The foreign exchange (forex) market is the global marketplace where currencies are traded. It is one of the largest, most liquid, and decentralized financial markets in the world. This forex market guide provides an in-depth overview of how the forex market works, who the major players are, what drives currency fluctuations, and how to start trading currencies.
An Introduction to Forex Trading
The forex market enables participants to buy, sell, and exchange currencies. It operates 24 hours a day, five days a week across the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris, and Sydney.
The forex market exists thanks to the decentralized global network of banks, businesses, individuals, and forex trading companies. It allows market participants to take advantage of fluctuations in exchange rates between different currencies. For instance, a forex trader may buy the British pound when it is priced low relative to the U.S. dollar, and then sell it when the exchange rate appreciates.
The primary function of the forex market is to facilitate international trade and investments by enabling the conversion of one currency into another. It provides companies and individuals with an important hedging tool against currency risk. The market also offers speculators a chance to profit from changes in the value of currencies.
Major Currencies Traded on Forex
There are many currencies traded on the forex market, but a few get the lion’s share of attention from traders:
U.S. Dollar (USD)
As the most traded and liquid currency in the world, the U.S. dollar is involved in about 84% of all forex transactions. The dollar acts as the primary reserve currency and is influenced by the monetary policy decisions of the U.S. Federal Reserve.
Euro (EUR)
The euro is the official currency of 19 of the 27 member countries of the European Union. It ranks second behind the U.S. dollar in terms of trading volume, involved in about 39% of forex transactions. Central banks and traders pay close attention to policy shifts by the European Central Bank, which can influence the euro’s value.
Japanese Yen (JPY)
The yen is an extremely liquid currency that represents the third-most-traded currency on forex markets. As the national currency of Japan, it is influenced heavily by the Bank of Japan’s monetary policy goals and decisions.
British Pound (GBP)
Also known as the sterling, the British pound is the fourth most traded currency on the forex market. As the national currency of the United Kingdom, policy decisions by the Bank of England are key drivers of price movements for the pound.
Australian Dollar (AUD)
The Aussie dollar is the fifth most traded currency, often used by traders as a proxy for commodities because Australia is rich in natural resources. The Reserve Bank of Australia plays a central role in setting interest rate guidance and influencing the value of the Australian dollar.
Swiss Franc (CHF)
As the national currency of Switzerland, the Swiss franc holds safe haven appeal due to Switzerland’s history of banking secrecy and independence. The Swiss National Bank institutes policies aimed at reducing volatility and increasing the appeal of the franc.
What Impacts Exchange Rates?
There are a variety of macroeconomic factors that can impact the supply and demand for a currency, causing its exchange rate to fluctuate:
Interest Rates
Central bank interest rate decisions and expectations surrounding future rate moves have a significant influence on exchange rates. Currencies with higher interest rates tend to attract greater demand than currencies with lower yields.
Inflation Rates
The rate of inflation in a country impacts the real return on its currency. Rising inflation tends to devalue a currency and lead investors to seek higher returns elsewhere.
Economic Performance
The overall health of an economy, as measured by GDP, employment, manufacturing activity, and other metrics guides currency valuations. Strong economic growth tends to correlate with an increasing currency value.
Trade and Current Account Balance
Countries that run sustained trade surpluses tend to see an appreciation in the value of their currency compared to countries running trade deficits.
Political Factors
Geopolitical instability, domestic political strife, elections, and leadership changes can all impact currency valuations due to shifts in economic policy.
Credit Ratings
Sovereign credit ratings by agencies like Standard & Poor’s, Moody’s, and Fitch determine the perceived health of a nation’s finances. Any changes to a country’s credit outlook or rating will affect demand for its currency.
Forex Market Size and Liquidity
The foreign exchange market is by far the largest and most liquid market in the world. According to the 2019 Triennial Central Bank Survey of the Bank for International Settlements, daily trading volume in the forex market reached $6.6 trillion.
The enormous trading volume is facilitated by the 24-hour nature of the market across global time zones and the high leverage available to traders. The most traded currency pairs are also extremely liquid, enabling the large transaction sizes in the interbank market.
The forex market’s liquidity allows traders to enter and exit the market seamlessly, with low transaction costs and tight bid-ask spreads. The high liquidity also helps limit exchange rate volatility and makes currencies efficiently priced relative to each other.
Forex Market Players
The forex market involves a diversity of market participants, each playing a role in currency valuations:
Commercial Companies
Commercial companies involved in importing and exporting conduct foreign exchange transactions to pay for goods and services. Their business is a major driver of currency transaction volume.
Central Banks
Central banks are responsible for stabilizing the value of their domestic currency through monetary policy decisions and currency interventions. They hold sizable foreign exchange reserves.
Investment Managers
Asset managers and hedge funds conduct forex trading as part of their investment strategies. They seek to generate returns for clients by speculating on currency movements.
Retail Traders
Individual retail traders participate in the forex market through brokers and speculating on currency moves. Retail trades account for a relatively small portion of overall volume.
Multinational Corporations
Large corporations use forex markets to hedge currency exposure and minimize exchange rate risk when they have multinational operations involving multiple currencies.
Brokers
Forex brokers give traders access to the foreign exchange market using trading platforms and provide leverage up to 50:1 in some countries. They profit from commissions and trading spread markups.
Banks
Banks facilitate currency conversions for clients and are the main players in the interbank market, trading directly with other large institutions in enormous transaction sizes.
Forex Trading Sessions
The forex market is unique in that it remains open for trading 24 hours a day, five days a week. Trading sessions are broken up into Asian, European, and North American sessions based on when the trading activity for each regional market is most active.
Asian Session
The Asian trading session covers currency trading during Asian business hours, which runs from 11pm-8am EST. The main trading centers during this session are Sydney, Tokyo, Hong Kong, and Singapore.
European Session
The European session lasts from 3am-12pm EST as markets in Europe including London, Frankfurt, and Zurich are open for business. This session has high trading volume and participation from North American traders.
North American Session
The North American session is active when New York trading opens from 8am-5pm EST and has the highest average daily trading volume, with tight spreads and high liquidity.
Sydney Session
Some traders focus exclusively on the Sydney session from 5pm-2am EST, which overlaps with both Asian and European markets to provide both volatility and ample liquidity.
Non-Farm Payrolls Releases
The non-farm payrolls report, released on the first Friday of every month at 8:30am EST, generates heightened volatility as traders react to the key jobs indicator.
How to Trade on the Forex Market
As a retail forex trader, it’s important to work with a regulated forex broker to gain access to the foreign exchange market. The process involves the following steps:
Conduct Due Diligence
Research brokers and scrutinize factors like regulatory licenses, trading platforms, leverage, funding options, spreads, and customer support. Select a broker that matches your experience level and trading needs.
Open a Forex Trading Account
Fill out the new account paperwork and complete the broker’s Know Your Customer and Anti-Money Laundering checks. Fund your account through a bank transfer or e-wallet platforms like PayPal.
Download the Trading Platform
Gain access to your broker’s proprietary or third-party trading platform such as MetaTrader 4 (MT4) on your chosen device. Use the demo account to practice and get comfortable.
Perform Technical and Fundamental Analysis
Analyze currency pairs through chart patterns, trends, technical indicators, economic data releases, interest rates, geopolitics, and other factors to inform your trading strategy.
Place Trading Orders
Use market, limit, and stop orders to enter and exit forex trades according to your strategy. Apply proper risk management using stop losses and position sizing based on a percentage of account balance.
Pros and Cons of Forex Trading
Forex trading offers distinct advantages but also comes with inherent risks:
Pros
- 24-hour market with high liquidity
- Ability to profit from rising or falling exchange rates
- Leverage provides exposure beyond capital
- Low transaction costs and small bid-ask spreads
- Wide range of currency pairs to choose from
Cons
- Leverage can multiply losses rapidly
- Requires constant monitoring of the market
- Unregulated brokers carry risk
- Bank manipulation possible during interventions
- Speculating is complex and risky
Conclusion
The foreign exchange market is a multifaceted global marketplace that offers plenty of opportunities for both institutional and individual traders. The forex market is extremely liquid, volatile at times, and driven by a diverse set of macroeconomic factors ranging from interest rate differentials to geopolitics.
While currency trading can potentially generate outsized returns, it also comes with significant risks due to high leverage, complexity, and constant fluctuations. Conducting thorough research, gaining adequate knowledge, and working with regulated brokers gives aspiring forex traders the best opportunity for success.
