We like to think of it as the Big Kahuna of financial markets. The foreign exchange market — most often called the Forex market. Simply the FX market — is the largest and most liquid of all international financial markets.
The Forex market is the crossroads for international capital. The intersection through which global commercial and investment flows have to move. International trade flows, such as when a Swiss electronics company purchases Japanese-made components. Were the original basis for the development of the Forex markets.
Today, however, global financial and investment flows dominate trade as the primary non-speculative source of Forex market volume. Whether it’s an Australian pension fund investing in U.S. Treasury bonds, or a British insurer allocating assets to the Japanese equity market, or a German conglomerate purchasing a Canadian manufacturing facility, each cross-border transaction passes through the Forex market at some stage.
The forex market is the ultimate traders’ market. It’s a market that’s open around the clock six days a week. Enabling traders to act on news and events as they happen. It’s a market where half-billion-dollar trades can be executed in a matter of seconds. May not even move prices noticeably. That is what’s unique about forex — try buying or selling a half-billion of anything in another market and see how prices react.
The rise of electronic currency trading
The forex markets have had a limited form of electronic trading since the mid-1980s. At that time, the primary means of electronic trading relied on an advanced communication system developed by Reuters, known as Reuters Dealing. It was a closed-network, real-time chat system well before the Internet ever hit the scene. The Reuters system enabled banks to contact each other electronically for price quotes in so-called direct dealing. This system functioned alongside a global network of brokerage firms that relied on telephone connections to currency trading desks and broadcast running price quotes, making them known as voice brokers.
The modern form of electronic currency trading
Debuted in the forex market in the early to mid- 1990s. Eventually supplanting much of the voice brokers’ share of trading volume. The two main versions of electronic matching systems were developed by Reuters and EBS for the institutional “interbank” forex market. Both systems allowed banks to enter bids and offers into the system and trade on eligible prices from other banks, based on prescribed credit limits. The systems would match buyers and sellers, and the prices dealt in these systems became the benchmarks for currency price data, such as highs and lows.
Advances in trading software saw the development by major international banks of their own individualised trading platforms. These platforms allowed banks and their institutional clients, like corporations and hedge funds, to trade directly on live streaming prices fed over the banks’ trading platforms. These systems function alongside the matching systems, which remain the primary sources of market liquidity.
At the same time, retail forex brokers introduced online trading platforms designed for individual traders. Online currency trading allows for smaller trade sizes instead of the 1 million base currency units that are standard in the interbank market, such as $1 million or £1 million. Forex markets trade in such large, notional amounts because the price fluctuations are in tiny increments, commonly known as pips, usually 0.0001.
Remember:
When retail currency trading broke into the mainstream. Most online currency platforms offered trade sizes in amounts commonly known as lots. Standard-size lot equal to 100,000 base currency units. Mini lots equal to 10,000 base currency units. However, as the retail market has evolved, brokers have started to act on demand for the ability to place smaller trades. Most brokers now have an option to trade in micro 1,000 lots. Which require a lot less capital than a mini or standard lot. This means that traders can enter the forex market with a lot less capital at risk.
In addition to multiple lot sizes, online brokerages offer generally high levels of margin. Ranging from 50:1 to 200:1 and sometimes higher, depending on the regulations of the country that you trade in. This allows individual traders to make larger trades based on the amount of margin on deposit. For example, at 100:1 leverage. $2,000 margin deposit would enable an individual trader to control a position as large as $200,000. Retail forex brokerages offer leverage to allow individual traders to trade in larger amounts relative to the small size of pips.
Many firms 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.
Getting Inside the Numbers
Average daily currency trading volumes exceed $5 trillion per day. That’s a mind-boggling number, isn’t it? $5,000,000,000,000 — that’s a lot of zeros, no matter how you slice it. 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.
That $5-trillion-a-day number, which you may’ve seen in the financial press or other books on currency trading, actually overstates the size of what the forex market is all about — spot currency trading.
Trading for spot
Spot refers to the price where you can buy or sell currencies now. As in “on the spot.” If you’re familiar with stock trading, the price you can trade at is essentially a spot price. The term is primarily meant to differentiate spot; or cash, trading from futures trading; or trading for some future delivery date. The spot currency market is normally traded for settlement in two business days. Unless otherwise specified, the spot price is most likely to be what you buy and sell at with your currency broker.
Speculating in the currency market
While commercial and financial transactions in the currency markets represent huge nominal sums. They still pale in comparison to amounts based on speculation. By far the vast majority of currency trading volume is based on speculation. Traders buying and selling for short-term gains based on minute-to-minute, hour-to-hour, and day-to-day price fluctuations.
Estimates are that upwards of 90 percent of daily trading volume is derived from speculation. Meaning, commercial or investment-based FX trades account for less than 10 percent of daily global volume. The depth and breadth of the speculative market means that the liquidity of the overall forex market is unparalleled among global financial markets.
The bulk of spot currency trading, about 75 percent by volume, takes place in the so-called “major currencies,” which represent the world’s largest and most developed economies. Trading in the major currencies is largely free from government regulation and takes place outside the authority of any national or international body or exchange.
Additionally, activity in the forex market frequently functions on a regional “currency bloc” basis. Where the bulk of trading takes place between the USD bloc, JPY bloc, and EUR bloc. Representing the three largest global economic regions.
Trading in the currencies of smaller, less-developed economies, Such as Thailand or Chile, is often referred to as emerging market or exotic currency trading. Although trading in emerging markets has grown significantly in recent years. In terms of volume it remains some way behind the developed currencies. Due to some internal factors. Such as local restrictions on currency transactions by foreigners. And some external factors. Such as geopolitical crises and the financial market crash, which can make emerging market currencies tricky to trade. The emerging-market forex space can be liquid, which can be a turnoff for a small investor.
Getting liquid without getting soaked
Liquidity refers to the level of market interest — the level of buying and selling volume — available at any given moment for a particular asset or security. The higher the liquidity, or the deeper the market, the faster and easier it is to buy or sell a security.
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 liquid, or thin, market will tend to see prices move more rapidly on relatively lower trading volumes. A market that only trades during certain hours (futures contracts, for example) also represents a less liquid, thinner market.
We refer to liquidity, liquidity considerations, and market interest throughout this book because they’re among the most important factors affecting how prices move, or price action.
We refer to liquidity, liquidity considerations, and market interest throughout this book. Because they’re among the most important factors affecting how prices move. Or price action. several hundred million dollars, it needs to be concerned about the tactical levels of liquidity. Such as how much its trade is likely to move market prices depending on when the trade is executed. For individuals, who generally trade in smaller sizes. The amounts are not an issue. But the strategic levels of liquidity are an important factor in the timing of when and how prices are likely to move.
In the next section, we examine how liquidity and market interest changes throughout the global trading day. With an eye to what it means for trading in particular currency pairs.
Around the World in a Trading Day
The forex market is open and active 24 hours a day. From the start of business hours on Monday morning in the Asia-Pacific time zone straight through to the Friday close of business hours in New York. At any given moment, depending on the time zone, dozens of global financial centres. Such as Sydney, Tokyo, or London are open. Currency trading desks in those financial centres are active in the market.
In addition to the major global financial centres, many financial institutions operate 24-hour-a-day currency trading desks, providing an ever-present source of market interest.
Currency trading doesn’t even stop for holidays. When other financial markets, like stocks or futures exchanges, may be closed. Even though it’s a holiday in Japan. For example, Sydney, Singapore, and Hong Kong may still be open. It might be the Fourth of July in the United States. But if it’s a business day, Tokyo, London, Toronto, and other financial centres will still be trading currencies. About the only holiday in common around the world is New Year’s Day, and even that depends on what day of the week it falls on.
The opening of the trading week
There is no officially designated starting time to the trading day or week. But for all intents the market action kicks off when Wellington, New Zealand. The first financial centre west of the international dateline, opens on Monday morning local time. Depending on whether daylight saving time is in effect in your own time zone, it roughly corresponds to early Sunday afternoon in North America, Sunday evening in Europe, and very early Monday morning in Asia.
The Sunday open represents the starting point. Where currency markets resume trading after the Friday close of trading in North America (5 p.m. eastern time [ET]). This is the first chance for the forex market to react to news. And events that may have happened over the weekend. Prices may have closed New York trading at one level. But depending on the circumstances, they may start trading at different levels at the Sunday open. The risk that currency prices open at different levels on Sunday versus their close on Friday is referred to as the weekend gap risk. The Sunday open gap risk. A gap is a change in price levels where no prices are tradable in between.
As a strategic trading consideration,
Individual traders need to be aware of the weekend gap risk and know what events are scheduled over the weekend. There’s no fixed set of potential events and there’s never any way of ruling out what may transpire, such as a terror attack, a geopolitical conflict, or a natural disaster. You just need to be aware that the risk exists and factor it into your trading strategy.
Of typical scheduled weekend events. The most common are quarterly Group of Twenty (G20) meetings and national elections or referenda. Just be sure you’re aware of any major events that are scheduled. During the height of the Eurozone sovereign debt crisis. A lot of last-minute bailout decisions were made over the course of a weekend. Which had major implications for the markets when they opened.
On most Sunday opens, prices generally pick up where they left off on Friday afternoon. The opening price spreads in the interbank market will be much wider than normal, because only Wellington and 24-hour trading desks are active at the time. Opening price spreads of 10 to 30 points in the major currency pairs are not uncommon in the initial hours of trading. When banks in Sydney, Australia, and other early Asian centres enter the market over the next few hours, liquidity begins to improve and price spreads begin to narrow to more normal levels.
Because of the wider price spreads in the initial hours of the Sunday open, most online trading platforms do not begin trading until 5 p.m. ET on Sundays, when sufficient liquidity enables the platforms to offer their normal price quotes. Make sure you’re aware of your broker’s trading policies with regard to the Sunday open, especially in terms of order executions.