Forex 101: What Every Beginner Needs to Know About FX
Wondering what this forex fuss is all about? In this article, we will cover everything a beginner needs to know to gain the basic understanding of the forex market.
What is Forex?
Forex, also referred to as “FX”, stands for Foreign Exchange, and it is the market where currencies are traded. It is actually the largest and most liquid market in the world, with a traded volume of USD 5 trillion per day. If you compare it with New York stock exchange that reaches up to USD 22.4 billion per day, you would probably understand what we are talking about! Tokyo Stock exchange measures around USD 18.9 billion of trading volume per day and London Stock exchange around USD 7.2 billion per day. If we illustrate the markets by towers of dollars, here’s how they compare:
What is Trading?
There are several examples of currency trading, from something very simple to complex activities. For example the exchange of a British tourist’s Pounds into US Dollar when traveling abroad, or the hedging of a bank’s exposures to different countries.
In forex market, trading is simply the process of buying one currency and simultaneously selling another in order to gain a profit, where the profit (or loss if you do not estimate it well enough) results from the changes in the exchange rates. When you trade forex, you do not physically buy or sell a currency but speculate on how its value will change in relation to another currency – this is why FX trading happens in pairs. The price of one currency compared to another reflects what the currency is worth based on the country’s current and future economy. As the economy of a country is affected by many factors, the country’s currency is affected by them as well.
Let’s take a closer look at currency pairs. The first currency in the pair is called ‘base’ currency while the second one is ‘quote’ currency. In the USDEUR pair, for example, we can estimate that a US dollar will grow compared to EUR. In this case, buying USDEUR is a good idea. However, if we expect the dollar to lose value and the EUR to grow, then we’ll be selling the USDEUR. Remember that you can NEVER switch places of currencies in the pair. The base currency always remains the base, and the quote is the quote currency. Therefore, USDEUR and EURUSD are entirely different financial instruments.
Currencies’ symbols are always determined by three letters, where usually the first two letters declares the name of the country that owns the currency and the third letter declares the name of the currency (with some exceptions of course). There are standard abbreviations for all the currencies which have been determined by the International Organization for Standardization (ISO). The main currencies traded in the FX market are the below:
|USD||United States||US Dollar||Buck, Greenback|
|NZD||New Zealand||New Zealand Dollar||Kiwi|
The most traded currency in forex market is the US Dollar, which is included in the 85% of all reported transactions. This can be explained by the fact that the US economy is the largest economy in the world. The second most traded currency is Euro with 39%, the third is JPY presenting 19% of the transactions and the fourth GBP covering 13% of the transactions.
There are three types of currency pairs, the majors, the minors or major crosses and the exotics. Majors are the most liquid currency pairs and therefore the most frequently traded. Majors consist of a combination of USD and another liquid currency, as USD is the most important currency.
Here are the majors:
Major crosses are pairs that do not contain the USD, such as EUR/JPY, EUR/CHF, AUD/JPY, but they consist by two major currencies.
Some forex traders prefer to focus on exotics, or exotic currency pairs. Those are made up of one major currency paired with a rare currency, often the currency of an emerging economy, such as Mexico, South Africa, Thailand etc. Below is a table with examples of exotic pairs.
|USD/PLN||US Dollar/Polish Zloty|
|USD/HUF||US Dollar/Hungarian Forint|
|USD/SEK||US Dollar/Swedish Krona|
|USD/MXN||US Dollar /Mexican Peso|
|USD/ZAR||US Dollar/South African Rand|
|USD/NOK||US Dollar/Norwegian Krone|
|GBP/THB||Great Britain Pound/Thai Baht|
FX vs Stocks
Is trading forex is better than trading stocks? In a way – YES. Trading forex has multiple advantages. First of all, there are no commissions on the transactions. In the forex market, margin requirements are very low; this means that if your deposit is not enough for a big trade, you can always control a largest contract value using leverage. Leverage gives you the chance to trade larger amounts than the amount of your balance (deposit). The table below reflects the major benefits of forex trading versus stocks trading.
|Leverage||Up to 1:500||No|
|Minimal or No Commission||Yes||No|
|Influence of Brokerage Firms||Less likely||More likely|
|Restriction on Short Selling||No||Yes|
Who are the market players?
Retail Traders and Speculators
Retail traders and Speculators make money through buying and selling currencies and could include anyone from hedge funds through to a retail trader at home with an account of USD50. Although in terms of size they are the smaller traders, in terms of trading volume they hold the majority of 90%. Retail traders are generally about 30% accurate at picking the trend, the rest just lose on average and they are expecting to keep doing so.
Large Commercial Companies
Large commercial companies participate in the forex market to do business. For example, electronics manufacturers need to buy electronics’ parts from all over the world, exchanging their currencies to the providers’ countries currencies. By using the FX market, they can get the best deal on currency fluctuations and use the forex market to protect themselves against adverse currency movements. This type of market players achieves their transactions through commercial banks.
Banks are the largest players in the forex market, mainly due to their influence on exchange rates. As forex market does not have a central exchange, the world’s largest banks determine the exchange rates by providing the market with sell and buy prices based on the prices they are willing to buy and sell at. The prices they set are based on supply and demand for currencies. These large banks, which are collectively known as the interbank market, take on a large number of forex transactions every day for both their customers and themselves. Another big advantage of banks is that they are among the few players that have access to a full picture of order books. This information often allows banks to predict where moves will happen before they do. Governments and Central Banks Governments use the forex markets for their operations, international trade payments, and handling their foreign exchange reserves. Central banks, such as European Central Bank, affect the forex markets by adjusting interest rates to control inflation which can affect currency valuation. Central banks may also intervene in the forex market to realign exchange rates. If central banks feel that their currency is priced too high or too low, they will start large sell/buy operations to alter exchange rate.
Although forex market is open 24 hours per day, it does not mean that it remains active 24/7. There are four major trading sessions during which most of the trading happens. These include New York, London (or European session), Tokyo (usually referred to as Asia session) and Sydney. Below is the table of the open and close times for each summer session in GMT:
The most movement on the market happens during the overlap between London and New York as these two are the largest financial centers in the world. Most trends begin during the London session, and they typically will continue until the beginning of the New York session. Most economic reports are released near the start of the New York session, as USD is involved in 85% of transactions. When those reports are released from US and Canada during the overlap of those two sessions, there is the most movement in the market. Also, some late news coming from Europe can influence the market during the overlap. On the other hand, Tokyo-London overlap is the time with the thinnest liquidity as it is just the start for European traders’ day.
Although European session is the busiest of them all, there are also specific days in the week with more movement from all the markets. This is the middle of the week, where the most movement happens. It is also important to notice that Fridays are usually busy until half day, after 16:00 GMT the market practically stops. Thus, Friday after midday is considered one of the worst times to trade, just as weekends and holidays, when market liquidity is limited.
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