Welcome to this, your first lesson in our SF Free Forex Course. We hope you find the content interesting, informative and helpful to your trading future. In this first lesson you will learn about all the basic information regarding the Forex market. While these following lessons will cover a large number of concepts and ideas in great depth.
In any kind of business, from selling used cars to trading the Forex market, it is important to understand every aspect of the market, from the very essentials to the most complex issues that affect it.
Picture this scenario, if you were to adventure into the used cars business, would you just buy a car lot and try to sell them without any planning? I don’t think so, if you do this you will probably end up with a different car to use each day of the week. What would you do then? You will probably want to do some research on the market in which you are about to venture: Who are my possible clients? Check out strategies and prices of competitors, do some analysis of advantages and disadvantages of the used car market, and much more…
The same goes for trading. I’ve seen many traders getting a margin call (MC) without being aware what kind of leverage was being used when the MC happened and some other traders without even knowing what a margin call was!! (If you are not familiar with these terms, don’t worry about it, we will go through them in the following lesson).
In this lesson, we will analyze every aspect of Forex trading, from how it was formed, the main participants, advantages and disadvantages of trading the Forex market, how the Forex market compares to futures and equity markets and all concepts related to Forex trading.
This Lesson is structured in the following way:
Section 2: The Forex market - In this section, we will answer important questions such as: What is the Forex market? When did the Forex market start? What is traded in the Forex market? Where is the physical location of the Forex market?
Section 3: Benefits of the Forex market - We compare the Forex market with other financial markets and see what makes the Forex market so attractive.
Section 4: Main Forex Participants - We analyze who participates in the Forex market and what is their part in it.
Section II: The Forex Market
What is The Forex Market?
The Forex market is an acronym of The Foreign Exchange Market also called The Currency Market.
Money, as simple as that!
Currencies are bought and sold freely. This is the simultaneous buying of one currency and the selling of another.
For instance, you have some inside information that leads you to think that the Euro will go up, you want to buy the Euro pair (or EUR/USD). When you buy the EUR/USD pair you are actually buying the EUR and selling the US dollar. When you buy the EUR it is also said that you are “long” the EUR. When you sell the EUR it is also said that you are “short” the EUR.
More than 80% of the volume is generated by what we call the seven major currencies:
- The US dollar (USD)
- The Euro (EUR)
- The British Pound (GBP)
- The Swiss Franc (CHF)
- The Canadian dollar (CAD)
- The Australian dollar (AUD)
- The Japanese Yen (JPY)
When did it at all start?
You could not say it all started after a sole event. A series of events happened and in the end it resulted in the Forex market, as we know it today.
It all started when the Bretton Woods agreement was finally abandoned around 1971.
In this agreement, participating countries had their currency pegged to either the gold or the US dollar. By 1973 the most powerful countries around the globe introduced a free exchange rate regime where they let their currencies fluctuate driven by the market or more precisely by the forces of supply and demand. It was then when the Forex market was available to speculate, hedge as well as other reasons.
It was not until 1997 when the Forex market became available to individual investors and traders through online trading capabilities and leverage (margin trading), offering traders around the world great opportunities to profit from the Forex market.
The Forex market is now the most liquid financial market of the world, with a generated volume of nearly 2 trillion US dollars (source: BIS) on a daily basis (more than all other US financial markets combined).
Section III: Benefits of Trading Forex
Trading the Forex market has several advantages over other financial markets. Amongst the most important are: liquidity, it’s a 24hr market, leverage trading (margin), low transaction costs, low minimum investment, specialized trading, you can trade from anywhere and others.
Why is the liquidity so important to us? Because it helps us in several ways:
- The most important of all is that superior liquidity ensures price stability. With such a big market, there will be always someone willing to buy or sell any currency at the quoted price, making it easy to open and close trades or transactions at any time of the day. However, there are periods of high volatility during which it might be not easy to get a good fill.
- Because of the great amount of liquidity, most of the time we are able to get in and out the market fast with consistent executions. But as any other market, during periods of instability slippage is always a possibility.
[Table 1]
Source: Bank of International Settlements (BIS) 2006 Survey
[Table 2]
Here you have a more comprehensible table:
[Image 1]
(Click on image to enlarge)
[Image 2]
Imagine this scenario: Two traders with the same capital using different leverage:
Trader A: using 400:1 with a US$2,000 trading account
Trader B: using 100:1 with a US$2,000 trading account
If both of them open a standard trade (100,000 units) trader A will have at risk US$1,750 (2,000 – 250 = 1750) while trader B will only have at risk US$1,000 (2000 – 1000 = 1000)*.
*Of course there are risk management techniques that allow traders to reduce that amount of risk such as stop loss orders. We will go deeper in to this in the following lesson...
For this reason, using leverage greater than 100:1 is not advised.
Remember: the margin is used as a deposit; everything else is also at risk.
Spread – Brokers collect their fees by charging a different price for long and short positions. The difference is what is collected by the broker.
Spread and Commissions – Most brokers under this scheme charge a commission but usually the spread is tighter and transaction costs can even fall below brokers under the spread “only” scheme.
Of course, you can’t expect to make a fortune with that investment but it will get your feet wet before you start risking a larger amount of capital or you can try to slowly start growing your account from there.
[Table 3]
Section IV: Main Forex Participants
These days however, the market has changed, with technological development and the ability to conduct transactions overseas with more ease, other financial / non-financial institutions are able to participate in the foreign exchange market, as well as individual investors and traders.
These days speculation accounts for more than 80% of the overall daily activity. These transactions are conducted from commercial banks to individual traders.
The main participants in the Forex market are: banks, central banks, commercial companies, individual investors and traders and brokers and the main reasons they participate in the Forex market are:
- Profit from fluctuations in currency pairs, speculating (close to 80% of the volume)
- Protection from fluctuating currency pairs, derived from trading goods and services, hedging
- Profit from the rollover generated by differences on interest rates
Banks
Banks are the greatest participant of the Forex market. Large transactions are conducted by these banks (billions on a daily basis), both on their customer’s behalf and on their own. Speculative transactions made by banks accounts for around 70% of the volume generated by banks.
Largest Traders in the Spot Market
[Table 5]
Source: Wikipedia
Central banks are mayor players in the Forex market, although the main reason they get in the market is not for speculative reasons. The main goal of central banks is to control the money supply of a nation, so an economy can achieve its economic goals. A central bank could intervene in the Forex market for the following reasons:
- To regain price stability of an exchange rate
- To protect certain levels of price in an exchange rate
- When economic goals need to be achieved (inflation, growth, etc.)
Some central banks are less conservative than others, some of them intervene regularly (like the Japanese Central Bank*) and some of them not very often (Federal Reserve) - at least visually.
The most important central banks are:
The Federal Reserve (US central bank)
The Bank of Japan
The Bank of England
The Bank of Canada
The Swiss National Bank
The European Central Bank
The Reserve Bank of Australia
*The Japanese Central Bank used to intervene a great deal in the past. However, recently there has not been a lot of intervention.
These are corporations that participate in the Forex market trading goods and services abroad. Most companies like to be paid in their home currencies or US dollars, so in order to complete the transactions they need to acquire foreign currency through commercial banks.
Other reason a commercial company may participate in the Forex market is to hedge their exposure. For instance, a company is to receive payments in the future in its home currency. The home currency has been depreciating and it is expected to continue that way until next year. In this case, the company might go short (sell) in its home currency and long (buy) the other currency in the same amount of the payment to be received. This way the price fluctuation will not affect the company.
Investment funds
These are companies represented by pension and mutual funds, international investments and arbitrage funds that invest in other countries securities.
Today, more and more funds are participating in the Forex market to speculate and hedge themselves.
Brokers
Broker companies’ main objective is to bring together buyers and sellers of foreign currency. Most Forex brokers charge no commissions. Brokers get their fee from the spread.
There are two types of brokers:
Money Maker (with dealing desk) – The broker is the counterpart of every transaction made by the trader. When a trader opens a transaction the broker opens the same transaction in the opposite direction, if the trader longs one currency pair, the broker shorts the same currency pair. This is the way for Money Makers to hedge themselves.
Non dealing desk – The broker only connects the trader to banks through an ECN (Electronic Communication Network). No trade is taken by the broker. These are the type of brokers that usually charge a commission plus the spread, but as we said before, transaction costs can fall below what Money Makers charge just for the spread.
Individuals including traders
Summary Report
This lesson mostly talks about theory of the forex market, how it was formed, how it works, who participates in it so, I’m not going to send you back to give it another read. Probably the most important part in this lesson was the difference between brokers (so if you skip it go back to the participants section and scroll down to the brokers section).
Now, we have got a couple brain feeders in this lesson, here are the answers:
Brain Feeder 1 – About the volume, if you have a very complex answer and a new theory of how the volume can be calculated, scratch it! It just can’t be calculated, there is no exchange. We can have rough estimates through the futures market, data from different brokers, etc. but they are only estimates.
Brain Feeder 2 – About overlapping sessions, yep, you got this one right, didn’t you? When sessions overlap, the market tends to have more liquidity and volume thus the market has (on average) larger moves and its better for us traders (when those moves are in our favor of course).
