Table of contents:
- 1 Introduction and Definition
- 1.1 How do exchange rates arise?
- 1.2 When do you trade in the foreign exchange market?
- 1.3 The market participants
- 1.4 Read currency pairs
- 1.5 The specifics of the foreign exchange market
- 1.6 The different types of trading in the foreign exchange market
- 1.7 Cash market
- 1.8 Futures market
- 1.9 Comparison of the risks on the foreign exchange and stock markets
- 1.10 Can the risks be minimized?
- 1.11 Important data influence the foreign exchange market
- 1.12 Labour market data
- 1.13 The Gross Domestic Product
- 1.14 Retail sales
- 1.15 Balance of trade and capital flow
- 1.16 Fundamental and technical analysis
- 1.17 Requirements for participating in the Forex market
- 1.18 Fees and commission
- 1.19 customer service:
- 1.20 Trading platform:
- 1.21 Reputation:
In order to be able to trade successfully in the foreign exchange market, you need to be familiar with the special conditions in this area. The exchange of foreign currencies has been practiced for thousands of years due to international trade relations. Of course, the trade with foreign exchange has changed a lot and is now an independent financial market with many more participants who do not only act as traders and want to sell their goods to other countries. The foreign exchange market is very complex, but the following guide will help you to better understand the process and structures. Only what you understand should be traded.
Introduction and Definition
The market for trading currencies (Forex Trading) is called the foreign exchange market. The English term for this has also been in use in this country for a long time and is called foreign exchange market, short Forex market or FX market. All these terms describe the currency market, i.e. the market where the demand for and the supply of currencies meet and the exchange is carried out. In this context, foreign exchange generally stands for foreign currencies.
How do exchange rates arise?
Currency rates are not set by a government as long as they are freely tradable and not pegged to another currency. They are based solely on supply and demand. However, as the major banks trade among themselves and set rates, slightly different rates may arise in the foreign exchange market for the same currency pairs.
When do you trade in the foreign exchange market?
Trading is as good as possible on weekdays. Since most online brokers offer access to the major international stock exchanges, traders can also speculate at night. Foreign exchange trading usually begins on the night from Sunday (10pm) to Monday and continues until Friday night (11pm).
Some exchanges are closed on the various holidays, so trading is restricted or not possible at all. Even if currency trading takes place off-exchange, market participants are guided by the exchange trading hours. You can find more details about the trading hours in our Forex Terms.
The market participants
Foreign exchange trading usually takes place off-exchange, i.e. it is not centrally organised, but takes place directly between market participants or via a broker. This trading without a central marketplace is also known as OTC trading (“over-the-counter”). The bulk of currency trading is carried out in interbank trading, i.e. trading between credit institutions. However, there are several participants in the foreign exchange market:
- Large banks: also act as market makers
- Broker: Link between customers and market makers
- Traders of banks: make profits with short-term speculation through proprietary trading, also known as proprietary trading or prop trading
- International companies: hedge against currency fluctuations in international trade through foreign exchange trading
- Investment companies: try to make profits (hedge funds) or hedge foreign investments against currency fluctuationsCentral banks: participate in foreign exchange trading for fiscal policy reasons
- Private individuals: through holidays etc. people participate in foreign exchange trading, but more and more private investors use currencies as an object of speculation
Unlike the stock market, there are not only private and institutional investors in the foreign exchange market, but also other participants who are active in this financial market for various reasons. Due to the number and the size as well as the financial “power” of the participants, it is not surprising that the Forex market could become the largest financial market.
The total daily turnover in the Forex market is over 5 trillion US dollars, making it the largest financial market in the world. The rise in turnover (see Statistics 1) is partly due to the emergence and spread of the Internet and related technologies, such as electronic trading platforms. This has made trading much easier, and it is now possible for ordinary private investors to buy and sell currencies via forex brokers with just a few mouse clicks.
The biggest “players” in the Forex market are obviously governments and central banks, which in principle also participate in currency trading in the interest of the respective government. Due to their financial capabilities, central banks are able to exert a discernible influence on the foreign exchange market. In principle, however, they only use currency trading to adjust and hedge their currency reserves.
The next largest participants are banks and other credit institutions. As already mentioned, interbank trading is responsible for the majority of foreign exchange trading. The share of private speculators is very small in comparison. In the interbank market, large banks trade with each other via an electronic trading system and set the currency prices at which they are willing to buy and sell. So they act as market makers and at the same time try to make profits from foreign exchange trading. Since the Forex market is a decentralized trading place, it happens that the banks offer slightly different prices for the same currencies.
Customers of these banks are often companies with international relations. Whenever purchases are received from foreign customers or orders are placed with foreign suppliers, these companies have to accept currency fluctuations. However, it is common for a certain amount of time to pass between placing an order and payment – sometimes even a year or more.
During this time, exchange rates can change significantly, which means that companies with high sales volumes are exposed to major exchange rate risks. In order to minimize or eliminate these risks, trading is carried out on the foreign exchange market. Normally, they enter into a contract with fund companies that guarantees them the current exchange rates on a specific date.
Speculators form a special group of market participants, to which you probably want to belong. Their only goal on the Forex market is to generate profits by using the fluctuations of currency rates to their advantage. Speculators include both private and institutional investors. Hedge funds are the speculators with the largest capital in the Forex market.
Read currency pairs
For beginners, the display of currency pairs can be confusing at first glance. If a currency is specified on the Forex market, it is always compared to a counter currency. The first currency in a pair is called the base currency. The counter currency is also called the quoted currency. This is the representation of the currency pair consisting of the Euro and the US dollar:
EUR/USD = 1.15
The base currency always has the value of one unit. If you now look at a currency pair, you can see the value of a unit of the base currency represented by the value of the quoted currency. In our example:
The rate for EUR/USD is 1.15.
In this case, the Euro is the base currency and the US Dollar is the quoted currency.
A unit of the euro is therefore worth as much as 1.15 US dollars, that is, 1 € = 1.15 US-$.
If, on the other hand, the US dollar is the base currency, the USD/EUR exchange rate is 0.87 (1 divided by 1.15).
The abbreviations are mainly used to represent the exchange rates. One should know the most important currencies and their abbreviations:
- EUR: Euro
- USD: US dollar
- JPY: Japanese yen
- GBP: Pound sterling
- CHF: Swiss franc
- CAD: Canadian Dollar
- AUD: Australian Dollar
- NZD: New Zealand Dollar
Traders also use nicknames for the major currency pairs:
- GBP/USD: Cable
- USD/CHF: Swissy
- USD/CAD: Loonie
- AUD/USD: Aussie
- NZD/USD: Kiwi
In the Forex market, most currencies are traded against the US dollar, so the US dollar is often the base currency. A shift from base currency to counter currency is easily possible, and the rate is calculated inversely, as in the example above. Since it is possible to go long or short when trading in the Forex market, it does not matter which currency is the base currency for a given currency pair.
For example, if you want to buy Euros and pay in US dollars, open a long position for EUR/USD. Alternatively, you could open a short position for USD/EUR, which would sell USD and receive Euros. After closing the position, the actions are reversed and both options come out the same.
The specifics of the foreign exchange market
In general, fluctuations in the Forex market are very small. Most currencies show daily changes in the range of less than one percent. So the volatility is rather low compared to other financial markets. Therefore, most speculators use leverage to increase the total value of the changes and thus achieve higher profits. The English term “leverage” or “leverage effect” is also common for this leverage.
Due to the large number of market participants and the large trading volume in the foreign exchange market, there is a very high level of liquidity, i.e. a currency can be bought or sold quickly because there is always a trading partner available. In addition, a single trade has very little impact on the price.
Currency trading has a high trading volume, so the Ask price that a seller demands for a currency and the Bid price that a buyer is willing to pay are very close. The smaller the spread between the ask and bid price, the more liquid the market is.
The high liquidity of the market allows participants to work with very high leverage, up to 250:1. In such a case, the trader can use 250 times the trading volume, while he only has to deposit a part of it as a so-called margin with the trader.
The different types of trading in the foreign exchange market
Foreign exchange trading can be carried out as a spot or forward transaction. The cash market, also known as the spot market, is the larger market because it forms the underlying for the futures market. In the past, forward exchange transactions were more popular because they were also more accessible to private investors. However, with the advent of electronic trading, the spot market has overtaken the futures market. Nowadays, the cash market is basically meant when referring to the Forex market.
The cash market is the marketplace where currencies are bought and sold at current prices. The price depends on supply and demand. It is subject to numerous influencing factors such as economic performance, interest rates or political stability. A maximum of two banking days may elapse between the conclusion of the transaction and its execution. At that time, the seller delivers the relevant foreign exchange to the agreed account and the buyer pays in the agreed currency. Due to electronic trading, this usually happens very quickly. Transactions on the spot market are also called spot transactions.
On the futures market, on the other hand, no actual currencies are traded. Instead, contracts are traded that guarantee claims to a currency at a certain price on a certain date. Forward transactions can be concluded for a period of at least three days up to more than one year.
Irrespective of the price development, the contracting parties must fulfil their obligations on the due date. Mainly large, international companies use these forward transactions in the form of forwards or futures to hedge against future currency fluctuations.
Forwards are contracts whose content and conditions are freely negotiated between the contracting parties. In contrast, the contents of futures contracts are determined and standardized by the exchange on which they are traded. Both forms of contract are of course binding, even if trading in the contracts is possible before the end of the term.
The opportunities and risks of the Forex market
The factors trading volume, volatility and global structures are the reasons for the success story of the foreign exchange market in recent years. Due to the high liquidity that prevails on this financial market, individual investors are able to place very large trades without having a significant influence on the exchange rates. As a result, fairness is offered in the market because prices are created by supply and demand, but cannot be manipulated by means of individual large positions.
In addition, the high liquidity in the Forex market influences the validity of the technical analysis. As a result, a large number of speculators trust chart analysis when trading currencies and act very precisely.
While the market per se already reveals advantages, trading also has its advantages. Thanks to the leverage effect, private investors are also able to hold large positions of, for example, 50,000 euros, even though they have only deposited 1,000 euros of trading capital as margin with the broker.
The lever effect is of course a double-edged sword. By using large levers you can increase your profits, but at the same time the possible amount of losses increases if the prices run against you. However, despite the risks involved, it is precisely the leverage effect that is the reason why so many speculators participate in currency trading.
Comparison of the risks on the foreign exchange and stock markets
Compared with equities, the risk in the foreign exchange market can be higher due to the large leverage. Large profits can turn into heavy losses in a few minutes and consume a large part of the trading capital. Due to the large number of market participants, the market reacts very quickly to new information. Beginners must therefore learn to maintain concentration when trading and to react quickly.
If you look at the percentage change of a currency and a share, you will notice that the shares fluctuate more. On the Forex market, however, the leverage effect “generates” the necessary volatility. For example, if you use 1,000 euros of investment capital to buy a currency with a leverage of 100:1, you open a position with a volume of 100,000 euros.
If the currency now moves against this position with a change of 1 percent, the investment capital drops to 99,000 euros, which corresponds to a loss of 1,000 euros – the loss of the entire investment. In contrast, stock trading does not usually use leverage. If you invest 1,000 euros in shares and these lose 1 percent of their value, the loss adds up to 10 euros. As a beginner in the Forex market, you have to be aware of these risks before you start trading.
Can the risks be minimized?
Through a targeted “money management” you can reduce the risk and minimize losses. This includes, for example, using only a small part of the available trading capital for a trade. Often traders use a share of two to five percent of their capital for a position.
The setting of so-called stop-loss orders is carried out by almost all traders in order to protect themselves from large losses due to opposite price movements. A stop-loss order is an order that automatically closes the position when the price reaches a certain price limit, which is opposite to the traded direction.
For example, if you expect prices to rise, you open a long position and set a stop loss below the entry price to limit the risk of loss. The opposite is true for a short position. Here the stop loss is correspondingly higher than the entry price. This is particularly advantageous for private speculators, as it is not absolutely necessary to keep a constant eye on the price development.
Important data influence the foreign exchange market
Economic data not only has a great influence on equities, but also on the price movements of currencies. In the same way that financial news, the publication of balance sheets or other current events influence the share price of a company, new information about a country can have a major impact on the development of the currency exchange rate. Such data or information is also called an indicator. The most important indicators that influence the foreign exchange market include
- The key interest rate
- Labour market data
- The gross domestic product (GDP)
- Retail sales
- Consumer Goods
- Macroeconomic and political events
- Trade and cash flow
- The base rate
The key interest rates are set by the competent central banks in the context of monetary policy. The key interest rate is the interest rate at which commercial banks can borrow money from the relevant central bank. The competent central banks for the major currencies are:
The key interest rate has an influence on the interest rates for loans and savings as well as on the Forex market. If a central bank lowers the key interest rate, more money of the corresponding currency comes into circulation, because the banks borrow more money and pass it on to companies and private customers via loans. As more money is available, the inflation rate also increases. So a currency basically loses value if the key interest rate is lowered. Of course, this should always be seen in relation to the counter currency, as currencies are always traded as pairs.
Labour market data
Thanks to the labour market data of a country, one can get an overview of the number of working people and the unemployment rate of the respective population. As a rule, an increase in the number of employed and a decrease in the unemployment rate is a sign of an emerging economy.
This has different consequences. On the one hand, positive labour market data will strengthen the currency because the economy is healthy and growing. On the other hand, a high level of employment causes the inflation rate to rise, which can cause the currency to lose value again. The influence of economic data on the exchange rate therefore also depends on the circumstances of the country.
By the way, the labor market data from the US is immensely important for Forex trading. Since most currencies are traded against the Dollar, the so-called “non-farm payrolls” have a noticeable impact on the major currency pairs. The Labor Market data is released monthly on the first Friday by the Bureau of Labor Statistics.
The Gross Domestic Product
The total value of all goods and services produced or rendered within a country is called gross domestic product (GDP). It usually refers to the period of one year.
The GDP is considered the best measure to describe the overall economic development of an economy. If GDP increases, this is a sign of a growing and healthy economy. Among other things, this attracts foreign investors, which increases the value of the currency because there is greater demand.
Retail sales reflect the strength of an economy and consumer spending. High retail sales indicate a healthy economy and thus provide market participants with buying signals. However, if sales fall, this also weakens the currency.
Macroeconomic and political events
The greatest changes in exchange rates are caused by macroeconomic and political events such as
- Change in monetary policy
- Financial Crises
Political unrest can result in considerable fluctuations in the exchange rate, and wars can put a heavy burden on the economy. It is important to always be aware of such events, as they can cause major changes in currencies.
Balance of trade and capital flow
International trade leads to large capital movements, which can have a major effect on the value of currencies. An important indicator here is the trade balance, which compares a country’s exports with its imports.
A trade balance deficit exists when more is imported than exported. In such a case, the value of the currency falls because the domestic currency must be sold in order to pay for the imports in the foreign currency. As one of the largest exporters in the world, Germany, with its large trade surplus, is therefore partly responsible for a strong euro.
The flow of capital describes the amount of capital that has come into the country through investments and exports and the amount that has gone out through investments in other countries and through imports. Different currencies react differently to the two indicators.
Currencies of countries that rely on a trade surplus, such as Australia, react more strongly to changes in trade gains. Currencies of countries where the financial sector is very important experience stronger exchange rate changes due to changes in foreign investment.
Fundamental and technical analysis
The use of such information belongs in the field of fundamental analysis. While stock trading in fundamental analysis is about determining the true value of a company and making trading decisions based on this, the situation is similar in Forex trading. Here, the country is the company, so to speak, and economic data is used to analyze the value of the currency in question.
The news about a country in the form of current news, economic data and political events gives the trader an overview of the strength of a currency. As described above, there are numerous factors that influence the price changes. Based on this analysis, there are virtually numerous forex strategies that traders can and should use to identify good trading opportunities.
Technical analysis takes a different approach to evaluating currencies. A fundamental principle of this method of analysis is that past price changes predict future changes. Because the forex market is open virtually 24 hours a day and has a huge trading volume, there is a huge amount of data that can be used for technical analysis.
As a result, the statistical power of the predictions made in this way increases. Therefore, it is not surprising that the forex market is ideally suited to use technical tools such as trend and chart patterns and technical indicators to determine trading opportunities.
In the Forex market, there are many large market participants, such as banks or hedge funds, which have sophisticated computer systems that detect discrepancies in currency pairs. These discrepancies therefore usually last only a few seconds. With such a large number of market participants and the large daily turnover volume, it is more important to keep an eye on the trend and the flow of capital than to identify an undervalued currency.
Countless traders trust the technical analysis because the method assumes that all changes in the price are already priced in. This means that all economic data, political and social events and psychological factors are already factored into the currency rate.
Technical analysis has also created a variety of forex strategies and supporting technical indicators in recent years. In order to be successful in the forex market, you need to master some of them.
Requirements for participating in the Forex market
Thanks to electronic trading and the appearance of Forex brokers as intermediaries, the foreign exchange market has become much more interesting for private investors. For several years now, many private individuals have been able to participate in currency trading without having very large amounts of capital at their disposal due to the leverage offered. Thanks to the “leverage effect”, it is possible to profit from the low exchange rate fluctuations of foreign exchange rates even with comparatively small capital.
As has already been made clear, as a private individual you need a broker who receives and executes the trading orders. In order to open an account with a Forex broker, you must be of full age and have full legal capacity. After you have completed the registration process and deposited funds into your account, you can start trading on the broker’s trading platform.
Each broker offers a different range of services. There are different advantages and disadvantages resulting from the offers, so when choosing a forex broker, you should also take your time to find the broker that suits you best. The most important thing is the amount of fees that a broker charges.
Fees and commission
Unlike stock trading, you do not have to pay a commission to the broker for each trade when trading Forex. Nevertheless, brokers must of course earn money for providing their services. Basically this is done via the so-called spread.
The spread is the difference between the bid and ask price, i.e. the prices at which traders are prepared to sell and buy the currency. If you want to open a Forex account, you should know that each broker sets the spread himself for different currency pairs. Even if the difference is only a few pips, this can have a noticeable effect on the trading capital when added up.
If you do not know what a pip is, click here. In addition to the cost of the actual trade, you should also compare other cost centers such as payout fees and the like. There are also other factors that make a broker:
If problems arise, a helpful customer service is worth its weight in gold or money. Is the service available around the clock? In which language and by which means (telephone, chat, e-mail) is communication possible?
For many traders the trading platform they use is very important. Many brokers offer their services via the web browser or enable the integration into a trading software like the well-known MetaTrader.
Is the reputation of a provider good or are there already complaints? The location of the company’s headquarters can also be a good indication here, so that in case of doubt one knows under which legislation the provider is subject.
This brings us to the end of our introduction to the foreign exchange market. If you want to delve deeper into the topics, take a look at our further advice. It is also important to deal with the basic strategies of Forex trading. If you already want to get into trading, you should first practice the first steps with a demo account.
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