Lesson 2: Forex Markets Basics and Trading Examples Unlike other financial markets like the New York Stock Exchange or the London Stock Exchange, the forex market has neither a physical location nor a central exchange. The forex market is considered an Over-the-Counter (OTC), or “Interbank” market due to the fact that the entire market is run electronically, within a network of banks, continuously over a 24-hour period. This means that the spot forex market is spread all over the globe with no central location. Trades can take place anywhere. The forex OTC market is by far the biggest and most popular financial market in the world, traded globally by a large number of individuals and organizations. In the OTC market, participants determine who they want to trade with depending on trading conditions, the attractiveness of prices, and reputation of the trading counterpart. This chart shows the seven most actively traded currencies, which are also called the major currencies. The dollar is the most traded currency, taking up 84.9% of all transactions. The euro’s share is second at 39.1%, while that of the yen is third at 19.0%. One of the huge advantages of trading the forex market is the leverage. The concept of leverage is used by both investors and companies. Investors use leverage to significantly increase the returns that can be provided on an investment. They lever their investments by using various instruments that include options, futures and margin accounts.
In forex, investors use leverage to profit from the fluctuations in exchange rates between two different countries. The leverage that is achievable in the forex market is one of the highest that investors can obtain. Leverage is activated through a loan that is provided to an investor by the broker that is handling the investor’s or trader’s forex account. When a trader decides to trade in the forex market, he or she must first open a margin account with a forex broker. Usually, the amount of leverage provided is either 50:1, 100:1 or 200:1, depending on the broker and the size of the position that the investor is trading. What does this mean? A 50:1 leverage ratio means that the minimum margin requirement for the trader is 2 percent. A 100:1 ratio means that the trader is required to have at least 1% of the total value of trade available as cash in the trading account, and so on. Standard trading is done on 100,000 units of currency, so for a trade of this size, the leverage provided is usually 50:1 or 100:1. Leverage of 200:1 is usually used for positions of $50,000 or less. To trade $100,000 of currency, with a margin of 1%, an investor will only have to deposit $1,000 into her or his margin account. The leverage provided on a trade like this is 100:1. Leverage of this size is significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage provided in the futures market. Although 100:1 leverage may seem extremely risky, the risk is significantly less when you consider that currency prices usually change by less than 1% during intraday trading. If currencies fluctuated as much as equities, brokers would not be able to provide as much leverage. Although the ability to earn significant profits by using leverage is substantial, leverage can also work against investors. For example, if the currency underlying one of your trades moves in the opposite direction of what you believed would happen, leverage will greatly amplify the potential losses. To avoid a catastrophe, forex traders usually implement a strict trading style that includes the use of stop orders and limit orders designed to control potential losses. Forex exchange markets provide traders with a lot of flexibility. This is because there is no restriction on the amount of money that can be used for trading. Also, there is almost no regulation of the markets. This combined with the fact that the market operates on a 24 by 7 basis creates a very flexible scenario for traders. People with regular jobs can also indulge in Forex trading on the weekends or in the nights. However, they cannot do the same if they are trading in the stock or bond markets or their own countries. It is for this reason that Forex trading is the trading of choice for part time traders since it provides a flexible schedule with least interference in their full time jobs. There’s a plethora of high quality knowledge and news, all free on the internet, including charts, economic calendar and market analysis.
Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the interbank foreign exchange market, which is made up of the largest commercial banks and securities dealers. Within the interbank market, spreads, which are the difference between the bid and ask prices, are razor sharp and not known to players outside the inner circle. The difference between the bid and ask prices widens as you go down the levels of access. This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the "line", which is the amount of money with which they are trading. The top-tier interbank market accounts for 51% of all transactions. From there, smaller banks, followed by large multinational corporations, which need to hedge risk and pay employees in different countries, large hedge funds, and even some of the retail market makers. Central banks also participate in the foreign exchange market to align currencies to their economic needs. The top 5 market participants are City Bank, JP Morgan, UBS, Deutsche Bank and Merril Lynch.