Forex Overview

Forex Overview

What is forex ( History of the financial markets)

The foreign exchange market is the generic term for the worldwide institutions that exist to exchange or trade currencies. Foreign exchange is often referred to as “forex” or “FX.” The foreign exchange market is an over-the-counter (OTC) market, which means that there is no central exchange and clearinghouse where orders are matched. FX dealers and market makers around the world are linked to each other around the clock via internet, telephone, computer, and fax, creating one cohesive market.Over the past few years, currencies have become one of the most popular products to trade.

Foreign exchange dates back to ancient times, when traders first began exchanging coins from different countries. However, the foreign exchange it self is the newest of the financial markets. In the last hundred years, the foreign exchange has undergone some dramatic transformations.Trading volume has increased rapidly over time, especially after exchange rates were allowed to float freely in 1971. In 1971, the Bretton Woods Agreement was first tested because of uncontrollable currency rate fluctuations, by 1973 the gold standard was abandoned by president Richard Nixon, currencies where finally allowed to float freely. Thereafter, the foreign exchange market quickly established itself as the financial market. Before the year 1998, the foreign exchange market was only available to larger entities trading currencies for commercial and investment purposes through banks, now online currency trading platforms and the internet allow smaller financial institutions and retail investors access a similar level of liquidity as the major foreign exchange banks, by offering a gateway to the primary (Interbank) market. FOREX refers to the Foreign Currency Exchange Market in which over 4,600 International Banks and millions of small and large speculators participate worldwide. Every day this worldwide market exchanges more than $4.7 trillion in dozens of different currencies. This is estimated to be approximately 20 times larger than the daily trading volume of the NewYork Stock Exchange and the Nasdaq combined. 

Although there are many reasons that can be used to explain this surge in activity, one of the most interesting is that the timing of the surge in volume coincides fairly well with the emergence of online currency trading for the individual investor. With the current growth rate the market is projected to grow to more than $1.9 trillion per day by the year 2020. With such volume, one can assume that the forex market is extremely volatile, changing at a moment’s notice, depending on conditions within that country.

Forex Exchange market

So, what is forex trading market, really? The answers are simple and complex. Here, we will go over the basics so that you, easily learn and understanding how trading takes place. The basic concept behind the foreign exchange (or forex) market is for trading currencies, one pair against another. It is the world’s largest market, consisting of almost $5 trillion in daily volume and is growing rapidly.The value of one currency is determined by its comparison to another currency via the exchange rate. The major currencies traded most often in the foreign exchange market are the euro (EUR), United States dollar (USD), Japanese yen (JPY), British pound (GBP) and the Swiss franc (CHF). These combine to form the most commonly traded currency pairs (EUR/USD) (USD/JPY) (GBP/USD) (USD/CHF) The first currency of a currency pair is the base currency; the second currency in the pair is the counter currency. One can think of currency pairs as a single unit. When buying a currency pair, the base currency is being bought, while the counter currency is being sold. The opposite is true when selling a currency pair.Foreign currency trading is conducted without a central exchange, but instead is traded over-the-counter (OTC). 

Unlike other markets, this decentralization allows traders to choose from a large number of different dealers or brokers with which to place their trades. This also provides the means to compare prices and pip spreads before buying or selling.A number of tools and charts are used in forex currency trading and the learned trader uses these tools extensively to perform accurate analysis to determine whether to buy or sell a given currency pair.The forex market is operated in Europe, Asia and the United States in overlapping shifts, so currencies are constantly traded 24 hours a day. No single entity has the capability of influencing the market  at least for very long. So in simple we were saying currency trading  at its most basic definition  is the act of buying and selling (trading) different currencies of the world.A typical scenario might go something like this: A trader is looking at the Swiss franc (CHF) and U.S. dollar (USD). This is called a currency pair. The CHF is the  currency, and the USD is the secondary currency which is called the counter currency. News that the value of the CHF is up from previous reports creates a positive reaction and a spike in the value of the CHF. This, in turn, will cause a rally on the CHF/USD currency pair. If the opposite occurred, and a positive announcement for the USD was reported, then the CHF/USD currency pair will fall, or dip. Either scenario can offer up a profit, depending on which part of the currency pair is bought or sold. The price of each currency within the pair is determined by a number of factors, such as changes in political leadership, economic booms or busts, even natural disasters.

Comparing FX market with other markets

As stated on the previous chapter, traditionally FX has not been the most popular market to trade because access to the foreign exchange market was primarily restricted to hedge funds, Commodity Trading Advisors who manage large amounts of capital,major corporations, and institutional investors due to regulation, capital requirements, and technology. One of the primary reasons why the foreign exchange market has traditionally been the market of choice for these large players is because the risk that a trader takes is fully customizable. That is,one trader could use a hundred times leverage while another may choose to not be leveraged at all. However, in recent years many firms have opened up the foreign exchange market to retail traders, providing leveraged trading as well as free instantaneous execution platforms, charts, and real time news. As a result, foreign exchange trading has surged in popularity, increasing its attractiveness as an alternative asset class to trade.Many equity and futures traders have begun to add currencies into the mix of products that they trade or have even switched to trading currencies exclusively. The reason why this trend is emerging is because these traders are beginning to realize that there are many attractive attributes to trading FX over equities or futures. 

FX versus Equities:

Here are some of the key attributes of trading spot foreign exchange compared to the equities market.

  •  Foreign exchange is the largest market in the world and has growing liquidity.
  •  There is 24-hour around-the-clock trading.
  • Traders can profit in both bull and bear markets.
  •  Instant executable trading platform minimizes slippage and errors.
  •  Even though higher leverage increases risk, many traders see trading the FX market as getting more bang for the money one can make.

Equities Market Attributes

  •  There is decent market liquidity, but it depends mainly on the stock’s daily volume.
  • The market is available for trading only from 8:30 a.m. to 5:00 p.m.South African time with limited after-hours trading.
  •  The existence of exchange fees results in higher costs and commissions.
  •  There is an uptick rule to short stocks, which many day traders find frustrating. Trading gaps may be frustrating for day traders as well.
  •  The number of steps involved in completing a trade increases slippage and error.

The volume and liquidity present in the FX market, one of the most liquid markets in the world, have allowed traders to access a 24-hour market. With low transaction costs, high leverage, the ability to profit in both bull and bear markets, minimized error rates, limited slippage, and no trading gaps or uptick rules. Traders can implement in the FX market the same strategies that they use in analyzing the equity markets. For fundamental traders, countries can be analyzed like when doing macro analysis for countries. For technical traders, the FX market is perfect for technical analysis, since it is already the most commonly used analysis tool by professional traders. It is therefore important to take a closer look at the individual attributes of the FX market to really understand why this is such an attractive market to trade.

Fx Market trading times

One of the primary reasons why the FX market is popular is because for active traders it is the ideal market to trade. Its  24-hour nature offers traders instant access to the markets at all hours of the day for immediate response to global developments.This characteristic also gives traders the added flexibility of determining their trading day. Active day traders no longer have to wait for the equities market to open at 8:30 a.m. South African time to begin trading. If there is a significant announcement or development either domestically or overseas between 5:00 p.m.South African time and 8:30 a.m. South African time, most day traders will have to wait for the exchanges to open at 8:30 a.m. to place trades. By that time, in all likelihood, unless you have access to electronic communication networks (ECNs) such as Unum Capital for pre-market trading,the market would have gapped up or gapped down against you. All of the professionals would have already priced in the event before the average trader can even access the market.In addition, most people who want to trade also have a full-time job during the day. The ability to trade after hours makes the FX market a much more convenient market for all traders. Different times of the day will offer different trading opportunities as the global financial centers around the world are all actively involved in foreign exchange. With the FX market,trading after hours with a large online FX broker provides the same liquidity and spread as at any other time of day.As a guideline on the picture above, at 11:00 p.m. Sunday, South African, trading begins as the markets open in Sydney, Australia. Then the Tokyo markets open followed by  European markets in Frankfurt  and then London. When European markets are in full swing,  Asia has concludes its trading day. The U.S. markets open first in NewYork around 2:00 pm Monday as Europe winds down. Sydney is set to reopen once again.The most active trading hours are when the markets overlap; for example,Asia and Europe trading overlaps between 2:00 a.m. GMT  and approximately4:00 a.m., Europe and the United States overlap between 8:00 a.m. which is 2pm South African time.

Market Cycles and volatility

It is great that forex is a market that can be traded around the clock, 24 hours, 5.5 days a week, 12 months a year. Being open all day and most of the week brings to the market a greater liquidity than otherwise, and it gives traders from around the world the flexibility to trade when they want. They can trade as little or as often as they want, during their business hours, after work or even in the middle of the night. However, there are drawbacks to having the market being open 24/7. It is nice to have the flexibility to trade at any time, but we are also human, which means that we must sleep, eat or relax, and cannot be monitoring our positions all day and all night. There will always be times of missed opportunities or jumps in price that will move against established positions when we are not around. This is a human limitation. Although there is always liquidity in each session, they are not created equal there are periods when price action is consistently volatile and periods when it is muted. Moreover, currency pairs exhibit varying activity over certain times of the trading day in relation to the demographics of the participants online at the time. In the 24 hour fast paced forex market, timing is critical and choosing the best time to trade can add to one's profit potential.The best trading hours are the times when volume and volatility levels are highest. High trading volume means that more lots of a particular currency pair are being bought and sold and high volatility means that the currency pair is moving fast and trending quickly. High volume and strong volatility cause large pip movements during the best trading hours. Moreover, the spreads become narrower during high volume trading hours, and narrow spreads means lower transaction costs. As seen on the picture, there is an overlap between the Asian market and the London market. During the Asian markets, candles on the charts are kept in a range, signifying low volatility and low volume, during London opening, the charts starts to trend with bigger size candles, showing high volume traded and higher volatility. Given that 34.1% of the world daily turnover occurs in United Kingdom (London) and that another 7.5% occur in the nearby time zones of France, Germany and Denmark, it is easy to see why the London session is one that should not be ignored. The large number of market participants has made London the world’s most volatile market for trading currencies.

Fx fees compared with other markets

The existence of much lower transactioncosts also makes the FX market particularly attractive. In the equities market,traders must pay a spread ( the difference between the buy and sell price) and/or a commission. With online equity brokers, commissions can run upwards of $20 per trade. With positions of $100,000, average round trip commissions could be as high as $120. The over the counter structure of the FX market eliminates exchange and clearing fees, which in turn lowers transaction costs. Costs are further reduced by the efficiencies created by a purely electronic marketplace that allows clients to deal directly with the market maker, eliminating both ticket costs and middlemen. Because the currency market offers around the clock liquidity, traders receive tight competitive spreads both intra day and at night. Equities traders are more vulnerable to liquidity risk and typically receive wider dealing spreads, especially during after hours trading.Low transaction costs make online FX trading the best market to trade for short term traders. For an active equity trader who typically places 30 trades a day, at a $20 commission per trade you would have to pay up to $600 in daily transaction costs. This is a significant amount of money that would definitely take a large cut out of profits or deepen losses. The reason why costs are so high is because there are several people involved in an equity transaction. More specifically, for each trade there is a broker, the exchange, and the specialist. All of these parties need to be paid, and their payment comes in the form of commission and clearing fees. In the FX market,because it is decentralized with no exchange or clearinghouse everything is taken care of by the market maker, these fees are not applicable.

Fx Leverage

Even though many people realize that higher leverage comes with risks, traders are humans and few of them find it easy to turn away the opportunity to trade on someone else’s money. The FX market caters perfectly to these traders by offering the highest leverage available for any market. Most online currency firms offer 500 times leverage on regular sized accounts and up to 1000 times leverage on the miniature accounts. Compare that to the 2 times leverage offered to the average equity investor and the 10 times capital that is typically offered to the professional trader, and you can see why many traders have turned to the foreign exchange market. The margin deposit for leverage in the FX marketis not seen as a down payment on a purchase of equity, as many perceive margins to be in the equities markets. Rather, the margin is a performance bond, or good faith deposit, to ensure against trading losses. This is very useful to short term day traders who need the enhancement in capital to generate quick returns. Leverage is actually customizable, which means that the more risk averse investor who feels comfortable using only 10 or 20 times leverage or no leverage at all can elect to do so. However, leverage is really a double edged sword. Without proper risk management a high degree of leverage can lead to large losses as well.

Profit in Both Bull and Bear Markets

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In the FX market, profit potentials exist in both bull and bear markets. Since currency trading always involves buying one currency and selling another, there is no structural bias to the market. Therefore, if you are long one currency, you are also short another. As a result, profit potentials exist equally in both upward trending and downward trending markets. This is different from the equities market, where most traders go long instead of short equties, so the general equity investment community tends to suffer in a bear market.While in the fx market bulls and bears market co exist. 

Error Rates

In general, a shorter trade process minimizes errors. Online currency trading is typically a three step process. A trader would place an order on the platform, the FX dealing desk would automatically execute it electronically, and the order confirmation would be posted or logged on the trader’s trading station. Typically,these three steps would be completed in a matter of seconds. For an equities trade, on the other hand, there is generally a five step process. The client would call his or her broker to place an order, the broker sends the order to the exchange floor, the specialist on the floor tries to match up orders the broker competes with other brokers to get the best fill for the client, the specialist executes the trade, and the client receives a confirmation from the broker. As a result, in currency trades the elimination of a middleman minimizes the error rates and increases the efficiency of each transaction.

Limited Slippage

Unlike the equity markets, many online FX market makers provide instantaneous execution from real time, two way quotes.These quotes are the prices at which the firms are willing to buy or sell the quoted currency, rather than vague indications of where the market is trading, which aren’t honored. Orders are executed and confirmed within seconds. Robust systems would never request the size of a trader’s potential order, or which side of the market he’s trading, before giving a bid/offer quote. Inefficient dealers determine whether the investor is a buyer or a seller, and shade the price to increase their own profit on the transaction.The equity market typically operates under a “next best order” system,under which you may not get executed at the price you wish, but rather at the next best price available. For example, let’s say Standard bank is trading at R52.50. If you enter a buy order at this price, by the time it reaches the specialist on the exchange floor the price may have risen to R53.25. In this case,you will not get executed at R52.50; you will get executed at R53.25, which is essentially a loss of three quarters of a pip. The price transparency provided by some of the better market makers ensures that traders always receive a fair price. 

Perfect Market for Technical Analysis

For technical analysts, currencies rarely spend much time in tight trading ranges and have the tendency to develop strong trends. Over 80 percent of volume is speculative in nature, and as a result the market frequently overshoots and then corrects itself. Technical analysis works well for the FX market and a technically trained trader can easily identify new trends and breakouts, which provide multiple opportunities to enter and exit positions. Charts and indicators are used by all professional FX traders, and candlestick charts are available in most charting packages. In addition, the most commonly used indicators—such as Fibonacci retracements, stochastics, moving average convergence/divergence (MACD), moving averages, (RSI), and support/resistance levels have proven valid in many instances. You will further learn about trading these markets succesfully using technical analysis on chapters to come.