“Introduction to Forex“
> Explanatory Article by Marios Kyriakou, MSc Economics
About the author: Marios Kyriakou has a bachelor’s degree in Economics from the University of Cyprus and a master’s degree in Economics from the University of Warwick. He is also a holder of CySEC’s Advanced Certificate in Financial Services Legal Framework and a professional in Online Trading, Forex and CFDs with more than 7 years of experience.
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<Last updated 03.12.2020>
Hi! If you are interested in Forex please read carefully the below article so you can be prepared and fully informed before making any decisions about investing and trading forex online.
Forex and Spot Forex Market
In a local market, at the foreign country, you exchange the money you have in your wallet into the currency of the country you are visiting.
Thus, you are a participant in the Forex Market. You’ve exchanged one currency for another.
An American visiting Japan: sold dollars and bought yen at spot USD/JPY rate (exchange on the spot). (1 US Dollar = 106.106 JPY). Trading/Exchanging currency can be profitable if the rates change. Changes in the exchange rates allow you to make a profit in the foreign exchange market.
What Is Forex and Forex Market?
Forex means simply “Foreign Exchange”. The Foreign Exchange market is the global market that allows the exchange of one currency for another. It is known as “forex” or “FX”.
Trillions of dollars is traded daily, making it the largest and most liquid market in the world with approx. $6 TRILLION a day trade volume (EOY 2019 data).
Note: market is the mechanism/system and/or the physical place where buyers and sellers meet for the purchase and sale of provisions of goods or services, trading/exchange of currencies in this case.
How the Forex Market is compared to other markets?
New York Stock Exchange (NYSE), Tokyo Stock Exchange, and London Stock Exchange (LSE): Securities exchanges provide a marketplace for buying and selling corporate stocks and other securities. Each exchange has a maximum traded volume of the size of approx. 22 billion USD > the Forex market of course is way bigger. We are talking about trillions USD per day.
What type of market is FX Market?
The Forex Market is considered an Over-the-Counter (OTC), or “interbank” market due to the fact that the entire market is run electronically within a network of banks, continuously over a 24-hour period. Unlike other financial markets, like the New York Stock Exchange (NYSE), or London Stock Exchange (LSE), the Forex Market has neither a physical location nor a central exchange. It is a decentralized market.
How is the Forex Market Structured?
Unlike in trading stocks or futures, you don’t need to participate in a centralized exchange like the NYSE with just one price. In Forex, participants include large financial institutions, Banks, ECN Brokers, Retail Investors, Market Makers.
> Tier 1 Banks: At the very top is the interbank market. The participants of this market trade directly with each other or electronically through the Electronic Brokering Services (EBS) or the Reuters Dealing. The largest banks in the world determine the exchange rates.
> Hedge funds, corporations, retail Market Makers, and retail ECNs.
> Large Commercial Companies. These enter the foreign exchange market for the purpose of doing business. In international cross-border M&As, a lot of currency conversations happens that could move prices around.
> Governments and central banks, such as the European Central Bank (ECB), the Bank of England (BOE), and the Federal Reserve (FED), are regularly involved in the Forex Market too. They do not have tight credit relationships with the participants of the interbank market and they must do their transactions via commercial banks.
> Retail Investors.
Can you trade Forex Online?
Online Forex Brokers allow with online trading, investors can trade Forex CFDs 24 hours a day/ 5 days a week. Combined with a highly volatile and extremely competitive CFD market, the FX/CFD industry has attracted massive attention and an increasing number of individual investors.
With recent developments in financial platforms, a high number of investors and traders participate in the Forex markets. These online trading platforms offer advanced financial trading functions, as well as helpful tools for technical and fundamental analysis.
What are the major currencies and pairs?
Currency symbols always have three letters, where the first two letters identify the name of the country and the third letter identifies the name of that country’s currency. (i.e. USD > United States –Dollar)
In this market there are currencies traded called majors. They are the most widely traded ones. i.e. United States Dollar (USD)
The US dollar is the most traded currency, taking up 84.9% of all transactions (2019).
USD, EUR, JPY, GBP, CHF, CAD, AUD, NZD
Most Brokers let you trade CFDs on Forex (foreign exchange), Stocks, Futures, Metals, Energy. The Market Watch is the area on the trading platform that shows you the products available for trading online.
Which ones are called Major, Minor and Exotic pairs
There are six most-traded forex pairs in the market, these include:
EUR/USD: The euro and the U.S. dollar.
USD/JPY: The U.S. dollar and the Japanese yen.
GBP/USD: The British pound sterling and the U.S. dollar.
USD/CHF: The U.S. dollar and the Swiss franc.
As you can see, all currencies listed above are used in developed economies, as they make up the highest share of the world trade, which makes these currencies the most traded in the world.
Minor Pairs are the currency pairs that are less traded, less liquid than and they often have wider spreads. Minor currency pairs are basically any pairs other than the six major currency pairs listed previously.
Exotic pairs typically include a currency from an emerging market country. Exotic currency pairs also feature wider spreads (> the difference between BID and ASK price)
Currencies have a price (or quote), the Exchange Rate, which is the value of one currency for the conversion to another foreign. That is why a forex quote always consists of two currencies.
i.e. EUR/USD = 1.20 > Price of 1 Euro in terms of US dollars.
In other words, to buy 1 EUR we need 1.20 USD, Euro is more expensive yes?
When trading currency pairs, you are simultaneously buying one currency and selling the other. Let’s see another example with Euro and US dollar, EUR/USD.
The EUR is referred to as the base currency and the USD is referred to as the quote currency.
A quote of EUR/USD of 1.30 means that 1 euro buys 1.30 U.S. dollars. A rise of the quote of EUR/USD to 1.40, means that now 1 euro buys 1.40 U.S. dollars. In this situation, the euro became stronger and the US dollar weaker.
The Forex Market and Liquidity
The currency markets, unlike many other markets, are open 24 hours a day, 5 days a week. A global decentralized market for the trading of currencies.
Liquidity (the amount of buying and selling volume happening at any given time) is extremely high. It determines how easily prices change over a given time period. (they change fast/rapidly)
Liquidity in the forex market is extremely deep, so if you decide to buy or sell currency, it will take you milliseconds to do so online.
What affects currency values?
The goal of a forex trader is to speculate the rise or fall of a currency’s value, in order to buy or sell that currency.
Currency values can change quickly and for many reasons. Sometimes it’s a reaction to external political and economic news.
Other times, the market itself drives value changes. Oftentimes, both external and internal events. Interest rates, new economic data from the largest countries and geopolitical tensions, are just a few of the events that may affect currency prices.
How currency pairs are affected?
We describe the pair EUR/USD, as Euro divided by US Dollar. Positive news about the Euro, for example, unexpectedly high inflation in Europe, would raise the value of the Euro.
On the other hand, positive news for the US dollar would raise the value of the USD. As the second currency in the currency pair, this would lead to a negative performance in the EUR/USD rate.
Trading can be on spot forex, currency futures, currency options, and currency exchange-traded funds (or ETFs).
“Spot Market” or Spot Forex is a term referring to a market where currencies are immediately exchanged, on the spot, (delivered) at a “cash” price or conversion rate.
Example: If you exchange Swiss Francs for US Dollars at a bank, you are making a spot transaction at whatever conversion rate the bank charges you at that time.
On the contrary, currency futures are a transferable contract that specifies the price at which a currency can be bought or sold at a future date. For example, currency futures are traded via exchanges, such as the CME (Chicago Mercantile Exchange)
Since currency forward rates are based on the currency spot rate, currency futures tend to change as the spot rates changes. Currency futures contracts are marked-to-market daily.
Online Trading Forex
Combined with a highly volatile and extremely competitive CFD market, the FX/CFD industry has attracted massive attention and an increasing number of individual investors. With recent developments in financial platforms, a high number of investors and traders participate in the Forex market online.
We will see how Forex is traded online with the help of numerous service providers such as financial institutions and technology providers.
Market Watch and Currency (FX) Pairs
“Market watch” is a section of MT4/MT5 online trading platforms which shows currency pairs available for trading on spot.
i.e. The Ask price is the price used to buy the base currency, while the Bid is used to sell it. Liquidity in Forex is so high that these quotes change by even less than a second.
Forex Brokers are financial institutions offering Forex and CFD investment services. These services allow online traders/investors to trade the financial markets through CFDs, derivative contracts.
These services can be provided by the Broker with the help of software development companies that produce sophisticated online trading platforms.
These Financial Institutions can hire developers to develop their own systems and platforms. In today’s world people are introduced to fast, friendly to use products mostly mobile apps.
Forex Brokers have liquidity providers (or LPs). These are, among others, large financial institutors and tier 1 banks.
There are two main types of Forex Brokers depending on their execution policy and dealing practices.
- Market Makers, or Dealing Desk Brokers
- No Dealing Desk
They receive liquidity from multiple liquidity providers and they are filling both buy and sell orders of their clients. They are the sole execution venue.
The competition among brokers is huge so the rates offered by Dealing Desks brokers are similar, if not the same, to the interbank rates.
NDD brokers do not take the other side of their clients’ trade. They simply link parties together. They can be STP or STP+ECN. Straight through processing is a financial information transfer protocol for order routing.
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