banks (billions on a daily basis), both on their customer’s behalf and on their own. Speculative transactions made by banks accounts for around 70% of the volume generated by banks.
Largest Traders in the Spot Market
Central banks are mayor players in the Forex market, although the main reason they get in the market is not for speculative reasons. The main goal of central banks is to control the money supply of a nation, so an economy can achieve its economic goals. A central bank could intervene in the Forex market for the following reasons:
- To regain price stability of an exchange rate
- To protect certain levels of price in an exchange rate
- When economic goals need to be achieved (inflation, growth, etc.)
Some central banks are less conservative than others, some of them intervene regularly (like the Japanese Central Bank*) and some of them not very often (Federal Reserve) – at least visually.
The most important central banks are:
The Federal Reserve (US central bank)
The Bank of Japan
The Bank of England
The Bank of Canada
The Swiss National Bank
The European Central Bank
The Reserve Bank of Australia
*The Japanese Central Bank used to intervene a great deal in the past. However, recently there has not been a lot of intervention.
These are corporations that participate in the Forex market trading goods and services abroad. Most companies like to be paid in their home currencies or US dollars, so in order to complete the transactions they need to acquire foreign currency through commercial banks.
Other reason a commercial company may participate in the Forex market is to hedge their exposure. For instance, a company is to receive payments in the future in its home currency. The home currency has been depreciating and it is expected to continue that way until next year. In this case, the company might go short (sell) in its home currency and long (buy) the other currency in the same amount of the payment to be received. This way the price fluctuation will not affect the company.
These are companies represented by pension and mutual funds, international investments and arbitrage funds that invest in other countries securities.
Today, more and more funds are participating in the Forex market to speculate and hedge themselves.
Broker companies’ main objective is to bring together buyers and sellers of foreign currency. Most Forex brokers charge no commissions. Brokers get their fee from the spread.
There are two types of brokers:
Money Maker (with dealing desk) – The broker is the counterpart of every transaction made by the trader. When a trader opens a transaction the broker opens the same transaction in the opposite direction, if the trader longs one currency pair, the broker shorts the same currency pair. This is the way for Money Makers to hedge themselves.
Non dealing desk – The broker only connects the trader to banks through an ECN (Electronic Communication Network). No trade is taken by the broker. These are the type of brokers that usually charge a commission plus the spread, but as we said before, transaction costs can fall below what Money Makers charge just for the spread.
Individuals including traders
Individuals that conduct transactions for a wide variety of reasons including: speculating, a tourist wanting foreign currency, etc.
This is one of those lessons that nobody wants to go through, “just blah blah” and it is understandable, but if you came so far and are actually reading this congratulations! You definitely know how things are done! First things first! Congratulations again and good luck in your journey.
This lesson mostly talks about theory of the forex market, how it was formed, how it works, who participates in it so, I’m not going to send you back to give it another read. Probably the most important part in this lesson was the difference between brokers (so if you skip it go back to the participants section and scroll down to the brokers section).
Now, we have got a couple Questions in this lesson, here are the answers:
– About the volume, if you have a very complex answer and a new theory of how the volume can be calculated, scratch it! It just can’t be calculated, there is no exchange. We can have rough estimates through the futures market, data from different brokers, etc. but they are only estimates.
– About overlapping sessions, yep, you got this one right, didn’t you? When sessions overlap, the market tends to have more liquidity and volume thus the market has (on average) larger moves and its better for us traders (when those moves are in our favor of course).