If you’ve ever traveled to another country, you typically had to find a currency exchange booth at the airport, and then exchange the money you have, into the currency of the country you are visiting. When at the counter you may notice, a screen displaying different exchange rates for different currencies. You find “Indian Rupee” and think to yourself, my one Rand is worth 5 Rupees. And I have a thousand Rand, after the conversion now I have 5000 Rupees.
When you do this, you’ve basically contributed to the forex market. You’ve exchanged one currency for another. Or in forex trading terms, assuming you’re a South African visiting India, you’ve sold Rand’s and bought Rupees. Before you fly back home, you stop by the currency exchange booth to exchange the Rupees that you have left over and notice the exchange rates have changed. It’s these changes in the exchanges rates that allow you to make money in the foreign exchange market. The foreign exchange market, which is usually known as “forex” or “FX,” is the largest financial market in the world. Compared to the much smaller $22.4 billion per day volume of the New York Stock Exchange (NYSE), the foreign exchange market has a $5.3 TRILLION a day trade volume.
Check out the graph of the average daily trading volume for the forex market, New York Stock Exchange, Tokyo Stock Exchange, and London Stock Exchange:
The forex market is over 200 times bigger that the NYSE. The $5 trillion covers the entire global foreign exchange market, but retail traders, like yourself, trade the spot market and that’s about $1.49 trillion. The forex market is big, but not as big as the media would like you to believe.
What Is Traded in Forex?
Forex is money; therefore, money is traded. In the forex market, you’re not buying anything physical, you are trading the underlying value of a currency. Think of buying a currency as buying a share in a country, like buying stocks in a company. The price of the currency is usually a direct reflection of the market’s opinion on the current and future strength of its respective economy. In forex trading, when you buy, say, the British pound, you are technically buying a share in the British economy. You are wagering that the British economy is doing well, and will even get better as time goes. Once you sell those British pounds back to the market, with some skill, you will end up with a profit. In general, the exchange rate of a currency versus other currencies reflects the condition of that country’s economy, compared to other countries’ economies.
Currency symbols always have three letters, where the first two letters identify the name of the country and the third letter identifies the name of that country’s currency. Take AUD for instance. AU stands for Australia, while D stands for dollar. The currencies included in the chart above are called the majors because they are the most widely traded.
Buying and Selling in Currency Pairs
Forex trading is the instantaneous buying of a currency and selling of another. Spot currencies are quoted through a broker, liquidity provider or dealer, and are traded in pairs; for example, the British pound and the U.S. dollar (GBP/USD) or the Euro and the Australian dollar (EUR/AUD). When you trade, you buy or sell in currency pairs. Envision each currency pair continually in a push and pull with each other. Both currencies getting weaker and stronger over time as the price of the currency pair changes up and down.
Major Currency Pairs
The following currency pairs are known as the majors. These pairs all contain the U.S. dollar (USD) on one side and are the most frequently traded. The majors are the most liquid and widely traded currency pairs in the world.
Major Cross-Currency Pairs or Minor Currency Pairs
Currency pairs that don’t contain the U.S. dollar (USD) are known as cross-currency pairs or simply as the crosses. Major crosses are also known as minors. The most actively traded crosses are derived from the three major non-USD currencies: EUR, JPY, and GBP.
Other Crosses (AUD, NZD, CAD)
Exotic Currency Pairs
Exotic currency pairs are made up of one major currency paired with the currency of an emerging economy, such as South Africa, Brazil, Singapore or Mexico. The currency of a country with an emerging economy is not as valuable as the Majors and therefore not traded as much. The trading activity on exotic currency pairs takes places at a slower volatility than the majors and the crosses therefore the transaction cost (the spread) is more expensive (bigger) when trading exotic currency pairs. It isn’t unusual to see spreads that are two or three times bigger than that of EUR/USD or USD/JPY. Professional traders typically do not trade exotic currencies, without having fundamental knowledge.
Liquidity & Market Size
Unlike other financial markets like the New York Stock Exchange, the forex market has neither a physical location nor a central exchange. The forex market is considered an Over-the-Counter (OTC), or Interbank market due to the fact that the entire market is run electronically, within a network of banks, continuously over a 24-hour period. This means that the spot forex market is spread all over the globe with no central location. They can take place anywhere. The forex market can be traded by anyone, from anywhere in the world, there is an internet connection and a computer device.
The worlds currency market is by far the biggest and most widespread financial market, traded globally by a vast number of individuals and institutions. In the currency market, traders determine who they want to trade with depending on trading conditions, attractiveness of prices, and reputation of the trading counterpart.
The chart below shows the seven most actively traded currencies. The dollar is the most traded currency, comprising almost 85% of all transactions. The euro’s share is second at around 40% while that of the yen is third at just under 20%
*Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200% instead of 100%
The Dollar is half the Forex Market
The United States Dollar (USD) is the most widely used currency, the USD is on one side of every major currency transaction and the major forex pairs include 755 of all trades. The International Monetary Fund (IMF) stated the United States Dollar is just over 60% of the world’s official foreign exchange reserves. That’s means over half the world currency is being held in USD. Forex Traders, investor, businesses, and big central banks own dollars. In times of global market uncertainty and crisis the United States Dollar acts as a world standby currency, strengthening the USD, and its role in the forex market:
Currency Composition of World FX Reserves
- The U.S. dollar is the reserve currency of the world.
- The United States of America has the largest and most liquid financial markets in the world.
- The United States economy and political are large and influence world politics.
- The United States has the by far the world’s largest military power and budget.
- The USD is the medium of exchange for many cross-border transactions. (For example, oil is priced in U.S. dollars. So, if Mexico wants to buy oil from Saudi Arabia, it can only be bought with U.S. dollar. If Mexico doesn’t have any dollars, it must sell its pesos first and buy U.S. dollars.)
Speculation in the Forex Market
One important thing to note about the forex market is that while commercial and financial transactions are part of trading volume, most currency trading is based on speculation. In other words, most trading volume comes from traders that buy and sell based on intraday price movements. The trading volume brought about by speculators is estimated to be more than 90%. The scale of the forex market means that liquidity, is very high. This makes it very easy for anyone to buy and sell currencies. From the perspective of an investor, liquidity is very important because it determines how fast price can change over a given time-period. A liquid market environment like forex enables large trading volumes to happen with a small effect on the price, or price action. While the forex market is relatively very liquid, the market depth could change depending on the currency pair and time of day.
Ways to Trade Forex
The general types are forex spot, futures, options, and exchange-traded funds (or ETFs).
In the spot market, currencies are traded immediately or on the spot, using the current market price. It is simple, liquid and has tight spreads, and round-the-clock operations. It’s very easy to participate in this market since accounts can be opened easily. Professional traders participate in the Forex spot market.
Futures are contracts to buy or sell a certain asset at a specified price on a future date. Forex futures started in 1972 by the Chicago Mercantile Exchange. Since futures contracts are standardized and traded through a centralized exchange, the market is very transparent and well-regulated. This means that price and transaction information are readily available.
An option is a financial instrument that gives the buyer the right or the option, but not the obligation, to buy or sell an asset at a specified price on the option’s expiration date. If a trader sold an option, then they would be obliged to buy or sell an asset at a specific price at the expiration date. Just like futures, options are also traded on an exchange, such as the Chicago Board Options Exchange or the International Securities Exchange. However, the disadvantage in trading forex options is that market hours are limited for certain options and the liquidity is not nearly as great as the futures or spot market.
Exchange-traded funds or ETFs are the newest members of the forex world. An ETF could contain a set of stocks combined with some currencies, allowing the trader to diversify with different assets. These are created by financial institutions and can be traded like stocks through an exchange. Like forex options, the limitation in trading ETFs is that the market isn’t open 24 hours. Also, since ETFs contain stocks, these are subject to trading commissions and other transaction costs.