Currency Market Overview

The Currency Market goes by many names – Currency Exchange, Foreign Exchange, Forex, FX – but no matter the term, it is simply the trading of one currency against another. Currencies are traded in the form of currency pairs with pricing based on exchange rates and spreads established by participants in the forex market.

History of the FX Market

The FX market is an inter-bank or inter-dealer network first established in 1971 when many of the world’s major currencies moved towards floating exchange rates. It is considered an over-the-counter (OTC) market, meaning that transactions are not conducted on an exchange like some equity stock markets such as the New York Stock Exchange (NYSE) or the Chicago Options Board Exchange (CBOE) where options and futures are traded. OTC trades exist as agreements made between two parties that agree to trade via telephone or electronic network.

As FX trading has evolved, several locations have emerged as market leaders. Currently, London, England contributes the greatest share of transactions with over 32% of the total trades. Other trading centers – listed in order of volume – are New York, Tokyo, Zurich, Frankfurt, Hong Kong, Paris, and Sydney.^[1]

Because these trading centers cover most of the major time zones, FX trading is a true 24-hour market that operates six days a week. For example, as a trader in New York, you have access to the FX market starting Sunday evening when the market opens in Sydney for the start of the trading week. Trading centers around the globe then come online until New York – your “home” market - closes at 4:30 PM EST. Of course, by this time, Sydney will have reopened for the next trading day so you can continue to trade well past the New York close.

Historically, trading between central banks, commercial financial institutions, and multinational corporations comprises most of the FX market. However, with the advent of web-based trading applications, small retail traders and even individuals can now participate directly in the FX market on equal footing with large institutions.

FX Market Size and Currencies Traded

The FX market has become the world’s largest financial market, and it is not uncommon to see over $3 trillion US traded in a single day.^[2] By contrast, the NYSE – the world’s largest equity market with daily trading volumes in the $60 to $80 billion dollar range – is positively dwarfed when compared to the FX market.^[3] Even when combining the US bond and equity markets, total daily volumes still do not come close to the values traded on the currency market.

Most Commonly Traded Currencies

The sheer volume of trading completed every day in the FX market makes it by far the most liquid and most efficient market available. Because of the magnitude of the volumes traded, it is virtually impossible for individuals or companies to influence the exchange rate of the more commonly-traded currencies through any form of open market operations. No single individual has the resources required to manipulate pricing through targeted buying or selling on the market.

There are many currencies which you can trade but the vast majority of trades consist of pairs involving just these seven currencies:^[4]

Trading Currency Pairs

Currency exchange rates are advertised as currency pairs showing the value of one currency compared to the other currency. When you buy or sell a currency pair, you are buying (going long) one of the currencies, and selling (going short) the other currency. You are in a positive position when the currency you have bought rises in value against the second currency. Conversely, you are in a negative position if the currency you bought loses value against the second currency in the pair.

A trading position is said to be open if you have either bought or sold a currency and do not have an equal, offsetting amount of that currency to reduce your total holdings back to zero. Any time a position is open, the market could move in either direction thereby affecting your profit / loss for that currency. Once the position is back to zero, it is considered closed.

Trading Terms You Need to Know

• A long position means to buy a currency.
• A short position means to sell a currency.
• Opening a position means to enter a new trade for a currency – this can refer to either a long or short position.
• Closing a position means to buy or sell your holdings in a currency in order to reduce an open position to zero.

FX Market Analysis

Winning forex investment strategies hinge upon two factors; knowing which currencies to invest in, and identifying the optimal time to buy or sell a given currency. In an attempt to identify such opportunities, investors rely on market analysis to make informed investment decisions.

Market analysis falls into two broad categories - fundamental analysis and technical analysis. Both approaches seek to predict future values based on an analysis of historical information, with technical analysts creating charts and other tools to predict the direction a market is headed.

Fundamental analysts use the same historical information based on economic indicators such as Inflation Reports and Gross Domestic Product evaluations to identify possible trends. Fundamental analysts also attempt to determine the possible effect of economic news such as central bank announcement regarding interest rates.

Currency Codes

All currencies are assigned an International Standards Organization (ISO) code abbreviation. In currency trading, these codes are used to identify the currencies that make up a currency pair. For example, USD is the code for the US dollar, and JPY is the code for the Japanese Yen.

View currency ISO codes.

Despite the many currencies that can be traded, in actual practice, most FX trades – well over 75% – involve the US Dollar. In fact, the vast majority of currency trades involve the “big seven” currencies as listed in the following table:^[5]

Most Commonly Traded Currency Pairs

Seeing that US Dollars are the most traded currency, then it only stands to reason that USD dominates the list of most popular currency pairs as well. The following table lists in order the currency pairs that make up the majority of currency trades:^[6]

As you can see from this table, some currency pairs exist with US dollars as the base currency, while in others, US dollars are the quote currency. Currency pairs with USD as the base currency (USD/JPY, USD/CHF, and USD/CAD) are referred to as direct rates, while currency pairs that have USD as the quote currency (EUR/USD, GBP/USD, and AUD/USD), are known as indirect rates.

Trades that do not involve US dollars are referred to as cross-rate trades. This is because trading usually occurs by trading the first currency to obtain US Dollars, and then trading the US Dollars with the second currency in the currency pair. Examples of cross-rate currency pairs include Australian Dollars and New Zealand Dollars (AUD/NZD) and Canadian Dollars and Japanese Yen (CAD/JPY).

Note also that there are some non-US dollar currency pairs that are traded directly and are therefore considered to be direct rate trades as well. These include GBP/EUR and GBP/JPY as well as a number of currency pairs that exist with EUR as the base currency:

• EUR/GBP
• EUR/JPY
• EUR/CHF
• EUR/CAD

Exchange Rates

An exchange rate is simply the ratio of one currency valued against another. This relationship is typically displayed with the two currencies together as in the following currency pair:

USD / JPY

base currency / quote currency

In this example, the first currency (US Dollars) is the base currency, and the second currency (Japanese Yen) is referred to as the quote or counter currency. When buying a currency pair, the exchange rate specifies how much you have to pay in the quote currency to purchase one unit of the base currency – when selling, the exchange rate indicates how much you receive in the quote currency when selling the base currency.

Currency pairs are published together with an exchange rate that includes a bid price and an ask price. The bid price is always lower than the ask price and represents what will be obtained in the quote currency when selling one unit of the base currency. The ask price represents what you have to pay in the quote currency to obtain one unit of the base currency. The following US Dollar / Japanese Yen price quote is an example of a typical bid / ask notation:

USD/JPY:118.48/53

The first component (before the slash) refers to the bid price - in this example, the bid price is 118.48. The second component (after the slash) indicates the ask price which is what you must pay in JPY to buy USD. Here, the ask price is 118.53.

Spreads and Pips

The difference between the bid and the ask price is referred to as the spread. In the example above, the spread is 0.05 (118.53 – 118.48). In FX trading, the spread is expressed in terms of pips.

Unlike the USD / JPY price quote, most currency pair quotes are carried out to the 4th decimal place (i.e. EUR/USD may be quoted at 0.9517/22) in which case, five pips represents a difference of 0.0005. Just remember that “pip” – whether the spread is displayed to two or four decimal places – always refers to the last decimal place shown in the spread rate ratio.

Although a pip may seem small, a movement of one pip in either direction can translate into thousands of dollars in gains or losses in the market due to the volumes being traded. In fact, forex traders often express their gains or losses in relation to pips. The phrase “I'm up twenty pips today” is immediately understood to mean that the trader is in a positive position. Determining profit or loss requires a little calculation however to arrive at a monetary value.

Trading Terms You Need to Know

• Exchange Rate is the ratio of one currency valued against another.
• Base Currency is the first currency quoted in a currency pair exchange rate.
• Quote Currency is the second currency quoted in a currency pair exchange rate – also referred to as the Counter Currency.
• Bid Price is the price at which buyers want to buy a currency pair.
• Ask Price is the price at which sellers are willing to sell a currency pair; also known as The Offer.

FX Spot Deals

Also referred to as spot market deals, a spot deal consists of a bilateral contract between a party delivering a specified amount of a given currency to a counter party and receiving a specified amount of another currency in return, based on an agreed-upon exchange rate. Delivery for spot deals occurs within two business days of the deal date, which is commonly referred to as the settlement date. However, for USD / CAD transactions, the settlement date is only one business day after the deal date.

Market Orders

Market orders are orders that are executed immediately at the prevailing market price.

Limit Orders

Limit orders are submitted with instructions that a trade should only be executed in the future when certain market conditions occur. There are three types of limit orders:

Price Limit (new orders only)

Provides instructions that the currency pair should only be traded when it reaches a certain exchange rate. The price limit is applied when the order is entered. Note that pending Price Limit orders do not affect current positions.

Take-Profit Order (current open positions only)

Take-profit orders are used to clear a position by selling or buying the currency pair when the exchange rate reaches a specified level. Take-profit orders are typically used to lock-in a profit and will be executed automatically without requiring manual intervention on your part.

For example, if you are long USD / JPY at 118.48 and believe the rate will continue to rise until it reaches 120.00 but you are unsure what it will do past 120.00, placing a take-profit order at 120.00 will automatically close your position allowing you to lock in your profit once the rate reaches 120.00.

Stop-Loss Orders

Stop-Loss orders are similar to take-profit orders except they are used to set a threshold to prevent continuing losses on an order by automatically closing a position once the exchange rate reaches the level you specify.

If for example, you are long USD/JPY at 118.48 and you set a stop-loss at 118.40, your position will automatically be closed at 118.40 thus protecting you from any further price decline. For this reason, stop-loss orders are particularly beneficial because they allow you a certain level of comfort when leaving a position open when you are away from your computer and not actively following the markets.

Benefits of Currency Trading vs. Equity Trading

FX trading is rapidly winning favour as an alternative investment opportunity thanks not only to new trading tools, but also because FX trading has several inherent benefits when compared to equity trading – these include:

• Continuous 24-hour Trading
• High Liquidity and Greater Market Efficiency
• Intra-day Volatility
• Low Spreads
• Margin-Based Leverage
• Profit Potential Regardless of Market Direction
• No Commissions or Transaction Costs

Continuous 24-hour Trading

The currency exchange market is a true 24-hour market, operating six days a week. Equity trading, on the other hand, is restricted to the operating hours of the various equity exchanges. While after-hours trading for equities has become available to a limited degree through some electronic communication networks (ECNs), there are no guarantees that liquidity will be maintained after-hours or that trades can executed at true “market prices”.

High Liquidity and Greater Efficiency

Key to any efficient market is high liquidity. After all, as a trader, you want to know that you have an active market with plenty of buyers and sellers looking to participate. Trading volumes in the currency market can be one hundred times larger than that of the New York Stock Exchange, and daily dollar amounts traded in foreign currency can exceed $3 trillion compared to less than $100 billion for the NYSE. High volumes and “round-the-clock” trading ensures an active market for currency traders and greater liquidity.

The incredible volumes traded in the FX market also contribute to the integrity of the market as it is virtually impossible for an individual or group to manipulate prices. Compare this to the equity markets however, where large price movements can be triggered with no warning should a major holder of a stock suddenly decide to reduce their holdings.

Intra-day Volatility

FX trading is centered around a handful of currency pairs referred to colloquially as the Big Seven. The high volume and liquidity combined with fewer active instruments generates greater intra-day volatility than the equity markets. It is this volatility that can be profitability exploited by forex traders.

Low Spreads

Currency trading offers spreads that are much lower than what can be obtained when buying or selling equities, especially during after-hours trading. Although exceptionally tight currency spreads were previously reserved for transactions involving $1 million or more, a shift towards tighter spreads for smaller transactions is gaining traction.

Margin-Based Leverage

Leverage – or margin based trading – makes it possible for FX market participants to submit trades valued considerably higher than the deposits in their trading accounts. Typically, margin ratios for trading currencies are higher than those permitted for equities, and this is primarily attributable to the higher level of liquidity within the currency markets.

To illustrate the power of leverage provided through the use of margin, consider a margin ratio of 20:1 coupled with a trading account containing $10,000. This means that you could trade amounts up to $200,000! Trading in larger volumes allows you to take better advantage of even small price movements.

Profit Potential Regardless of Market Direction

By definition, an investor with an open forex position is long one currency and short another. If you determine that a currency is about to fall in value, then you can sell that currency short and go long with another currency. No matter whether you buy or sell a currency pair however, every trade you make involves the buying of one currency and the selling of another. Therefore, potential exists in the FX market regardless of whether the market is moving up or down.

Short-selling is much less common in the equity markets and there are many rules and regulations that you must abide by when shorting stock. This can make it difficult for you to take advantage of a declining share price or market trend. These same restrictions do not apply to the FX market thereby allowing you to gain no matter which direction the market heads.

No Commissions or Transaction Costs

A currency transaction typically incurs no commission or transaction fee outside of the quoted spread. This is in stark contrast to the equity market where commissions for stock trades can range anywhere from $8 to $70 per trade, in addition to the quoted spread.

Related Links

Understanding Margin-Based Trading

Calculating Trade Profit

Trading in the Currency Spot Market

References

1. ↑ International Financial Services London – www.isfl.org
2. ↑ Bank of International Settlements – www.bis.org
3. ↑ New York Stock Exchange – www.nyse.com
4. ↑ Bank of International Settlements – www.bis.org
5. ↑ International Financial Services London – www.isfl.org
6. ↑ International Financial Services London - www.isfl.org