What Is Foreign Exchange (Forex)?

Foreign Exchange (forex or FX) is the trading of one currency for another.

For example, one can swap the U.S. dollar for the euro. Foreign exchange
transactions can take place on the foreign exchange market, also known as
theForex Market.

The forex market is the largest, most liquid market in the world, with trillions
of dollars changing hands every day.1

There is no centralized location, rather the forex market is an electronic network of banks,
brokers, institutions, and individual traders (mostly trading through brokers or banks).
KEY TAKEAWAYS

 Foreign Exchange (forex or FX) is a global market for exchanging

national currencies with one another.
 Foreign exchange venues comprise the largest securities market in
the world by nominal value, with trillions of dollars changing hands
each day.
 Foreign exchange trading utilizes currency pairs, priced in terms of
one versus the other.
 Forwards and futures are another way to participate in the forex
market.
How Does Foreign Exchange Work? 
The market determines the value, also known as an exchange rate, of the
majority of currencies. Foreign exchange can be as simple as changing
one currency for another at a local bank. It can also involve trading
currency on the foreign exchange market. For example, a trader is betting a
central bank will ease or tighten monetary policy and that one currency will
strengthen versus the other.

When trading currencies, they are listed in pairs, such as USD/CAD,

EUR/USD, or USD/JPY. These represent the U.S. dollar (USD) versus the
Canadian dollar (CAD), the Euro (EUR) versus the USD and the USD
versus the Japanese Yen (JPY).

There will also be a price associated with each pair, such as 1.2569. If this
price was associated with the USD/CAD pair it means that it costs 1.2569
CAD to buy one USD. If the price increases to 1.3336, then it now costs
1.3336 CAD to buy one USD. The USD has increased in value (CAD
decrease) because it now costs more CAD to buy one USD.

In the forex market currencies trade in lots, called micro, mini, and standard
lots. A micro lot is 1000 worth of a given currency, a mini lot is 10,000, and
a standard lot is 100,000. This is different than when you go to a bank and
want $450 exchanged for your trip. When trading in the electronic forex
market, trades take place in set blocks of currency, but you can trade as
many blocks as you like. For example, you can trade seven micro lots
(7,000) or three mini lots (30,000) or 75 standard lots (7,500,000), for
example.

Size of the Foreign Exchange Market

The foreign exchange market is unique for several reasons, mainly
because of its size. Trading volume in the forex market is generally
very large. As an example, trading in foreign exchange markets averaged
$6.6 trillion per day in April 2019, according to the Bank for International
Settlements, which is owned by 62 central banks and is used to work in
monetary and financial responsibility.2  

The largest trading centers are London, New York, Singapore, and Tokyo.

Trading in the Foreign Exchange Market

The market is open 24 hours a day, five days a week across major financial
centers across the globe. This means that you can buy or sell currencies at
any time during the day.
The foreign exchange market isn't exactly a one-stop shop. There are a
whole variety of different avenues that an investor can go through in order
to execute forex trades. You can go through different dealers or through
different financial centers which use a host of electronic networks.

From a historical standpoint, foreign exchange was once a concept for

governments, large companies, and hedge funds. But in today's
world, trading currencies is as easy as a click of a mouse—accessibility is
not an issue, which means anyone can do it. In fact, many investment
firms offer the chance for individuals to open accounts and to trade
currencies however and whenever they choose.

When you're making trades in the forex market, you're basically buying or
selling the currency of a particular country. But there's no physical
exchange of money from one hand to another. That's contrary to what
happens at a foreign exchange kiosk—think of a tourist visiting Times
Square in New York City from Japan. He may be converting his
(physical) yen to actual U.S. dollar cash (and may be charged a
commission fee to do so) so he can spend his money while he's traveling.

But in the world of electronic markets, traders are usually taking a position

in a specific currency, with the hope that there will be some upward
movement and strength in the currency that they're buying (or weakness if
they're selling) so they can make a profit. 

Differences in the Forex Markets

There are some fundamental differences between foreign exchange and
other markets. First of all, there are fewer rules, which means investors
aren't held to as strict standards or regulations as those in the stock,
futures or options markets. That means there are no clearing houses and
no central bodies that oversee the forex market.
Second, since trades don't take place on a traditional exchange, you won't
find the same fees or commissions that you would on another market. Next,
there's no cut-off as to when you can and cannot trade. Because the
market is open 24 hours a day, you can trade at any time of day. Finally,
because it's such a liquid market, you can get in and out whenever you
want and you can buy as much currency as you can afford.

The Spot Market

Spot for most currencies is two business days; the major exception is the
U.S. dollar versus the Canadian dollar, which settles on the next business
day. Other pairs settle in two business days. During periods that have
multiple holidays, such as Easter or Christmas, spot transactions can take
as long as six days to settle. The price is established on the trade date, but
money is exchanged on the value date.

The U.S. dollar is the most actively traded currency. 3 The most common
pairs are the USD versus the euro, Japanese yen, British pound and
Australian dollar.4 Trading pairs that do not include the dollar are referred to
as crosses. The most common crosses are the euro versus the pound and
yen.

The spot market can be very volatile. Movement in the short term is

dominated by technical trading, which focuses on direction and speed of
movement. People who focus on technical are often referred to
as chartists. Long-term currency moves are driven by fundamental factors
such as relative interest rates and economic growth.

The Forward Market

A forward trade is any trade that settles further in the future than spot.
The forward price is a combination of the spot rate plus or minus forward
points that represent the interest rate differential between the two
currencies. Most have a maturity less than a year in the future but longer is
possible. Like with a spot, the price is set on the transaction date, but
money is exchanged on the maturity date.

A forward contract is tailor-made to the requirements of the counterparties.

They can be for any amount and settle on any date that is not a weekend
or holiday in one of the countries.

The Futures Market

A futures transaction is similar to a forward in that it settles later than a spot
deal, but is for standard size and settlement date and is traded on a
commodities market. The exchange acts as the counterparty.

Example of Foreign Exchange

A trader thinks that the European Central Bank (ECB) will be easing its
monetary policy in the coming months as the Eurozone’s economy slows.
As a result, the trader bets that the euro will fall against the U.S. dollar and
sells short €100,000 at an exchange rate of 1.15. Over the next several
weeks the ECB signals that it may indeed ease its monetary policy. That
causes the exchange rate for the euro to fall to 1.10 versus the dollar. It
creates a profit for the trader of $5,000.

By shorting €100,000, the trader took in $115,000 for the short-sale. When
the euro fell, and the trader covered their short, it cost the trader only
$110,000 to repurchase the currency. The difference between the money
received on the short-sale and the buy to cover is the profit. Had the euro
strengthened versus the dollar, it would have resulted in a loss.

Forex Market is an exciting place. The one good thing about entering into the forex
market is that you can trade anytime as per your convenience.

The global Foreign exchange market (‘FX’, ‘Forex’ or ‘FOREX’) is the largest
market in the world as measured by the daily turnover with more than US$5 trillion
a day eclipsing the combined turnover of the world’s stock and bond markets. The
forex market measuring a propelling turnover is one of the many reasons why so
many private investors and individual traders have entered the market. The
investors have discovered several advantages many of which are not available in
the other markets.

What is Forex?
Forex (in simple terms, currency) is also called the foreign exchange, FX or
currency trading. It is a decentralized global market where all the world’s currencies
trade with each other. It is the largest liquid market in the world.

The liquidity (more buyers and sellers) and competitive pricing (the spread is very
small between bid and ask price) available in this marked are great. With the
irregularity in the performance in other markets, the growth of forex trading,
investing and management is in upward trajectory.

Why Trade Forex?

So, why trade Forex? There are many reasons to trade in Forex. If we ask four
different people, you might get more than four different answers. Primarily, making
money is the most frequently cited reason for why trade Forex.

Let us now consider the following reasons why so many people are choosing forex
market −

Forex market never sleeps

The Forex market works 24 hours and 5-1/2 days a week. Because governments,
corporates and private individual who require currency exchange services are
spread around the world, so trading on the forex market never stops. Activity on the
forex market follows the sun around the world, so right from the Monday morning
opening in Australia to the afternoon close in New York. At any point of the day you
can find an active pair to trade.

Long or Short

A trader in forex can trade both ways. It means a forex trader can play the market
and make profits irrespective of whether market is going up, down or is in tight
range. So irrespective of the event that has triggered the movement – forex traders
do not care.

Low transaction cost

Most forex accounts trade with little or no commission and there is no exchange or
data license fees. Generally, the retail transaction fee (the bid/ask spread) is
typically less than 0.1% under normal market conditions. With larger dealers (where
volumes are huge), the spread could be as low as 0.05%. Leverage plays a crucial
role here.

Leverage

Leverage is the mechanism by which a trader can take position much larger than
the initial investment. Leverage is one more reason why you should trade in forex.
Few currency traders realize the advantage of financial leverage available to them.
For example, if you are trading in equity market, the maximum leverage a stock
broker is offered is 1:2 but in case of forex market, you will get a leverage up to
1:50 and in many parts of the world even higher leverage is available. For this
reason, it is not hard to see that why forex trading is so popular.

High leverage allows a trader with small investment to trade higher volumes of
currencies and thus provide the opportunity to make significant profits from the
small movement in the market. However, if the market is against your assumption
you might lose significant amount too. Therefore, like any other market, it is a two-
way sword.

High Liquidity

The size of forex market is enormous and liquid by nature. High liquidity means a
trader can trade with any type of currency. Timing is not a constraint as well; trading
can be done as per your convenience. The buyers and sellers across the world
accept different types of currencies. In addition, forex market is active 24 hours a
day and is closed only on the weekends.

Accessibility
Getting started as a currency trader would not cost a ton of money especially when
compared to trading stocks, option or future market. We have online forex brokers
offering “mini” or “micro” trading accounts that let you open a trading account with a
minimum account deposit of $25. This allows an average individual with very less
trading capital to open a forex trading account.

Who Trades Forex?

The forex market is enormous in size and is the largest market with millions of
participants. Hundreds of thousands of individuals (like us), money exchangers, to
banks, to hedge fund managers everybody participates in the forex market.

When can you trade forex?

Forex market is open 24 hours a day and 5 days a week. However, it does not
mean it is always active. Let us check what a 24-hour day in the forex world looks
like.

The forex market is divided into four major trading sessions: the Sydney session,
the Tokyo session, the London session and the New York session.

Forex Market Hours

The following table shows the opening and closing time of each session.

Summer Session (Around April – October)

TIME ZONE EDT GMT

Sydney open 6:00 PM 10:00 PM

Sydney close 3:00 AM 07:00 AM

Tokyo Open 7:00 PM 11:00 PM

Tokyo Close 4:00 AM 08:00 AM

London Open 03:00 AM 07:00 AM

London Close 12:00 PM 04:00 PM

New York Open 08:00 AM 12:00 PM

New York Close 05:00 PM 09:00 PM

Winter (Around October – April)

TIME ZONE EST GMT

Sydney Open 04:00 PM 09:00 PM

Sydney Close 01:00 AM 06:00 AM

Tokyo Open 06:00 PM 11:00 PM

Tokyo Close 03:00 AM 08:00 AM

London Open 03:00 AM 08:00 AM

London Close 12:00 PM 05:00 PM

New York Open 08:00 AM 01:00 PM

New York Close 05:00 PM 10:00 PM

Note − The actual opening and closing timing of forex market depends on local
business hours

We can see in the above chart that in between different forex trading
session(region wise), there is a period of time where two sessions (region time) are
open at the same time.

There is always more volume of trade when two markets (in different regions) are
open at the same time.

In this chapter, we will learn about the structure of the forex market.

The structure of a typical stock market is as shown below −

But the structure of the forex market is rather unique because major volumes of
transactions are done in Over-The-Counter (OTC) market which is independent of
any centralized system (exchange) as in the case of stock markets.

The participants in this market are −

 Central Banks

 Major commercial banks

 Investment banks

 Corporations for international business transactions

 Hedge funds

 Speculators

 Pension and mutual funds

 Insurance companies

 Forex brokers

Hierarchy of Participants
The forex market structure may be represented as shown below −

Market Participants
In the above diagram, we can see that the major banks are the prominent players
and smaller or medium sized banks make up the interbank market. The participants
of this market trade either directly with each other or electronically through the
Electronic Brokering Services (EBS) or the Reuters Dealing 3000-Spot Matching.

The competition between the two companies – The EBS and the Reuters 3000-
Spot Matching in forex market is similar to Pepsi and Coke in the consumer market.

Some of the largest banks like HSBC, Citigroup, RBS, Deutsche Bank, BNP
Paribas, Barclays Bank among others determine the FX rates through their
operations. These large banks are the key players for global FX transactions. The
banks have the true overall picture of the demand and supply in the overall market,
and have the current scenario of any current. The size of their operations effectively
lay down the bid-ask spread that trickles down to the lower end of the pyramid.

The next tier of participants are the non-bank providers such as retail market
makers, brokers, ECNs, hedge funds, pension and mutual funds, corporations, etc.
Hedge funds and technology companies have taken significant chunk of share in
retail FX but very less foothold in corporate FX business. They access the FX
market through banks, which are also known as liquidity providers. The
corporations are very important players as they are constantly buying and selling
FX for their cross-border (market) purchases or sales of raw or finished products.
Mergers and acquisitions (M&A) also create significant demand and supply of
currencies.

Sometimes, governments and centralized banks like the RBI (in India) also
intervene in the Foreign Exchange market to stop too much volatility in the currency
market. For instance, to support the pricing of rupees, the government and
centralized banks buy rupees from the market and sell in different currencies such
as dollars; conversely, to reduce the value of Indian rupees, they sell rupees and
buy foreign currency (dollars).
The speculators and retail traders that come at the bottom of the pyramid pay the
largest spread, because their trades effectively get executed through two layers.
The primary purpose of these players are to make money trading the fluctuations in
the currency prices. With the advancement of technology and internet, even a small
trader can participate in this huge forex market.

Currency pair
If you are new to the forex market and have just started trading Forex online, you
may find yourself overwhelmed and confused both at a time by the huge number of
available currency pairs inside your terminal (like the MetaTrader4, etc.). So what
are the best currency pairs to trade? The answers is not that straightforward as it
varies with each trader and its terminal window or with what exchange (or OTC
market) he is trading. Instead, you need to take the time to analyse different pairs of
currencies against your own strategy to determine the best forex pairs to trade on
your accounts.

The trade in Forex market occurs between two currencies, because one currency is
being bought (buyer/bid) and another sold (seller/ask) at the same time. There is an
international code that specifies the setup of currency pairs we can trade. For
example, a quote of EUR/USD 1.25 means that one Euro is worth $1.25. Here, the
base currency is the Euro(EUR), and the counter currency is the US dollar.

Commonly Used Currency Pair

In this section, we will learn about a few commonly used currency pair.

The most traded, dominant and strongest currency is the US dollar. The primary
reason for this is the size of the US economy, which is the world’s largest. The US
dollar is the preferred base or reference currency in most of the currency exchange
transactions worldwide. Below are some of the most traded (high liquidity) currency
pairs in the global forex market. These currencies are part of most of the foreign
exchange transactions. However, this is not necessarily the best currency to trade
for every trader, as this (which currency pair to choose) depends on multiple factors
−

 EUR/USD (Euro – US Dollar)

  GBP/USD (British Pound – US Dollar)

 USD/JPY (US Dollar – Japanese Yen)

 USD/CHF ( US Dollar – Swiss Franc)

 EUR/JPY ( Euro – Japanese Yen)

 USD/CAD (US Dollar – Canadian Dollar)

 AUD/USD (Australian Dollar – US Dollar)

As prices of these major currencies keep changing and so do the values of the
currency pairs change. This leads to a change in trade volumes between two
countries. These pairs also represent countries that have financial power and are
traded heavily worldwide. The trading of these currencies makes them volatile
during the day and the spread tends to be lower.

EUR/USD Currency Pair

The EUR/USD currency pair is considered to be the most popular currency pair and
has the lowest spread among modern world forex brokers. This is also the most
traded currency pair in the world. About 1/3rd of all the trade in the market is done
in this currency pair. Another important point is that this forex pair is not too volatile.
Therefore, if you do not have that much risk appetite you can consider this currency
pair to trade.

The following diagram shows some of the major currency pairs and their values −

Note − The above currency pair quotes were taken from www.finance.google.com.

The Bid-Ask Spread

The spread is the difference between the bid price and the ask price. The bid price
is the rate at which you can sell a currency pair and the ask price is the rate at
which you can buy a currency pair (EUR/USD).

Whenever you try to trade any currency pair, you will notice that there are two
prices shown, as shown in the image below −
The following image shows the spread between USD and INR (US Dollar – Indian
Rupees) pair.

(Source: Above data is taken from nseindia.com)

The lower price (67.2600 in our example) is called the “Bid” and it is the price at
your broker (through which you’re trading) is willing to pay for buying the base
currency (USD in this example) in exchange for the counter currency (INR in our
case). Inversely, if you want to open a short trade (sell), you will do so at the price
of 67.2625 in our example. The higher price (67.2625) is called the ‘Ask’ price and it
is the price at which the broker is willing to sell you the base currency (USD)
against the counter currency (INR).

What are Bullish and Bearish Markets?

The term “bull” (bullish) and “bear” (bearish”) are often used to describe how the
overall financial market is performing in general – whether there is an appreciation
or depreciation. Simply put, a bull (bullish) market is used to describe conditions
where market is rising and a bear (bearish) market is the one where market is going
down. It is not, a single day which describes if the market is in bullish or bearish
form; it is a couple of weeks or months which tell us if the market is in the
bull(bullish) or the bear(bearish) grip.

What happens in a Bull Market?

In a bull market, the confidence of the investor or the traders is high. There is
optimism and positive expectations that good results will continue. So in all, bull
market occurs when the economy is performing well – unemployment is low, GDP
is high and stocks marketsare rising.

The bull market is generally related with the equity (stock) market but it applies to
all financial markets like currencies, bonds, commodities, etc. Therefore, during a
bull market everything in the economy looks great - the GDP is growing, there is
less unemployment, the equity prices are rising, etc.

All this leads to rises not only in stock market but also in FX currencies such as
Australian Dollar (AUD), New Zealand Dollar (NZD), Canadian Dollar (CAD) and
emerging market currencies. Conversely, the bull market generally leads to a
decline in safe-haven currencies such as US dollar, the Japanese yen or the Swiss
franc (CHF).

Why does it Matter to You?

Forex trading is always done in pairs, where if one currency is weakening the other
is strengthening. As you can trade both ways means you can take a long (buy) or
short (sell) view in either currency pair, thereby allowing you to take advantage of
rising and falling markets.

In forex market, bull and bear trends also determine which currency is stronger and
which is not. By correctly understanding the market trends, a trader can make
proper decisions of how to manage risk and gain a better understanding of when it
is best to enter and exit from your trades.

What happens in a Bear Market?

A bear market denotes a negative trend in the market as the investor sells riskier
assets such as stock and less-liquid currencies such as those from emerging
markets. The chances of loss are far greater because prices are continually losing
value. Investor or traders are better off short-selling or moving to safer investments
like gold or fixed-income securities.

In a bearish market, investor generally moves to safe-haven currencies like

Japanese Yen (JPY) and US Dollar (USD) and sold off riskier instruments.

Why does it Matter to You?

Because a trader can earn great profit during bull and bear market considering you
are trading with the trend. As forex trading is always done in pairs, buy the strength
and sell the weak should be your trade.

What is Lot size?

Let us now learn what a lot size is.

A lot is a unit to measure the amount of the deal. Your value of your trade always
corresponds to an integer number of lots (lot size * number of lots).
Trading with the proper position or lot size on each trade is key to successful forex
trading. The position size refers to how many lots (micro, mini or standard) you take
on a particular trade.

The standard size for a lot is 100,000 units of base currency in a forex trade, and
now we have mini, micro and nano lot sizes that are 10,000, 1,000 and 100 units
respectively.

What is long in forex trade?

Whenever you purchase (buy) a currency pair, it is called going long. When a
currency pair is long, the first currency is purchased (indicating, you are bullish)
while the second is sold short (indicating, you are bearish).

For example, if you are purchasing a EUR/INR currency pair, you expect that the
price of Euro will go high and the price of Indian rupees (INR) will go down.

What is short in forex trade?

When you go short on a forex, the first currency is sold while the second currency is
bought. To go short on a currency means you sell it hoping that its prices will
decline in future.

In forex trade, whether you are making “long” (buying a currency pair) or “short”
(selling a currency pair) trades, you are always long on one currency and short on
another. Therefore, if you sell, or go short on USD/INR, then you are long on INR
and short on USD. It means you expect the prices of INR (Indian rupees) will rise
and the price of the USD (US dollar) will fall.

What are Pending Orders in Forex Trade?

A pending order in any trade is an order that was not yet executed thus not yet
becoming a trade. Generally, while trading we place the order with a limit, means
our order (pending trade) will not get executed if the price of a financial instrument
does not reach a certain point.

A large section of traders follows technical analysis, so if anyone (traders or

investors) wants to place an order at the support or resistance level but currently
market is not on these levels, then he/she can place pending order rather than
waiting. Pending order will automatically get executed once price reaches to the
pending order position. The following are the four types of pending order −

Buy Limit

A pending order to buy a currency at a lower price (whatever price trader wants to
buy) than the current one.

Buy Stop

A pending order to buy a currency at a higher price (whatever price trader wants to
execute) than the current one.

Sell Limit

A pending order to sell a currency pair at a higher price (whatever price trader
wants to sell) than the current price.

Sell Stop

A pending order to sell a currency pair at a lower price (buy high, sell low).

What is Leverage and Margin?

In this chapter, we will learn about leverage and margin and how these influence
the financial market.

What is Leverage?

Forex trading provides one of the highest leverage in the financial market. Leverage
means having the ability to control a large amount of money using very little amount
of your own money and borrowing the rest.

For example, to trade a $10,000 position (traded value of security); your broker
wants $100 from your account. Your leverage, which is expressed in ratios, is now
100:1.

In short, with mere $100, you are controlling $10,000.

Therefore, if during the trade $10,000 investment rises in value to $10,100, it
means a rise in $100. Because you are leveraged 100:1, your actual amount
invested is $100 and your gain is $100. This in turn your return to a groovy 100%.

In such case, the trade goes in your favor. What if, you have ended up with a -1%
return ($10,000 position). -100% return using 100:1 leverage.

Therefore, risk management of leverage position is very important for every trader
or investor.

What is Margin?

Margin is the amount of money your trading account (or broker needs) should have
as a “good faith deposit” to open any position with your broker.

So consider the leverage example in which we are able to take position of $100,000
with an initial deposit amount of $1000.

This $1000 deposit amount is called “margin” you had to give in order to initiate a
trade and use leverage.

Your broker to maintain your position uses it. The broker collects margin money
from each of its client (customer) and uses this “super margin deposit” to be able to
place trades within the interbank network.

Margin is expressed as a percentage of the full amount of the position. Your margin
may vary from 10% to .25% margin. Based on the margin required by your broker,
you can calculate the maximum leverage you can yield with your trading account.

For example, if your broker required 5% margin, you have the leverage of 20:1 and
if your margin is 0.25%, you can have leverage of 400:1.

Hedging
Hedging is basically a strategy which is intended to reduce possible risks in case
prices movement against your trade. We can think of it with something like
“insurance policy” which protects us from particular risk (consider your trade here).

To protect against a loss from a price fluctuation in future, you usually open an
offsetting position in a related security. Traders and investors usually use hedging
when they are not sure which way the market will be heading. Ideally, hedging
reduces risks to almost zero, and you end up paying only the broker's fee.

A trader can utilize hedging in the following two ways −

To open a position in an off-setting instrument

The offsetting instrument is a related security to your initial position. This allows you
to offset some of the potential risks of your position while not depriving you of your
profit potential completely. One of the classic example would be to go long say an
airline company and simultaneously going long on crude oil. As these two sector
are inversely related, a rise in crude oil prices will likely cause your airline long
position to suffer some losses but your crude oil long helps offset part or all of that
loss. If the oil prices remain steady, you may profit from the airline long while
breaking even on your oil position. If the prices of oil goes down, the oil long will
give you losses but the airline stock will probably rise and mitigate some or all your
losses. So hedging helps to eliminate not all but some of your risks while trading.

To buy and/or sell derivative (future/forward/option) of some sort in order to reduce

your portfolio’s risk as well as reward exposure, as opposed to liquidating some of
your current positions. This strategy may come handy where you do not want to
directly trade with your portfolio for a while due to some market risks or
uncertainties, but you rather not liquidate part or all of it for other reasons. In this
type of hedging, the hedge is straightforward and can be calculated precisely.

Stop Losses

A stop-loss is an order placed in your trading terminal to sell a security when it

reaches a specific price. The primary goal of a stop loss is to mitigate an investor’s
loss on a position in a security (Equity, FX, etc.). It is commonly used with a long
position but can be applied and is equally profitable for a short position. It comes
very handy when you are not able to watch the position.

Stop-losses in Forex is very important for many reasons. One of the main reason
that stands out is no one can predict the future of the forex market every time
correctly. The future prices are unknown to the market and every trade entered is a
risk.
Forex traders can set stops at one fixed price with an expectation of allocating the
stoploss and wait until the trade hits the stop or limit price.

Stop-loss not only helps you in reducing your loss (in case trade goes against your
bet) but also helps in protecting your profit (in case trade goes with the trend). For
example, the current USD/INR rate is 66.25 and there is an announcement by the
US federal chairperson on whether there will be a rate hike or not. You expect there
will be a lot of volatility and USD will rise. Therefore, you buy the future of USD/INR
at 66.25. Announcement comes and USD starts falling and suppose you have put
the stop-loss at 66.05 and USD falls to 65.5; thus, avoiding you from further loss
(stop-loss hit at 66.05). Inversely in case USD starts climbing after the
announcement, and USD/INR hit 67.25. To protect your profit you can set stop-loss
at 67.05(assume). If your stop-loss hit at 67.05(assume), you make profit else, you
can increase your stop-loss and make more profit until your stop-losses hit.

The foreign exchange market is a global online network where traders and
investors buy and sell currencies. It has no physical location and operates 24 hours
a day for 5-1/2 days a week.

The forex currencies of a country are influenced by a series of macro-economic

conditions as well as the world’s economic situation. Macro indicators like
Economic indicators (GDP growth, imports/exports), social factors (the
unemployment rate, country infra-structure or real estate market conditions) and the
country central bank’s (like RBI in india) policies are the key factors that determine
the value of a currency on the foreign exchange market.

Major Currencies
In this section, we will learn about the distinct features of six major currencies.

The US Dollar

The US Dollar dominates the world foreign exchange market heavily. The US Dollar
is the base or universal currency to evaluate any other currency traded on forex.
Almost all currencies are generally quoted in US dollar terms.
The US dollar currently represents about 86% of all foreign exchange market
transactions. Most commodities (metals, oil etc.) are traded with prices
denominated in US Dollars; as a result, any fluctuations in supply and demand of
these commodities have direct impact on the value of US Dollar. This happened in
2008 financial crisis when oil prices collapsed and the EUR/USD climbed to 1.60.

As US dollar is considered as the safe-haven currency. Therefore, investors move

towards the dollar when economic conditions deteriorate.

The Euro (EUR)

The Euro is the second most dominating currency in the forex market. Like the US
Dollar, the Euro also has a strong international acceptance streaming from the
members of the European Monetary Union.

The Euro is used by 18 member countries of the European Union and is currently
accounted for almost 37% of all forex transactions.

The main factors that influence the acceptance of Euro’s prices are often based on
wellestablished economies (developed countries) that use the common currency,
such as France and Germany. Euro prices depend on key countries (like Germany)
Consumer Price Inflation (CPI), the European Central Bank, unemployment rate,
and exports data.

The Euro is the common currency of all the European countries and there is a
difference between these countries’ economies, as was highlighted during the 2011
debt crisis. This restricts the dominance of Euro in the global forex market. In the
event of problems, EU leaders have a hard time finding common solutions that are
beneficial to both the large and small economies.

The Japanese Yen (JPY)

The Japanese yen is the most traded and dominating currency in the Asian forex
market. It is the third most popular or traded currency in the forex market and
represents almost 20% of the world’s exchange. The natural demand to trade the
Yen comes mostly from the Japanese Keiretsu, the economic and financial
conglomerates. The Japanese stock market, .i.e., the Nikkei index and real estate
market correlate with the volatility of the Japanese yen (JPY).
Because the Japanese economy is mostly an industrial exports economy, the
Japanese currency (JPY) among traders and investors is considered as a safe-
haven currency in periods when risk aversion hits the market. Low interest rates in
Japan allows traders to borrow at low cost and invest in other countries.

The JPY’s currency risks are related to the constant devaluation of the currency
and the interventions of the country’s central bank. Because japan is an export
oriented economy, the central bank is constantly trying to weaken its currency.

The British Pound (GBP)

The British Pound is the UK’s currency. Until the end of World War II, the pound
continued to have the same dominance in forex market what is US dollar today and
was the currency of reference. The currency (GBP) is heavily traded against the
euro and the US dollar but has less presence against other currencies.

The British Pound (GBP) is the fourth most traded currency internationally and
about 17% of all transaction is done through GBP in global forex market. Because
London is considered as the forex market hub globally, 34% of all forex transaction
pass through London City.

The fundamental factors that affect the pound are as complex and varied as the
British economy and its influence on the world. Inflation, country GDP and the
housing market influence the pound value.

Forex traders sometimes use the pound as an alternative to the euro especially
when the European Union’s problems become too bad.

The Swiss Franc (CHF)

The Swiss Franc is the currency and legal tender of Switzerland. The currency
code for Franc is CHF and the most popular Switzerland franc exchange rate is the
CHF/EUR pair. It is also, the only currency of a major European country that neither
belongs to the European Union nor to the G-7 countries. Though the size of the
Swiss economy is relatively small, the Swiss franc is one of the four major
currencies traded in the forex market, closely resembling the strength and quality of
the Swiss economy and finance.
The CHF is also considered as the safe-haven currency and investors move
towards it during periods of risk aversion: the Swiss economy and its foreign
reserves mainly gold (7th largest reserve in the world) add to the currency’s
credibility.

The CHF prices depend on the central bank policy. The CHF tends to be more
volatile compared to other major currencies due to lack of liquidity.

The Canadian Dollar (CAD)

The CAD is a commodity driven currency. This is because the Canadian economy
is exportoriented and the main product of export is crude oil. Therefore, the
Canadian Dollar prices are influenced by the price of crude oil.

Global economic growth and technological progress help to make the CAD
attractive to investors.

Different Trade systems on Forex

There are different ways in which trading is done in the global forex market. The
commonly followed trading systems in the forex market are described below −

Trading with brokers

The foreign exchange broker or the forex broker also known as the currency-trading
broker unlike the equity or commodity brokers does not hold positions. The main
role of these brokers is to serve banks. They act as intermediaries to buy and sell
currencies at commissioned rates.

Before the dawn of Internet, a majority of the FX brokers executed orders via phone
using an open box system. There was a microphone in the broker desk that
continuously transmitted all that he communicated on the direct phone lines to the
speaker’s boxes in the banks. This way, banks also received all the business
orders.

In an open box system used by brokers, a trader is able to hear all the prices
quoted; whether the bid was executed or the offer (ask) taken; and the price that
followed. What is hidden from the trader is the amounts of particular bids and offers
and the names of the banks showing the prices. The prices were confidential, and
the buyers and sellers were anonymous.

In this age of Internet, many brokers have allowed clients to access their accounts
and trade through electronic platform (mostly through their proprietary software)
and computer applications.

Direct Dealing

Direct dealing is based on the economy of mutuality. All participants in the currency
market – a bank, establishing a price, thinks that the other bank that has turned to it
will reply with mutuality, establishing its own price, when they turn to the bank.
Direct dealing provides freedom of actions than the dealing of the broker market.
Sometimes traders take advantage of this characteristic.

Direct dealing previously took place over the phone. This gave way to mistakes
which could not be identified and rectified. The mid-1980s witnessed a transition
from direct dealing to dealing systems.

Dealing systems are computers that link the contributing banks around the world.
Each computer is connected with a terminal. To connect to a bank through dealing
system is much faster than connecting through a phone. The dealing systems are
getting more secure by each day. The performance of dealing system is
characterized by its speed, safety and reliability. The trader is in permanent visual
contact with the information changing on its terminal/monitor. It is more comfortable
with this information rather than to be heard during the switches, during the
conversations.

Many banks use a combination of brokers and direct dealing systems. Both these
methods can be used by the same bank but not in the same market.

Matching Systems

Matching systems are quite different when compared with dealing systems.
Matching systems are anonymous and individual traders deal against the rest of the
market, similar to dealing in the broker’s market but unlike dealing systems where
trading is not anonymous and is conducted on a one-to-one basis. Unlike the
broker’s market, there are no individual to bring the prices to the market, and
liquidity is limited at times.
The different characteristics of matching systems are – speed, safety and reliability
like the dealing system we have. One advantage in matching system is that credit
lines are automatically managed by the systems.

In the interbank market, traders deal directly with dealing systems, matching
systems and brokers in a complementary fashion.

In this chapter, we will learn about the different types of market analysis. There are
three types of analysis used for the market movements forecasting −

 Fundamental Analysis: This is the analysis of social, economic and political

factors that affect currency supply and demand.
 Technical Analysis: This is the study of price and volume movement.
 Sentiment Analysis: Apart from mini and micro analysis of data, this is the
analysis of the mindsets and sentiments of traders and investors.

Fundamental Analysis and Technical Analysis (FA and TA) go hand-in-hand in

guiding the forex trader through the way the market (prices) may go under the ever
changing market conditions.

Fundamental Analysis
Fundamental analysis is analyzing the currency price forming, basic economical
and other factors influencing the exchange rate of foreign currency.

It is the analysis of economic and political information with the hope of predicting
future currency price movements.

Fundamental analysis helps in forecasting future prices of various foreign

currencies. Forecasting of prices is based on a number of key economic factors
and indicators that determine the strength of a country’s economy. The factors may
also include various geopolitical aspects that may impact the price movement of a
currency pair.

This analysis is not used to get the specific numbers for the exchange rates of
various currencies. Instead, it helps in determining the trend of the forex spot
market over a certain period.

If the fundamental analysis hints at a positive outlook for a particular currency pair,
it indicates that the price of that pair would experience an upward trajectory
movement in the near future. A negative outlook indicates a declining price
movement of currency pair in coming future. A neutral instance on currency pair
indicates a flat (not much +ve or – ve side movement) movement in the near future.

When to use fundamental analysis for the forex market?

Whenever a forex trader receives information about the state of a country, he
conducts a fundamental analysis to gauge the impact of this on various currency
pairs.

Forex traders and investors always look into reports (fundamental analysis reports)
based on critical economic data before trading (particular currency pair) on forex
market. These reports (FA) also enable them to minimize the risk factors involved in
executing forex transactions.

The Fundamental Analysis report for any market (equity, commodity, FX etc.) helps
in decision-making over medium to long term exchange rate prediction (in case of
FX market). On the other hand, Technical Analysis provides information for short-
term predictions.

The market’s momentum can easily reverse or an extreme volatility can be seen in
a matter of minutes after an important announcement or press release is made by
the central bank. Information related to the status of the local and global economies
can have huge impact on the direction in which the forex market trends.

Key factors influencing fundamental analysis

Let us now learn about the key factors that influence fundamental analysis. The
factors are described below in brief −

Interest Rates

The interest rates set by the central bank is one of the most important factors in
deciding the price movement of currency pairs. A high interest rate increases the
attractiveness of a country’s currency and also attracts forex investors towards
buying.

GDP Growth
A high GDP growth rate signifies an increase in the total wealth of the country. This
points towards the strengthening of the country’s currency and its value rises
relative to other foreign currencies.

Industrial Production

A high industrial growth in any country signifies a robust country economy. A

country with robust economy encourages forex traders to invest in country forex
currency.

Consumer Price Index (CPI)

The Consumer Price Index (CPI) is directly proportional to the prices of goods and
services in the country. If the CPI index is too high (above the central bank
benchmark of CPI), there is a high probability that central bank is most likely to
lower interest rates to bring down the rate of inflation and stabilize the growth rate
for the country’s economy.

Retail Sales

A country’s retail sales data gives an accurate picture of how people are spending
(people income level) and the health of its economy at the lowest level. A strong
retail sales figure shows that the domestic economy of a country is in strong shape;
it points towards positive growth rates in the future.

Apart from these above points, the traders and investors also look into other factors
of fundamental analysis like employment statistics, national debt levels, supply and
demand balance, monetary policy, political situation, trade deficit, commodity
prices, housing prices and capital market growth.

Technical Analysis
Technical analysis helps in the prediction of future market movements (that is,
changing in currencies prices, volumes and open interests) based on the
information obtained from the past.

There are different kinds of charts that help as tools for technical analysis. These
charts represent the price movements of currencies over a certain period preceding
exchange deals, as well as technical indicators. The technical indicators are
obtained through mathematical processing of averaged and other characteristics of
price movements.

Technical Analysis (TA) is based on the concept that a person can look at historical
price movements (for example currency) and determine the current trading
conditions and potential price movement.

Dow Theory for Technical Analysis

The fundamental principles of technical analysis are based on the Dow Theory with
the following main assumptions −

Price discounts everything

Price is a comprehensive reflection of all the market forces. At any point of time, all
market information and forces are reflected in the currency price (“The Market
knows everything”).

Prices usually move in the direction of the trend

Price movements are usually trend followers. There is a very common saying
among traders – “Trend is your friend”.

Trends are classified as −

 Up trends (Bullish pattern)

 Down trends (Bearish pattern)
 Flat trends (sideways pattern)

Price movements are historically repetitive. This results in similar behavior of

patterns on the charts.

Sentimental Analysis
The participants in every market, the traders and the investors have their own
opinion of why the market is acting the way it does and whether to trade in the
direction of market (towards market trends) or go against it (taking contrary bet).
The traders and investors come with their own thoughts and opinions on the
market. These thoughts and opinions depend on the position of the traders and
investors. This further helps in the overall sentiment of the market regardless of
what information is out there.

Because the retail traders are very small participants in the overall forex market, so
no matter how strongly you feel about a certain trade (belief), you cannot move the
forex markets in your favour.

Even if you (retail trader) truly believe that the Dollar is going to go up, but everyone
else (big players) is bearish on it, there is nothing much you can do about it (unless
you are one of the big investment banks like – Goldman Sachs or some ultra-rich
individual like Warren Buffet).

It is the trader’s view on how he is feeling about the market, whether it is bullish or
bearish. Depending on this, a trader further decides how to play the perception of
market sentiment into trading strategy.

What type of analysis is better?

Forex trading is all about trading based on a strategy. Forex trading strategies help
you gain an insight of the market movements and make moves accordingly. We
have already studied that there are three types of analysis methods.

 Technical analysis
 Fundamental analysis
 Sentiment analysis

Each strategy holds equal importance and neither can be singled out. Many traders
and investors prefer the use of a single analysis method to evaluate long-term
investments or to gain short-term profit. A combination of fundamental, technical
and sentimental analysis is the most beneficial. Each analysis technique requires
the support of another to give us sufficient data on the Forex market.

These three strategies go hand-in-hand to help you come up with good forex trade
ideas. All the historical price action (for technical analysis) and economic figures
(for fundamental analysis) are there – all you have to do is put on your thinking cap
(for sentimental analysis) and put those analytical skills to the test.
In order to become a professional forex trader, you will need to know how to
effectively use these three types of forex market analysis methods.

Foreign exchange markets are one of the most important financial markets in the
world. Their role is of utmost importance in the system of international payments. In
order to play their role efficiently, it is necessary that their operations/dealings be
trustworthy. Trustworthy is concerned with contractual obligations being honored.
For example, if two parties have entered into forward contract of a currency pair
(means one is purchasing and the other is selling), both of them should be willing to
honor their side of contract as the case may be.

Following are the major foreign exchange markets −

 Spot Markets

 Forward Markets

 Future Markets

 Option Markets

 Swaps Markets

Swaps, Future and Options are called the derivative because they derive their
value from the underlying exchange rates.

Spot Market
These are the quickest transactions involving currency in the foreign exchange
market. This market provides immediate payment to the buyers and sellers as per
the current exchange rate. The spot market account for almost one-third of all
currency exchange, and trades usually take one or two days to settle transactions.
This allows the traders open to the volatility of the currency market, which can raise
or lower the price, between the agreement and the trade.

There is an increase in volume of spot transactions in the foreign exchange market.

These transactions are primarily in forms of buying and selling of currency notes,
cash-in of traveler’s cheque and transfers through banking systems. The last
category accounts for almost 90 percent of all spot transactions are carried out
exclusively for banks.
As per the Bank of International Settlements (BIS) estimate, the daily volume of
spot transaction is about 50 percent of all transactions in foreign exchange markets.
London is the hub of foreign exchange market. It generates the highest volume and
is diverse with the currencies traded.

Major Participants on the Spot Exchange Market

Let us now learn about the major participants on the spot exchange market.

Commercial banks

These banks are the major players in the market. Commercial and investment
banks are the main players of the foreign exchange market; they not only trade on
their own behalf but also for their customers. A major chunk of the trade comes by
trading in currencies indulged by the bank to gain from exchange movements.
Interbank transaction is done in case the transaction volume is huge. For small
volume intermediation of foreign exchange, a broker may be sought.

Central banks

Central banks like RBI in India (RBI) intervene in the market to reduce currency
fluctuations of the country currency (like INR, in India) and to ensure an exchange
rate compatible with the requirements of the national economy. For example, if
rupee shows signs of depreciation, RBI (central bank) may release (sell) a certain
amount of foreign currency (like dollar). This increased supply of foreign currency
will halt the depreciation of rupee. The reverse operation may be done to halt rupee
from appreciating too much.

Dealers, brokers, arbitrageurs and speculators

Dealers are involved in buying low and selling high. The operations of these dealers
are focused towards wholesale and a majority of their transactions are interbank in
nature. At times, the dealers may have to deal with corporate and central banks.
They have low transaction costs as well as very thin spread. Wholesale
transactions account for 90 percent of the overall value of the foreign exchange
deals.
Forward Market
In forward contract, two parties (two companies, individual or government nodal
agencies) agree to do a trade at some future date, at a stated price and quantity.
No security deposit is required as no money changes hands when the deal is
signed.

Why is forward contracting useful?

Forward contracting is very valuable in hedging and speculation. The classic

scenario of hedging application through forward contract is that of a wheat farmer
forward; selling his harvest at a known fixed price in order to eliminate price risk.
Similarly, a bread factory want to buy bread forward in order to assist production
planning without the risk of price fluctuations. There are speculators, who based on
their knowledge or information forecast an increase in price. They then go long
(buy) on the forward market instead of the cash market. Now this speculator would
go long on the forward market, wait for the price to rise and then sell it at higher
prices; thereby, making a profit.

Disadvantages of forward markets

The forward markets come with a few disadvantages. The disadvantages are
described below in brief −

 Lack of centralization of trading

 Illiquid (because only two parties are involved)

 Counterparty risk (risk of default is always there)

In the first two issues, the basic problem is that there is a lot of flexibility and
generality. The forward market is like two persons dealing with a real estate
contract (two parties involved - the buyer and the seller) against each other. Now
the contract terms of the deal is as per the convenience of the two persons involved
in the deal, but the contracts may be non-tradeable if more participants are
involved. Counterparty risk is always involved in forward market; when one of the
two parties of the transaction chooses to declare bankruptcy, the other suffers.
Another common problem in forward market is - the larger the time period over
which the forward contract is open, the larger are the potential price movements,
and hence the larger is the counter-party risk involved.

Even in case of trade in forward markets, trade have standardized contracts, and
hence avoid the problem of illiquidity but the counterparty risk always remains.

Future Markets
The future markets help with solutions to a number of problems encountered in
forward markets. Future markets work on similar lines as the forward markets in
terms of basic philosophy. However, contracts are standardized and trading is
centralized (on a stock exchange like NSE, BSE, KOSPI). There is no counterparty
risk involved as exchanges have clearing corporation, which becomes counterparty
to both sides of each transaction and guarantees the trade. Future market is highly
liquid as compared to forward markets as unlimited persons can enter into the
same trade (like, buy FEB NIFTY Future).

Option Market
Before we learn about the option market, we need to understand what an Option is.

What is an option?

An option is a contract, which gives the buyer of the options the right but not the
obligation to buy or sell the underlying at a future fixed date (and time) and at a
fixed price. A call optiongives the right to buy and a put option gives the right to
sell. As currencies are traded in pair, one currency is bought and another sold.

For example, an option to buy US Dollar ($) for Indian Rupees (INR, base currency)
is a USD call and an INR put. The symbol for this will be USDINR or USD/INR.
Conversely, an option to sell USD for INR is a USD put and an INR call. The
symbol for this trade will be like INRUSD or INR/USD.

Currency Options

Currency options is a part of the currency derivatives, which emerged as an

important and interesting new asset class for investors. Currency option provides
an opportunity to take call on Exchange Rate and fulfil both investment and hedging
objectives.

Factors affecting the currency option prices

The following table shows the factors affecting the currency option prices −