What is the Forex Market?
When people usually think about foreign exchange, they think about changing their local currency into a foreign one, before or while traveling abroad. While they’re not wrong, the forex market has a lot to offer those who choose to invest in assets online. Not only is it popular among traders worldwide, but it is also considered one of the most prominent markets in terms of liquidity, which averages between $3-5 trillion in daily trading volume transactions within central banks, hedge funds, investment management companies, and more.
The market is usually open 24 hours a day, 5 days a week, in which traders could trade in the American, Asian, and European sessions. The exception is currencies from some emerging markets which are available for trading only during their local open market hours.
Although it is a giant among the financial markets, the Forex market’s principles are quite easy to grasp.
Major, Minor, and Exotic Currency Pairs
Unlike the stock market which offers investors thousands of different shares from which to choose, the FX markets consists of a variety currency pairs which are separated into majors, minors, and exotics. They include the following countries:
The United States
Eurozone (France, Germany, Italy, and Spain) to name a few.
The United Kingdom
The currencies of the countries mentioned above are mostly classified as major currencies (i.e. Majors). and they offer insights into the strength of some of the world’s largest economies with the opportunity to trade on them over-the-counter (OTC). Other currency pairs, may be categorized as minor currencies, for example the Russian (RUB), Norwegian (NOK), Swedish (SEK), or exotic currencies like the Turkish Lira (TRY), South African Rand (ZAR), and the Mexican Peso (MXN) to name a few. Traders could choose to trade the euro vs. the US dollar, or the Japanese yen against the Australian dollar, for example. The major currency pairs are usually the more popular ones, as well, and offer more liquidity. Exotic currency pairs are not as liquid and often come with higher spreads in comparison.
Yield and Return
One of the first things you need to remember when trading currency pairs is that yield drives return. When you trade these instruments, you are participating in the purchase and sales of these underlying assets. The interest rate of each currency is set by the central bank of that country, which could cause volatility. On the one hand, you’re paying interest on the currency you sold, but gain the interest of the one you bought.
All currencies are divided into pairs because they’re being traded in comparison to one another. In other words, in each transaction you make, you’re buying one currency and selling another.
For example, if the EUR/USD is quoted as 1.2300, then one euro is worth $1.23.
Another advantage of the forex market is its high leverage. To trade $10,000 of currency with a margin of 1:100 the investor will only require a deposit of $100. However, if you’re not careful, this could lead to losses should the trends go against you. Most web-based brokerages offer a margin watcher software which supervises trades, and automatically close any positions once they breach these limits.
The return is then the amount is the profit or loss on any trade that you open. Let’s say you put $100 on the EUR/USD, then your return in $50. The return can also be calculated in percentages, in which case your profit would be 50%.
If you compare forex to the other financial markets, it is often considered the most stable due to its usually gentle movements. There are instances, however, which can rock the boat, and cause significant change or damage to the currencies’ dynamic.
Interest Rate Hikes. Central banks will periodically hold a monetary policy meeting with the central bank’s board. The committee will then decide whether to raise the interest rates or leave them as is.
Political Events. National and international events on the global scene can affect the different currencies. A recent example is the protracted trade war between the United States and China.
Import and Export. The balance of trade often influences the local and foreign currency duo. If the export and import are unequal, then the supply or demand for the currency also rises or drops accordingly.