Chapter 2

What Is the Forex Market?

In This Chapter

Getting inside the forex market

Understanding that speculating is the name of the game

Trading currencies around the world

Linking other financial markets to currencies

Getting a feel for currency trading with a practice account

We like to think of it as the Big Kahuna of financial markets. The foreign exchange market — most often called the forex market, or simply the FX market — is the largest and most liquid of all international financial markets. (See the “Getting liquid without getting soaked” section, later in this chapter, for our discussion of liquidity.)

The forex market is the crossroads for international capital, the intersection through which global commercial and investment flows have to move. International trade flows, such as when a Swiss electronics company purchases Japanese-made components, were the original basis for the development of the forex markets.

Today, however, global financial and investment flows dominate trade as the primary nonspeculative source of forex market volume. Whether it’s an Australian pension fund investing in U.S. Treasury bonds, or a British insurer allocating assets to the Japanese equity market, or a German conglomerate purchasing a Canadian manufacturing facility, each cross-border transaction passes through the forex market at some stage.

The forex market is the ultimate traders’ market. It’s a market that’s open around the clock six days a week, enabling traders to act on news and events as they happen. It’s a market where half-billion-dollar trades can be executed in a matter of seconds and may not even move prices noticeably. That is what’s unique about forex — try buying or selling a half-billion of anything in another market and see how prices react.

Firms such as FOREX.com, Saxo Bank, Oanada, CMC Markets, and IG Group have made the forex market accessible to individual traders and investors. You can now trade the same forex market as the big banks and hedge funds.

Getting Inside the Numbers

Average daily currency trading volumes exceed $5 trillion per day. That’s a mind-boggling number, isn’t it? $5,000,000,000,000 — that’s a lot of zeros, no matter how you slice it. To give you some perspective on that size, it’s about 10 to 15 times the size of daily trading volume on all the world’s stock markets combined.

That $5-trillion-a-day number, which you may’ve seen in the financial press or other books on currency trading, actually overstates the size of what the forex market is all about — spot currency trading.

Trading for spot

Spot refers to the price where you can buy or sell currencies now, as in “on the spot.” If you’re familiar with stock trading, the price you can trade at is essentially a spot price. The term is primarily meant to differentiate spot, or cash, trading from futures trading, or trading for some future delivery date. The spot currency market is normally traded for settlement in two business days. Unless otherwise specified, the spot price is most likely to be what you buy and sell at with your currency broker.

Speculating in the currency market

While commercial and financial transactions in the currency markets represent huge nominal sums, they still pale in comparison to amounts based on speculation. By far the vast majority of currency trading volume is based on speculation — traders buying and selling for short-term gains based on minute-to-minute, hour-to-hour, and day-to-day price fluctuations.

Estimates are that upwards of 90 percent of daily trading volume is derived from speculation (meaning, commercial or investment-based FX trades account for less than 10 percent of daily global volume). The depth and breadth of the speculative market means that the liquidity of the overall forex market is unparalleled among global financial markets.

The bulk of spot currency trading, about 75 percent by volume, takes place in the so-called “major currencies,” which represent the world’s largest and most developed economies. Trading in the major currencies is largely free from government regulation and takes place outside the authority of any national or international body or exchange.

Additionally, activity in the forex market frequently functions on a regional “currency bloc” basis, where the bulk of trading takes place between the USD bloc, JPY bloc, and EUR bloc, representing the three largest global economic regions.

Trading in the currencies of smaller, less-developed economies, such as Thailand or Chile, is often referred to as emerging market or exotic currency trading. Although trading in emerging markets has grown significantly in recent years, in terms of volume it remains some way behind the developed currencies. Due to some internal factors (such as local restrictions on currency transactions by foreigners), and some external factors (such as geopolitical crises and the financial market crash, which can make emerging market currencies tricky to trade), the emerging-market forex space can be illiquid, which can be a turnoff for a small investor.

Getting liquid without getting soaked

Liquidity refers to the level of market interest — the level of buying and selling volume — available at any given moment for a particular asset or security. The higher the liquidity, or the deeper the market, the faster and easier it is to buy or sell a security.

From a trading perspective, liquidity is a critical consideration because it determines how quickly prices move between trades and over time. A highly liquid market like forex can see large trading volumes transacted with relatively minor price changes. An illiquid, or thin, market will tend to see prices move more rapidly on relatively lower trading volumes. A market that only trades during certain hours (futures contracts, for example) also represents a less liquid, thinner market.

We refer to liquidity, liquidity considerations, and market interest throughout this book because they’re among the most important factors affecting how prices move, or price action.

It’s important to understand that, although the forex market offers exceptionally high liquidity on an overall basis, liquidity levels vary throughout the trading day and across various currency pairs. For individual traders, though, variations in liquidity are more of a strategic consideration rather than a tactical issue. For example, if a large hedge fund needs to make a trade worth several hundred million dollars, it needs to be concerned about the tactical levels of liquidity, such as how much its trade is likely to move market prices depending on when the trade is executed. For individuals, who generally trade in smaller sizes, the amounts are not an issue, but the strategic levels of liquidity are an important factor in the timing of when and how prices are likely to move.

In the next section, we examine how liquidity and market interest changes throughout the global trading day with an eye to what it means for trading in particular currency pairs. (We look at individual currency pairs in greater detail in Chapters 8 and 9.)

Around the World in a Trading Day

The forex market is open and active 24 hours a day from the start of business hours on Monday morning in the Asia-Pacific time zone straight through to the Friday close of business hours in New York. At any given moment, depending on the time zone, dozens of global financial centers — such as Sydney, Tokyo, or London — are open, and currency trading desks in those financial centers are active in the market.

In addition to the major global financial centers, many financial institutions operate 24-hour-a-day currency trading desks, providing an ever-present source of market interest.

Currency trading doesn’t even stop for holidays when other financial markets, like stocks or futures exchanges, may be closed. Even though it’s a holiday in Japan, for example, Sydney, Singapore, and Hong Kong may still be open. It might be the Fourth of July in the United States, but if it’s a business day, Tokyo, London, Toronto, and other financial centers will still be trading currencies. About the only holiday in common around the world is New Year’s Day, and even that depends on what day of the week it falls on.

The opening of the trading week

There is no officially designated starting time to the trading day or week, but for all intents the market action kicks off when Wellington, New Zealand, the first financial center west of the international dateline, opens on Monday morning local time. Depending on whether daylight saving time is in effect in your own time zone, it roughly corresponds to early Sunday afternoon in North America, Sunday evening in Europe, and very early Monday morning in Asia.

The Sunday open represents the starting point where currency markets resume trading after the Friday close of trading in North America (5 p.m. eastern time [ET]). This is the first chance for the forex market to react to news and events that may have happened over the weekend. Prices may have closed New York trading at one level, but depending on the circumstances, they may start trading at different levels at the Sunday open. The risk that currency prices open at different levels on Sunday versus their close on Friday is referred to as the weekend gap risk or the Sunday open gap risk. A gap is a change in price levels where no prices are tradable in between.

As a strategic trading consideration, individual traders need to be aware of the weekend gap risk and know what events are scheduled over the weekend. There’s no fixed set of potential events and there’s never any way of ruling out what may transpire, such as a terror attack, a geopolitical conflict, or a natural disaster. You just need to be aware that the risk exists and factor it into your trading strategy.

Of typical scheduled weekend events, the most common are quarterly Group of Twenty (G20) meetings (see Chapter 3 for more on the G20) and national elections or referenda. Just be sure you’re aware of any major events that are scheduled. During the height of the Eurozone sovereign debt crisis, a lot of last-minute bailout decisions were made over the course of a weekend, which had major implications for the markets when they opened.

On most Sunday opens, prices generally pick up where they left off on Friday afternoon. The opening price spreads in the interbank market will be much wider than normal, because only Wellington and 24-hour trading desks are active at the time. Opening price spreads of 10 to 30 points in the major currency pairs are not uncommon in the initial hours of trading. When banks in Sydney, Australia, and other early Asian centers enter the market over the next few hours, liquidity begins to improve and price spreads begin to narrow to more normal levels.

Because of the wider price spreads in the initial hours of the Sunday open, most online trading platforms do not begin trading until 5 p.m. ET on Sundays, when sufficient liquidity enables the platforms to offer their normal price quotes. Make sure you’re aware of your broker’s trading policies with regard to the Sunday open, especially in terms of order executions.

Trading in the Asia-Pacific session

Currency trading volumes in the Asia-Pacific session account for about 21 percent of total daily global volume, according to the 2004 BIS survey. The principal financial trading centers are Wellington, New Zealand; Sydney, Australia; Tokyo, Japan; Hong Kong, and Singapore.

News and data reports from New Zealand, Australia, and Japan are going to be hitting the market during this session. New Zealand and Australian data reports are typically released in the early morning local time, which corresponds to early evening hours in North America. Japanese data is typically released just before 9 a.m. Tokyo time, which equates to roughly 7 or 8 p.m. ET. Some Japanese data reports and events also take place in the Tokyo afternoon, which equates to roughly midnight to 4 a.m. ET.

The overall trading direction for the NZD, AUD, and JPY can be set for the entire session depending on what news and data reports are released and what they indicate.

In addition, news from China, such as economic data, interest rate changes and official comments or currency policy adjustments, may also be released. Occasionally as well, late speakers from the United States, such as Federal Reserve officials speaking on the West Coast of the United States, may offer remarks on the U.S. economy or the direction of U.S. interest rates that affect the value of the U.S. dollar against other major currencies.

Because of the size of the Japanese market and the importance of Japanese data to the market, much of the action during the Asia-Pacific session is focused on the Japanese yen currency pairs, such as USD/JPY and the JPY crosses, like EUR/JPY and AUD/JPY. Of course, Japanese financial institutions are also most active during this session, so you can frequently get a sense of what the Japanese market is doing based on price movements.

For individual traders, overall liquidity in the major currency pairs is more than sufficient, with generally orderly price movements. In some less liquid, non-regional currencies, like GBP/USD or USD/CAD, price movements may be more erratic or nonexistent, depending on the environment. With no Canadian news out for the next 12 hours, for example, there may be little reason or interest to move that pair. But if a large market participant needs to make a transaction in that pair, the price movement could be larger than normal.

Trading in the European/London session

About midway through the Asian trading day, European financial centers begin to open up and the market gets into its full swing. European financial centers and London account for over 50 percent of total daily global trading volume, with London alone accounting for about one-third of total daily global volume, according to the 2004 BIS survey.

The European session overlaps with half of the Asian trading day and half of the North American trading session, which means that market interest and liquidity is at its absolute peak during this session.

News and data events from the Eurozone (and individual countries like Germany and France), Switzerland, and the United Kingdom are typically released in the early-morning hours of the European session. As a result, some of the biggest moves and most active trading takes place in the European currencies (EUR, GBP, and CHF) and the euro cross-currency pairs (EUR/CHF and EUR/GBP).

Asian trading centers begin to wind down in the late-morning hours of the European session, and North American financial centers come in a few hours later, around 7 a.m. ET.

Trading in the North American session

Because of the overlap between North American and European trading sessions, the trading volumes are much more significant. Some of the biggest and most meaningful directional price movements take place during this crossover period. On its own, however, the North American trading session accounts for roughly the same share of global trading volume as the Asia-Pacific market, or about 22 percent of global daily trading volume.

The North American morning is when key U.S. economic data is released and the forex market makes many of its most significant decisions on the value of the U.S. dollar. Most U.S. data reports are released at 8:30 a.m. ET, with others coming out later (between 9 and 10 a.m. ET). Canadian data reports are also released in the morning, usually between 7 and 9 a.m. ET. There are also a few U.S. economic reports that variously come out at noon or 2 p.m. ET, livening up the New York afternoon market. (See Chapter 9 for more details on individual economic data reports.)

London and the European financial centers begin to wind down their daily trading operations around noon eastern time (ET) each day. The London, or European close, as it’s known, can frequently generate volatile flurries of activity. A directional move that occurred earlier in European trading or the New York session may be reversed if enough traders decide to take profit (selling out or exiting long positions) or cover shorts (buying back short positions). Or the directional move may extend farther, as more traders jump onboard before the end of the trading day. There’s no set recipe for how the European close plays out, but significant flurries of activity frequently occur around this time.

On most days, market liquidity and interest fall off significantly in the New York afternoon, which can make for challenging trading conditions. On quiet days, the generally lower market interest typically leads to stagnating price action. On more active days, where prices may have moved more significantly, the lower liquidity can spark additional outsized price movements, as fewer traders scramble to get similarly fewer prices and liquidity. Just as with the London close, there’s never a set way in which a New York afternoon market move will play out, so traders just need to be aware that lower liquidity conditions tend to prevail, and adapt accordingly.

Lower liquidity and the potential for increased volatility is most evident in the least-liquid major-currency pairs, especially USD/CHF and GBP/USD.

North American trading interest and volume generally continue to wind down as the trading day moves toward the 5 p.m. New York close, which also sees the change in value dates take place. (See Chapter 4 for more on rollovers and value dates.) But during the late New York afternoon, Wellington and Sydney have reopened and a new trading day has begun.

As you can see, in terms of volume, London is the center of the forex world, but plenty of opportunities exist during the New York and Asia Pacific sessions. As a general rule, if you trade during the Asian session and no major data releases or events have taken place, the themes from the U.S. session the day before tend to prevail. When the European session comes around, there are usually a few meaty events to move the markets and create new themes; likewise during the U.S. trading session.

Key daily times and events

In addition to the ebb and flow of liquidity and market interest during the global currency trading day, you need to be aware of the following daily events, which tend to occur around the same times each day.

Expiring options

Currency options are typically set to expire either at the Tokyo expiry (3 p.m. Tokyo time) or the New York expiry (10 a.m. ET). The New York option expiry is the more significant one, because it tends to capture both European and North American option market interest. When an option expires, the underlying option ceases to exist. Any hedging in the spot market that was done based on the option being alive suddenly needs to be unwound, which can trigger significant price changes in the hours leading up to and just after the option expiry time.

The amount and variety of currency option interest is just too large to suggest any single way that spot prices will always react around the expiry (there may not even be any significant option interest expiring on many days), but if you do notice some volatility around 10 a.m. ET, it could be due to the expiry of some currency options.

Setting the rate at currency fixings

There are several daily currency fixings in various financial centers, but the two most important are the 8:55 a.m. Tokyo time and the 4 p.m. London time fixings. A currency fixing is a set time each day when the prices of currencies for commercial transactions are set, or fixed. (See Chapter 3 for more on fixings.)

From a trading standpoint, these fixings may see a flurry of trading in a particular currency pair in the run-up (generally 15 to 30 minutes) to the fixing time that abruptly ends exactly at the fixing time. A sharp rally in a specific currency pair on fixing-related buying, for example, may suddenly come to an end at the fixing time and see the price quickly drop back to where it was before.

The London forex fix is traditionally benchmarked to WM/Reuters fixing rates. At the time of writing, global financial market regulators were investigating potential manipulation of the forex fix. The outcome of this investigation could lead to changes to the fixing process in the future. (See Chapter 8 for more about forex-market regulation.)

Squaring up on the currency futures markets

The Chicago Mercantile Exchange (CME), one of the largest futures markets in the world, offers currency futures through its International Monetary Market (IMM) subsidiary exchange. A currency futures contract specifies the price at which a currency can be bought or sold at a future date. Daily currency futures trading closes each day on the IMM at 2 p.m. central time (CT), which is 3 p.m. ET. Many futures traders like to square up or close any open positions at the end of each trading session to limit their overnight exposure, or for margin requirements.

The 30 to 45 minutes leading up to the IMM closing occasionally generates a flurry of activity that spills over into the spot market. Because the amount of liquidity in the spot currency market is at its lowest in the New York afternoon, sharp movements in the futures markets can trigger volatility in the spot market around this time. There’s no reliable way to tell if or how the IMM close will trigger a move in the New York afternoon spot market, so you just need to be aware of it and know that it can distort prices in the short term.

The U.S. dollar index

The U.S. dollar index is a futures contract listed on the New York Board of Trade (NYBOT) and Dublin-based Financial Instruments Exchange (FINEX) futures exchanges. The dollar index is an average of the value of the U.S. dollar against a basket of six other major currencies, but it’s heavily weighted toward European currencies.

The exact weightings of other currencies in the U.S. dollar index are

• Euro: 57.6 percent
• Japanese yen: 13.6 percent
• British pound: 11.9 percent
• Canadian dollar: 9.1 percent
• Swedish krona: 4.2 percent
• Swiss franc: 3.6 percent

The European currency share of the basket — Eurozone, United Kingdom, Sweden, and Switzerland — totals 77.3 percent.

The U.S. dollar is the most important global currency, with the bulk of forex trading usually involving the dollar on one side of the transaction. Commodities are priced in dollars, and a vast amount of global currency reserves held by central banks are in dollars. This makes the dollar (also affectionately referred to as the greenback or the buck) the most liquid currency in the world. As a trader, you need to know if the dollar is strong or weak. The U.S. dollar index helps you do this because it gives you a broad-based view of how the dollar is performing in the G10 forex space. As a currency trader, be sure to follow the U.S. dollar index, especially its technical developments.

Currencies and Other Financial Markets

As much as we like to think of the forex market as the be all and end all of financial trading markets, it doesn’t exist in a vacuum. You may even have heard of some these other markets: gold, oil, stocks, and bonds.

There’s a fair amount of noise and misinformation about the supposed interrelationship among these markets and currencies or individual currency pairs. To be sure, you can always find a correlation between two different markets over some period of time, even if it’s only zero (meaning, the two markets aren’t correlated at all).

Be very careful about getting caught up in the supposed correlations between the forex market and other financial markets. Even when a high degree of correlation is found (meaning, the two markets move in tandem or inversely to each other), it’s probably over the long term (months or years) and offers little information about how the two markets will correlate in the short term (minutes, hours, and days). The other point to consider is that even if two markets have been correlated in the period, you have no guarantee that the correlation will continue to exist now or into the future. For example, depending on when you survey gold and the U.S. dollar, which supposedly have a strong negative correlation, you may find a correlation coefficient of as much as –0.8 (a solidly negative correlation) or as low as –0.2 (very close to a zero correlation, meaning that the two are virtually noncorrelated).

Always keep in mind that all the various financial markets are markets in their own right and function according to their own internal dynamics based on data, news, positioning, and sentiment. Will markets occasionally overlap and display varying degrees of correlation? Of course, and it’s always important to be aware of what’s going on in other financial markets. But it’s also essential to view each market in its own perspective and to trade each market individually.

With that rather lengthy disclaimer in mind, let’s look at some of the other key financial markets and see what conclusions we can draw for currency trading.

Gold

Gold is commonly viewed as a hedge against inflation, an alternative to the U.S. dollar, and as a store of value in times of economic or political uncertainty. Over the long term, the relationship is mostly inverse, with a weaker USD generally accompanying a higher gold price, and a stronger USD coming with a lower gold price. However, in the short run, each market has its own dynamics and liquidity, which makes short-term trading relationships generally tenuous.

Overall, the gold market is significantly smaller than the forex market, so if we were gold traders, we’d sooner keep an eye on what’s happening to the dollar, rather than the other way around. With that noted, extreme movements in gold prices tend to attract currency traders’ attention and usually influence the dollar in a mostly inverse fashion.

Oil

A lot of misinformation exists on the Internet about the supposed relationship between oil and the USD or other currencies, such as CAD, NOK, or JPY. The idea is that, because some countries are oil producers, their currencies are positively (or negatively) affected by increases (or decreases) in the price of oil. If the country is an importer of oil, the theory goes, its currency will be hurt (or helped) by higher (or lower) oil prices.

Correlation studies show no appreciable relationships to that effect, especially in the short run, which is where most currency trading is focused. When there is a long-term relationship, it’s as evident against the USD as much as, or more than, any individual currency, whether an importer or exporter of black gold.

The best way to look at oil is as an inflation input and as a limiting factor on overall economic growth. The higher the price of oil, the higher inflation is likely to be and the slower an economy is likely to grow. The lower the price of oil, the lower inflationary pressures are likely (but not necessarily) to be. Because the United States is a heavily energy-dependent economy and also intensely consumer-driven, the United States typically stands to lose the most from higher oil prices and to gain the most from lower oil prices. We like to factor changes in the price of oil into our inflation and growth expectations, and then draw conclusions about the course of the USD from them (see more in Chapter 7). Above all, oil is just one input among many.

Stocks

Stocks are microeconomic securities, rising and falling in response to individual corporate results and prospects, while currencies are essentially macroeconomic securities, fluctuating in response to wider-ranging economic and political developments. As such, there is little intuitive reason that stock markets should be related to currencies. Long-term correlation studies bear this out, with correlation coefficients of essentially zero between the major USD pairs and U.S. equity markets over the last five years.

The two markets occasionally intersect, though this is usually only at the extremes and for very short periods. For example, when equity market volatility reaches extraordinary levels (say, the Standard & Poor’s [S&P] loses 2+ percent in a day), the USD may experience more pressure than it otherwise would — but there’s no guarantee of that. The U.S. stock market may have dropped on an unexpected hike in U.S. interest rates, while the USD may rally on the surprise move.

In another example, the Japanese stock market is more likely to be influenced by the value of the JPY, due to the importance of the export sector in the Japanese economy. A rapid rise in the value of the JPY, which would make Japanese exports more expensive and lower the value of foreign sales, may translate to a negative stock-market reaction on the expectation of lower corporate sales and profitability.

Bonds

Fixed income or bond markets have a more intuitive connection to the forex market because they’re both heavily influenced by interest rate expectations. However, short-term market dynamics of supply and demand interrupt most attempts to establish a viable link between the two markets on a short-term basis. Sometimes the forex market reacts first and fastest depending on shifts in interest rate expectations. At other times, the bond market more accurately reflects changes in interest rate expectations, with the forex market later playing catch-up (because it takes longer to turn a bigger ship around).

Overall, as currency traders, you definitely need to keep an eye on the yields of the benchmark government bonds of the major-currency countries to better monitor the expectations of the interest rate market. Changes in relative interest rates exert a major influence on forex markets. (See Chapter 7 for more on interest rates and currencies.)

Getting Started with a Practice Account

For newcomers to currency trading, the best way to get a handle on what currency trading is all about is to open a practice account at any of the online forex brokers. Most online forex brokers offer practice accounts to allow you to experience the real-life price action of the forex market. Practice accounts are funded with “virtual” money, so you’re able to make trades with no real money at stake and gain experience in how margin trading works.

Practice accounts give you a great chance to experience the minute-to-minute price movements of the forex market. You’ll be able to see how prices change at different times of the day, as well as how various currency pairs may differ from each other. Be sure to check out the action when major news and economic data is released, so you can get a sense of how the forex market reacts to new information.

In addition to witnessing how the forex market really moves, you can

• Start trading in real market conditions without any fear of losing money.
• Experiment with different trading strategies to see how they work.
• Gain experience using different orders and managing open positions.
• Improve your understanding of how margin trading and leverage work.
• Start analyzing charts and following technical indicators.

We think using a practice account while you read this book is a great way to experience many of the ideas and concepts we introduce. If a picture is worth a thousand words, then a real-time currency trading platform with constantly changing prices, market updates, and charting tools has to be worth a book. We’d like to think we’re pretty good at explaining how currency trading works, but nothing beats being able to see it for yourself.

We recommend that you open practice accounts with a few different forex brokers, because each trading platform has varying capabilities and functionalities. In addition, different brokers have different trading policies, charting packages, and research offerings. Also, try to get a feel for the level of customer support you’ll receive as a client. (You can find more information on choosing a forex broker on the Cheat Sheet.)