The foreign exchange market is a global marketplace where currencies are traded. This market is also known as the FOREX market, or FX market. FOREX trading is the largest market on earth and is used for many purposes. While large institutions use it for rebalancing currency holdings, many traders use it as a way to generate profits.
The FOREX market has a turnover of at least $4 trillion US dollars on a daily basis, and there is likely more volume in the FX derivatives market. Unlike many other markets, FX trades five days a week and is open 24 hours per day. The FX week begins on Monday morning in Asia and closes when US exchanges wrap up on Friday night.
FOREX traders can access the markets from 9:00 pm UTC on Friday, until 9:00 pm UTC on Friday in the summertime and the hours may change during winter in the Northern Hemisphere. Because the markets are open all week long, there is always a way to buy into the market or sell an existing position.
The FOREX market is based on trading currency pairs. A currency pair is comprised of two different currencies that are traded at the same time. All currency pairs use ISO codes to identify the two currencies that comprise the pair.
For example, the most liquid contract globally is the EURO/US Dollar currency pair. In FOREX terms, this pair is written as EUR/USD. Some other common currencies are Swiss Francs (CHF), Japanese Yen (JPY), and British Pounds (GBP).
There are three groups of currencies. Major, minor, and exotic currencies. The major currency pairs always have the US Dollars (USD) included.
Here is a list of the major FX pairs:
EURUSD
GBPUSD
USDJPY
USDCAD
USDCHF
NZDUSD
AUDUSD
The minor and exotic currency pairs are comprised of other currencies. For example, GBPJPY is a minor currency pair. Exotics involve one major currency, with another currency that has a smaller market presence, like the Turkish Lira (TRY), or Argentine Peso (ARS).
In a currency pair, the currency on the left is called the base currency, and the currency on the right is the secondary currency. For example, in the GBP/USD pair, British Pounds are the base currency, and US Dollars are the secondary currency. In an FX trade, the secondary currency is used to make the transaction in the base currency.
When you buy or sell an FX pair, there will be two prices. The Bid price, and the Ask price. Both prices refer to how much it will cost to buy or sell the base currency with the secondary currency. There will always be some difference between the two prices, and this is called the 'spread'.
In general, the larger the currency pair's liquidity, the smaller the spread will be. Minor and exotic currency pairs tend the be traded less than the majors, and as a consequence of this, they will have larger spreads. Larger spreads also tend to mean more risk and volatility, which will affect how they are traded.
The base unit of trading currency in the FX market is a 'pip'. When a currency price is quoted, there are a few numbers after the decimal point. For example, in the GBP/USD pair, it may be quoted as 1.2101. This means that for every GBP that the trader wants to buy (or sell) they will have to spend 1.2101 USD.
While there are some variations depending on the currency, in the example given above, the fourth number after the dot would be considered the pip. The pip's value will vary based on the size of the position, and has no fixed value.
In most cases, the spread, gains, and losses will be denominated in pips. To reiterate, the value of the pip will be determined by the size of the position, and all subsequent calculations need to take this into account.
There are other terms that are used in the financial markets that are good to know. Two of the most common ones are 'bullish' and 'bearish', which refer to how a trader views the future direction of any given market.
A bullish trader thinks that the value of a market will rise, and a bearish trader thinks that it will fall. A rising market is called a bull market, and a falling market is referred to as a bear market. Traders will use these views to determine how they trade a market. If they are correct, their view will create profits.
Today, traders have the ability to make their own positions via online platforms. Software like MT4 and MT5 give retail traders access to their broker's servers directly, and it is no longer necessary to talk to a broker over the phone. There are also trading apps for smartphones, which allows mobile trading.
Every trader will have a different approach to trading, and there are many tools that will allow traders to trade in a way that suits them the best.
Using leverage is a common practice with FX traders. A broker will allow traders to use many times the amount of money they have on deposit in an account so that small moves in the market are magnified. Keep in mind that losses are also magnified by leverage, and using lots of leverage won't make a losing position turn profitable.
FX traders work around the clock, and there are many kinds of economic data that can move the FOREX market. Because of the high liquidity in the FX market, there are rarely major moves in the major currency pairs. Occasionally there are big moves, especially around central bank policy announcements, and a few other widely followed economic indicators.One of the most important factors that determine the demand for a currency is the market's expectation of future interest rates. There are many factors that will influence a central bank's policy, like the employment rate and overall economic activity.
When the market is caught off-guard, there can be big moves in the value of major currency pairs. Minor currency pairs are more likely to have higher volatility, which may be attractive to traders who want to take on larger risks. All of the economic information that drives the markets can be found on the economic calendar, which is widely used by FX traders.
Let's say that a trader thinks that the British Pound will appreciate against the US Dollar. The trader would buy the GBP/USD pair, at a theoretical price ask of 1.2102. The trader would have to buy at the ask price, which is 4 pips higher than the bid price of 1.2098. The 4 pips may go to the broker if the broker is the counterparty of the transaction.
Depending on how the contract is structured, the value of the position could be just about any size. Let's say that this position is for 1/10 of a standard contract of 100,000 units, which would be 10,000 GBP or 12,102 USD.
If the trader is correct, the value of the USD that they used to buy the GBP will fall relative to the GBP, and the trader can lock in a profit. Let's say that the value of the GBP rises to 1.2198, which would make the value of the position 12,198 in USD terms. Because the position cost 12,102, the small movement in the value of the two currencies would net the trader a profit of $96 USD.