Forex (FX)

This document has been written to provide a short introduction for people interested in the forex market. We will try to go through the basic terms and processes and provide some explanations.

Forex, sometimes abbreviated as FX, stands for the foreign exchange market. Money has been around us since ancient times but the forex market started to assume its present form around 1973, when the Bretton-Woods system was abandoned. In 1973, currencies of major industrialized countries became floating and since then, the exchange rates are mainly controlled by the supply and demand.

According to the Triennial Central Bank Survey, released by the Bank for International Settlements in 2007, average daily currency trading volume in 2007 exceeded 3.2 trillion US dollars making forex the biggest market in the world. For comparison, combined volume of all stock markets in the world is 10-15 times smaller.

The biggest difference between forex and other financial markets is that each currency trade consists of simultaneous purchase and sale operations which is why the market is called “foreign exchange market”. The next important definitions are: long and short positions. For example, taking a long position in EUR/USD means buying EUR and selling USD, thus exchanging USD for EUR on the speculation that EUR would appeciate against USD. Here is where the exchange is taking place, the counter (or quote) currency USD is being exchanged into the base currency EUR. Short position means exactly the opposite to the long. Because of this symmetry between long and short, there is always a bull market somewhere in forex no matter what happens with the financial markets at large, and you can benefit from it.

The Forex market has an internal hierarchy, whose tiers differ by the level of access determined by the amount of money traded.

  • The biggest component is the interbank market with a 43% share. The interbank market mainly consists of big investment banking firms. The big companies ensure a big flow of transaction for the significant amount and therefore enjoy a relatively small spread between bid and ask price. As we go down the hierarchy the spread has a tendency to increase as the volume traded decreases. Commercial traders (term used to denote non-speculative participants) and multinational companies are responsible for a big part of the market; they need currency transactions mainly to pay for commodities, goods and services.

  • Central banks control prices, money supply and interest rates and can sometimes intervene in the forex market by selling or buying currencies when the exchange rates rates are too high or too low which in general has a short term effect.

  • The next level is investment management firms, which mainly trade on behalf of the clients.

  • Finally, retail forex broker is at the bottom level of the market with the smallest market share.

There are three global forex sessions in the world: Asian-Pacific, European and North-American. Due to the time-zone layout of the financial centers the Forex market is literally open 24 hours during the business week. It’s open from the early Sunday hours (Asian-Pacific session) and closed on Friday in North-American session. Main trading currencies are EUR (Euro), GBP (British Pound), CHF (Swiss franc), JPY (Japanese Yen), AUD (Australian Dollar), NZD (New-Zealand Dollar) CAD (Canadian Dollar). They form exchange rate pairs against the USD (US Dollar) and cross-rates among themselves. The biggest moves on the market are tied to the data and news releases and often happen in the morning of the particular session. One of the best market characteristics is liquidity of the market, liquidity can be understood as trading volume. Liquidity varies from session to session and within the trading session. Liquidity usually peaks during in the overlap hours of the European and North-American sessions.

Currencies and other financial markets are highly correlated, among the most influential markets are: gold, oil, stocks and bonds. For example, gold is highly anti-correlated to the USD, oil price is often considered indicative of the inflation and growth expectations, and so on. The bottom line is that other financial markets influence currencies and the big picture has to be closely followed.

Opening a position through a retail broker requires maintaining a certain margin balance which is often defined by the broker. The ratio of margin balance to open positions has to be maintained all the time to avoid automatic positions liquidation which will lock your losses in and result in your margin balance decline. Most brokers provide real-time estimations of margin balance which is referred to as mark-to-market. That estimation shows trader’s unrealized P&L (profit and loss) and reflects would-be the output of the trade if the position were closed at this particular point in time. Realized P&L enters the margin balance once the position(s) has been closed. If a trader does not have an open position in the market such a state is called square or flat and if a trader wants to close an open position it’s often referred to as squaring up.

Before starting to operate in the forex market one has to have a trading plan. A trading plan is an organized approach to execute trading strategy, that has been developed based on the market analysis and outlook. An important part of the market analysis framework can be a which not only helps traders to make decisions and increase their profit but also allows them to lower the psychological pressure. Usually the system generates trading signals which can be easily understood and used to make decisions by the trader. Many traders use self-developed systems. Also there is a huge market of commercially developed trading systems with the price tag in the range from a couple of hundred dollars up to several hundred thousand.