Forex market overview for absolute beginners
Where and how and why do people trade forex? How big is the market? Everything you need to know in a single overview.
The forex market is the market in which you can exchange one currency for another. You have likely participated in it already without even noticing. If Bob from the UK goes on holiday to the US and buys a T-shirt for 20 USD, his UK bank needs to convert this 20 USD into the correct amount of GBP and remove that sum from Bob’s bank account.
On Bob’s behalf, his bank will go into the forex market to buy USD and sell the equivalent amount of GBP. We’ll look at exactly how that happens a little later. Of course our interest will not be in transactional FX like Bob’s example above but speculative trading in currency markets.
The market size
The first thing to realise is that the forex market is huge. Every day nearly two trillion USD (1.65 to be precise!) of spot FX is traded, according to the Bank for International Settlements.
This is many, many times larger than the global equity markets. For example, summing up all activity across every single stock on every single European stock exchange provides a daily turnover of just 50 billion USD.
That 50 billion USD is barely 3% of the global spot FX market. The FX market is simply huge, which means it is said to have great ‘liquidity’. What traders mean by this is that you can buy or sell at almost any time of day and the cost of doing these transactions is incredibly cheap - more on that later.
However, despite the huge size of this market, there are far fewer currencies traded than stocks. For example, whereas a major hedge fund might trade in the region of 7,000 stocks it will likely trade fewer than 20 currencies. There are tens of thousands of stocks trading globally whereas in currencies just nine currencies account for the majority of activity. In fact, just three currencies — USD, EUR, JPY — account for over 70% of all activity.
That still doesn't tell the whole story, however. FX is always traded as pairs of currencies. You buy one currency and sell the other. For example EURUSD means EUR versus USD. Here, again, activity is highly concentrated. A typical broker's volume might look like the illustrative example below with these top five pairs accounting for around three quarters of all activity.
So the FX market is huge and activity is concentrated in a handful of major pairs, which makes it a very accessible market for retail traders. The equities market by comparison requires monitoring thousands of stocks, each of which has far less daily trading volume and is less ‘liquid’ (i.e. more expensive to trade) than a typical currency pair.
When do people trade Forex?
Unlike equities exchanges which have defined hours of trading, the forex market is a ‘follow the sun’ market. This means it is open 24 hours a day, 5.5 days a week. Weekends are not traded. Interbank venues shut on Friday afternoon in NY and open again for the new week on Sunday evening in New Zealand.
Traders often refer to three sessions throughout the day: the Asia open; the London session; the New York close. Most trading activity occurs during London hours as they cross-over with both the Asia market in London morning and the US market in London afternoon. The below chart from Ernie Chan demonstrates the concentration of activity for EURUSD within the London session.
This pattern of activity is representative for most major pairs. It is worth noting that peak activity hours can and do shift for regionally-focused pairs. For example, the Chinese currency (CNH) is most liquid during the Asia-London crossover hours, as you might expect.
Having an idea of peak trading hours is important because the cost of trading — we'll cover that in the next article — is lowest in the most active hours. Also, prices tend to move the most in the busiest sessions so these timezones tend to provide the most trading opportunities. The ‘always open’ nature of the forex markets seems to appeal to retail traders who can fit trading in around their daily lives. We’ll cover this later but there are tools that automatically monitor the market and trade on your behalf, if for example the price reaches a target level, so you need not worry about losing sleep!
Who trades forex?
The FX market contains many diverse participants and one crucial thing to note is that they do not all have the same objective when trading and there is no central marketplace where all activity takes place. There are 4-5 major 'interbank' venues (known as ECNs) but activity across these accounts for less than 10% of overall FX market volumes.
Most activity occurs bilaterally and the market resembles a spider's web of connections between participants with the banks acting as connecting nodes. Whilst FX prices are very transparent (you can Google them in real-time) there is, for example, no single definitive EURUSD price in the market so choosing who you trade with is important. Different brokers will offer you slightly different prices.
Now we'll look at some of the major participant types in the FX markets.
1. Natural hedgers. There are of course the hedgers. This is non speculative activity, where the end-user is simply trying to facilitate global trade rather than bet on the direction of currencies. A very simple hedging example would be a European corporate who produces a product in Europe but sells it in the US and has to sell those USD to convert them back to EUR. These hedgers conduct their activity via banks who go to the interbank market on their behalf.
2. Banks. Banks are huge players in the forex market and sit in the middle of all the other participants. Banks can speculate for themselves but the majority of their business is based around providing liquidity to their clients. This means allowing large clients who trade in minimum clips of one million USD to buy and sell to them and then the bank hedging that risk with other interbank participants in the interbank ECN venues.
3. Central Banks. There are also Central Banks, who may intervene in the FX markets if they think their currency is priced too high or low for their economic policy goals. They are not seeking to profit but they are not hedging, either. For example, if a local currency is high vs the USD, it makes it challenging for domestic companies to export as their goods seem expensive to the international market and the central bank may intervene by selling its own currency in the interbank. Central Banks may also purchase foreign currencies to build up their national reserves.
4. Speculators. Finally, there are speculators, who are trading forex to make a profit. These range from retail traders, trading from their mobile phone, to multi-billion dollar hedge-funds. These speculators only wish to bet on the direction of the price so will only trade when they have reason to believe they have an edge.
Why might people trade forex?
There are several reasons commonly given for why trading FX is so popular.
1. Intellectual thrill. One reason is that it can be exciting and an intellectual challenge to speculate on global financial markets. This is true not only of forex but of many financial markets.
2. Edge-givers. Another reason is that the forex market is unlike, say, equities in that there are a number of non speculative traders (such as hedgers) whose non directional activity provides an edge for those looking instead to trade opportunistically for profit. For example, imagine an Aussie corporate does a huge amount of hedging, not because it believes the price is going lower but because it has just sold a subsidiary. This hedging activity temporarily drives the AUDUSD price down to a day’s low, buying the dip after they finish and betting on the market mean-reverting to its old price might allow a day-trader to take some profit out of the market by making it more efficient.
3. Low barriers to entry. The entry requirements are also low in FX. All that is really needed other than education and some time is the internet. Accounts can be opened with relatively small account balances — sometimes as low as $100 — and trading is generally commission-free and available in fractional ‘micro lot’ sizes to accommodate smaller accounts. It is common to trade 'on the go' via mobile apps.
4. Concentrated activity. Traders can focus on just 5-10 key pairs, rather than having to monitor thousands of stocks each with highly specific company stories.
5. 24-hours.The market also trades 24 hours which may appeal to traders who have day jobs that constrain their availability.
6. Liquidity. Finally, the forex market is huge, which means that liquidity is plentiful — one can buy or sell a given pair relatively easily throughout the day without paying too much to do so. Furthermore even really big players cannot easily corner (control) the direction of the market for any length of time in such a big market, which may be reassuring to smaller retail investors.
7. Popularity. Popularity begets popularity. There is a big ecosystem of apps and tools that has grown up around FX and CFD trading and there are large online communities of fellow traders with whom new traders can talk and bounce off ideas.
But ... and it is a big but
There may be many reasons that forex appears interesting. However, the absolute worst reason to trade FX is to get rich fast. Beware of misleading online marketing that suggests this is possible with little or no effort. The reality is that the majority of retail traders lose money as the redacted-but-real advert below shows.
It is absolutely the case that certain people do make a great living trading FX — two very famous examples are hedge fund investors, George Soros and Bruce Kovner — but retail trading is not a get-rich-quick scheme and, like any serious discipline, requires patience and effort.