Chapter 1
Your Forex Need-to-Know Guide
In This Chapter
Understanding currency trading and the forex market
Getting a handle on currency pairs and prices
Tracking markets during a trading day
Looking at the technical details of currency trading
Identifying factors that influence forex rates
The foreign exchange (forex or FX) market has exploded onto the scene and is the hot new financial market. It has been around for years, but advances in electronic trading have made it available to individual traders on a scale unimaginable just a few years ago. Because it's relatively new, a lot of people are still in the dark when it comes to exactly what the currency market is: how it's organized, who's trading it, and what a trading day looks like when the market never closes. This chapter sheds a bit of light on these topics.
Getting a Quick Overview of Currency Trading
Currency trading is speculation, pure and simple. The securities you're speculating with are the currencies of various countries. For that reason, currency trading is about both the dynamics of market speculation, or trading, and the factors that affect the value of currencies.
Speculating, or active trading, is about taking calculated financial risks in an attempt to realize a profitable return, usually over a very short time horizon. It's not gambling (playing with money even when you know the odds are stacked against you) or investing (minimizing risk and maximizing return, usually over a long time period).
Often called the forex market (or FX market), the foreign exchange market is the largest and most liquid of all international financial markets. It's the crossroads for international capital, the intersection through which global commercial and investment flows have to move. The following sections describe the market, its liquidity, and its key players.
Entering the interbank market
When people talk about the “currency market,” they're referring to the interbank market, whether they realize it or not. The interbank market is where the really big money changes hands. Minimum trade sizes are one million of the base currency, such as €1 million of EUR/USD (euro/U.S. dollar) or $1 million of USD/JPY (U.S. dollar/Japanese yen). (EUR/USD and USD/JPY are examples of currency pairs, the topic of discussion in the later section “Checking Out Currency Pairs and Prices.”) Much larger trades — between $10 million and $100 million, for example — are routine and can go through the market in a matter of seconds. For the individual trading FX online, the prices you see on your trading platform are based on the prices being traded in the interbank market.
As the prefix suggests, the interbank market is “between banks,” with each trade representing an agreement between the banks to exchange the agreed amounts of currency at the specified rate on a fixed date. The interbank market is alternately referred to as the cash market or the spot market to differentiate it from the currency futures market, which is the only other organized market for currency trading. (Flip to Book II for an introduction to futures.)
The sheer size of the interbank market is what helps make it such a great trading market, because investors of every size are able to act in the market, usually without significantly affecting prices. Daily trading volumes are enormous by any measure, dwarfing global stock trading volumes many times over. In 2010, for example, daily FX trading volumes reached nearly $4 trillion. To give you some perspective on that size, it's about 10 to 15 times the size of daily trading volume on all the world's stock markets combined.
The interbank market developed without any significant governmental oversight and remains largely unregulated. In most cases, no regulatory authority apart from local or national banking regulations exists for spot currency trading. Interbank trading essentially evolved based on credit lines between international banks and trading conventions that developed over time.
Firms such as FOREX.com, Saxo Bank, and Oanda have made the forex market accessible to individual traders and investors. You can now trade the same forex market as the big banks and hedge funds.
Trading in the interbank market
The interbank market is an over-the-counter (OTC) market, which means that each trade is an agreement between the two counterparties to the trade. The trades involve no exchanges or guarantors, just each bank's balance sheet and the promise to make payment.
The bulk of spot trading in the interbank market is transacted through electronic matching services, such as EBS and Reuters Dealing. Electronic matching services allow traders to enter their bids and offers into the market, hit bids (sell at the market), and pay offers (buy at the market). Price spreads vary by currency pair and change throughout the day depending on market interest and volatility. (You get the scoop on currency pairs later in this chapter.)
In recent years, the major international FX trading banks have also developed electronic trading platforms that function via the Internet, enabling their customers to bypass banks’ trading desks and deal directly in the market, potentially accessing more advantageous prices.
Looking at liquidity
Liquidity, liquidity considerations, and market interest are among the most important factors affecting how prices move, or price action. From a trading perspective, liquidity is a critical consideration because it determines how quickly prices move between trades and over time. A highly liquid market like forex can see large trading volumes transacted with relatively minor price changes. An illiquid, or thin, market will tend to see prices move more rapidly on relatively lower trading volumes. A market that trades only during certain hours (futures contracts, for example) also represents a less liquid, thinner market.
Although the forex market offers exceptionally high liquidity on an overall basis, liquidity levels vary throughout the trading day and across various currency pairs. As an individual trader, factor when and how prices are likely to move in the timing of your trades.
Meeting the key players: Hedgers, hedge funds, ...
