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Education Foreign Exchange Market – What it is and How Forex Trading Works

The term “Foreign Exchange Market” sounds like something from a spy novel rather than describe the largest financial market in the world.  The primary purpose of the foreign exchange market, also known as Forex, FX or the currency market, is to assist international trade and investment, by allowing businesses to convert one currency to another currency.  For example, it allows a US business to import Japanese goods and pay in Japanese Yen, even though the business’s income is in US dollars.  It also supports speculation, where traders attempt to profit from changing values of one currency to another.

The Foreign Exchange Market – Currency Pairs

As consumers, we determine the value of our currency by how much purchasing power it has.  If we spend $50 on a bag of groceries, we can then judge the value of the US Dollar based on what we can buy.  If we go into the same store to buy the same bag of groceries one month later and the cost is $51, we know that the value of the US Dollar has weakened.  It just didn’t buy as much as it did previously.

In the foreign exchange market, we judge the value of one currency based on its value with a different currency.  This is why we see currencies quoted in pairs.  For instance, the EUR/USD currency pair represents the value of Euro (EUR) in US Dollars (USD).

The first currency listed is the base currency which is what we are measuring while the second currency is known as the counter currency which is what we are using to measure the value of the first currency.

Here is a list of the symbols for some of the most heavily traded currencies in the FX market.

SymbolCurrencySymbolCurrency
AUDAustralian DollarMXNMexican Peso
CADCanadian DollarNOKNorwegian Krone
CHFSwiss FrancNZDNew Zealand Dollar
DKKDanish KroneSEKSwedish Krona
EUREuroSGDSingapore Dollar
GBPBritish PoundTRYNew Turkish Lira
HKDHong Kong DollarUSDUS Dollar
JPYJapanese YenZARSouth African Rand

Quotes/Charts

As we mentioned previously, while $1 is always worth $1, the buying power of that US Dollar can vary both in the US and in other countries.  So in order to determine its value today, the foreign exchange market measures the value of one currency against another currency.  The EUR/USD measures the value of the Euro in US Dollars while the USD/JPY measures the value of the US Dollar in Japanese Yen. This really isn’t all that different from a stock symbol.  Just think of AAPL, the symbol for Apple Inc., as AAPL/USD which means that the quote represents the value of AAPL measured in US Dollars.  An AAPL quote of 325 means that one share of AAPL is worth $325.  A EUR/USD quote of 1.4100 means that one Euro is worth $1.41.  A EUR/USD quote of 1.4101 means the Euro is worth $1.41 and 1/100th of a penny.  However, in the FX markets, the last digit is not referred to as 1/100th of a penny, but rather a “pip” which stands for Percentage in Point. Many firms are now quoting 1/1000th of a pip.  So a quote of 1.41011 would be $1.41 and 11/1000th of a pip.  This is a typical quote window you will find in a Trading Platform for FX.

foreign exchange market 1

This is a quote for the EUR/USD currency pair.  There are two prices in the quote window with the first being 1.40360.  The quote window notes that this is the sell price which means you can sell the EUR/USD for 1.40360.  This is $1.40 and 360/1000th of a penny or 36 pips.  The next price is 1.40381, which is $1.40 and 381/1000th of a penny or 38 and 1/10th of a pip.  This is the price where you can buy this pair.  The difference between the buy price and the sell price is the spread, which is where the brokerage firm and banks make their money.

We can see the history of where the pair has traded on a chart as seen below.  This is a daily chart of the EUR/USD and we can see that in general this chart has been moving up.  This means that the EUR has been stronger than the USD.  If the chart had been moving down, it would mean that the EUR has been weaker than the USD.

Foreign Exchange Market 2

Trading the Foreign Exchange Market

Trading FX is really no different from trading any other market.  The idea is to buy at a lower price and sell at a higher price in order to profit.  Like other markets, you can also sell first at a higher price and then buy it back later at a lower price to profit.  So you can buy low and then sell higher to profit or you can  sell high and then buy back lower to profit.  This flexibility allows the trader to profit from any strong move that takes place.

There is no central market for the currency trading like there is for a stock market or a futures market.  Trading is done between the largest banks in the world and is known as the Interbank Market.  Only the biggest traders had access to this market up until recent technological advances offered the opportunity for individual traders to also gain access through different FX firms.  This access has lowered the cost of trading for the individual which is one of the big reasons for its recent popularity and growth.

However, there are clearly other reasons why many traders prefer trading FX over stocks, futures or options.

  1. The FX market is a true 24 hour-a-day market.  This allows traders access to the market at all times.  More on this later.
  2. The Demo account.  Those firms offering access to the FX markets will usually also offer a free practice account.  This allows traders new to FX the chance to become more familiar with trading FX before using live funds.
  3. Free Live Quotes/Free Live Charts.  Not having to pay to access the market  means more money for the trader.
  4. Small account size.  A trader can start with a smaller amount and still use acceptable money management because of the small trade size available in FX.
  5. Day trade with any account balance.  There are no restrictions to be a day trader in the FX markets.

Market Hours

Unlike most other financial markets, the FX market is open for trading 24 hours a day. The trading week begins on Sunday afternoon New York time and remains open 24 hours a day until it closes on Friday afternoon New York time. Three major trading periods define the daily FX market, namely the Tokyo Trading Session, the London Trading Session, and the New York Trading Session. Generally, the FX market is most active when sessions overlap with a US/Europe overlap between 8 AM – 12 PM (New York Time) and a Europe/Asia overlap between 2 AM – 5 AM (New York Time).

Tokyo Trading Session: 7:00 PM – 4:00 AM (EDT)

Tokyo is the first market to open at the beginning of the week and many large participants use the trade momentum there to develop their strategies and as a gauge for future market dynamics.  Approximately 6% of the world’s FX transactions are enacted in the Tokyo Trading Session.

London Trading Session: 3:00 AM – 12:00 PM (EDT)

London is the largest and most important trading center in the world, with about a 34% market share of the daily FX volume.  Most of the world’s largest banks keep their dealing desks in London because of that market share.  The large number of participants in the London FX market and the high value of the transactions makes the London session more volatile than the other two sessions.

New York Trading Session: 8:00 am – 5:00 pm (EDT)

The second largest trading market, New York handles approximately 16% of the world’s FX transactions.  The majority of the transactions in New York occurs during the US/Europe overlap; with transactions slowing as liquidity dries up and European traders exit the market.  Since California has never served as a bridge between the US and Asia, there is a 50% drop in activity by midday.  As a result, market developments in the afternoon during the New York session do not garner as much attention.  The New York session is heavily influenced by the US equity and bond markets and pairs will often move closely in tandem with these capital markets.