Forex or FX are abbreviations for Foreign Exchange, which is a term used to refer to the global currency markets. As complex as these markets are, currencies are most probably the easiest of all the asset classes for beginners to learn. Even people who have never traded before will have a basic understanding of what currency trading involves. After all, everyone is familiar with using their national currency, and many have had the experience of converting this currency into another one of a different value when travelling.
Currencies differ in value and these differences are constantly changing; buying an undervalued currency as it begins to rise yields profits, selling an over-valued currency as it begins to fall also yields profits. Conversely, selling in the former example and buying in the latter will cause you to incur losses. Simple enough, right? Yes, but learning to find out the influences that cause these fluctuations, and being able to act upon them in a timely and consistently profitable way, that’s the real challenge of trading Forex.
What are Exchange Rates?
Exchange rates are the relative values between currencies that belong to different countries or economic regions. When you are presented with an exchange rate, say for EUR/USD, you are being quoted the value of one currency in relation to the other (in this case the euro against the US dollar). This is why you see two currencies in an exchange rate quote but only one figure; the value of one is determined by how much of it you can buy with the other.
The first currency in every pair is called the Base Currency, this is the one that you are being given the value of. It is also the one on which you are performing the action of either buying or selling when trading Forex. The second currency in the pair is the Quote or Counter Currency, the figure quoted in an exchange rate is denominated in this currency. When looking at an exchange rate for EUR/USD you are being quoted what the euro is worth in US dollars, or more accurately how many US dollars are required to purchase 1 euro. For example, a EUR/USD exchange rate of 1.17 means that 1 euro is worth 1 dollar and 17 cents, or that $1.17 is required to purchase 1 euro.
All currencies are given a three-letter abbreviation known as that currency’s ISO code, in most cases the first two letters refer to the country, and the third letter refers to the name of the currency in question. The most commonly traded currencies are known as the majors. These are: The US dollar (USD), the euro (EUR), the Japanese yen (JPY), the Great British pound (GBP), the Swiss franc (CHF), the Canadian dollar (CAD), the Australian dollar (AUD) and the New Zealand dollar (NZD).
The major pairs all involve USD being paired with each of the other major currencies listed above.
Pairs that do not feature the US dollar as either base or quote are known as the Cross Pairs, or Crosses. The most common cross pairs are those which feature the euro, pound sterling, or yen.
In addition to the majors and the crosses there are also the Exotic Pairs which consist of a major crossed with a lesser traded currency such as one belonging to an emerging market. Exotic pairs are less liquid and can cost more to trade due to them having wider spreads.
Buy & Sell Prices (Bid & Ask)
The two different prices that you see quoted on your trading platform for each currency pair are the respective Sell and Buy (or Bid and Ask) prices available for that pair, the difference between these two prices is known as the Spread. The Bid is the price on the left, this is the price at which you can sell a given currency pair and is the lower of the two prices listed. The Ask is the price on the right, it’s the price at which you can buy a given currency pair and is the higher of the two prices listed.
The Use of Leverage
Leverage enables you to command positions that exceed the value of your initial investment. Any time you borrow money or use a financial instrument such as a CFD to make an investment that exceeds the value of your capital, you are using leverage. In trading leverage is expressed as a ratio. The leverage ratio may vary from 1:1 (no leverage) to 500:1 (500 times the amount invested). So, say you want to buy 100,000 euros and have your account leveraged 100:1, then you will only need to have 1000 euros as margin to guarantee the position.
Unlike the stock market - where investors often only trade with institutional investors (such as mutual funds) or other individual investors - there are more parties that trade on the forex market for completely different reasons than those in the stock market. Therefore, it is very important to identify the functions and motivations of these main players in the forex market.
The most influential participant is Governments and Central Banks. Central banks are often involved in maintaining foreign reserve volumes to meet certain economic goals. For example, China has been buying up millions of dollars worth of U.S. Treasury bills in order to keep the Yuan (Chinese Currency) at its target exchange rate. Central banks use the foreign exchange market to adjust their reserve volumes. They have extremely deep pockets, which allow them to have a significant impact on the currency markets.
The second participant is Banks and Financial Institutions. Most people who need foreign currency for small-scale transactions, like money for travelling, deal with local banks. However, individual transactions pale in comparison to the dollars that are traded between banks, better known as the interbank market. Banks make currency transactions with each other on electronic brokering systems that are based on credit. Only banks that have credit relationships with each other can engage in transactions.
Banks act as dealers in the sense that they are willing to buy/sell a currency at the bid/ask price. One way that banks make money on the forex market is by exchanging currency at a higher price than they paid to obtain it. Since the forex market is a world-wide market, it is common to see different banks with slightly different exchange rates for the same currency.
The last major participant is Traders/Speculators. Traders are perhaps the most diverse group of market participants. Their influence depends on their capital. Traders are not interested in using the forex market to only hedge against the risk of future purchases, or even to take possession of the currencies they trade, they are, as well, concerned with profiting from price fluctuations.
Hedge funds are one of the most impactful groups of currency speculators and can easily influence currency values due to the large size of the trades they regularly place. They are also among the most knowledgeable and experienced market participants. Hedge funds invest on behalf of individuals, pension funds, companies and even governments. They apply many different techniques including discretionary trading, algorithmic trading, a combination of both and fully automated high frequency trading. They also have very deep pockets and the power to make huge waves.