Forex Definition

If you have ever taken a trip to a foreign country, chances are you had to exchange your domestic currency for the currency of the foreign country. Unbeknownst to you, you were part of the largest financial market in the world – the Forex market. If you’re interested in becoming a Forex trader now, then you’re in the right place. In this article, we’ll be covering everything you need to know about the exciting market known as Forex.

What is Forex? Here’s an overview

First, let’s define Forex. Forex is an abbreviation for the term "foreign exchange", which is the largest financial market in the world in terms of daily trading turnover. According to the Bank of International Settlement, the Forex market trades around 5 trillion USD per day. To put this is into perspective, the GDP of the United States is around $18 trillion, which means that the Forex market trades the entire US economy in three to four days!

The Forex market is the marketplace of the world’s currencies. Large companies, governments, central banks, hedge funds, investors, and retail traders exchange currencies every day, though with different objectives. Large companies usually have to take part in Forex to sell their products overseas, governments and central banks operate on the market to stabilise their currencies, while investors and traders want to make a profit from trading currencies.

As you’re probably in the group of traders, we’ll focus on retail currency trading for the rest of this article. Just like stock traders do with stocks, Forex traders make profits by buying a currency cheap and selling it later at a higher price. The difference in the buying and selling price of a currency would be your profit. If the euro vs US dollar pair (EUR/USD) trades at 1.20 and your analysis shows that it could rise to 1.25, you should buy the pair at 1.20 and sell it when the price goes up.

However, in the Forex market you can also make money during downtrends, with a technique called short-selling. When short-selling a currency, you’re betting that the value of the currency will fall in the coming period. Let’s say EUR/USD is currently trading at 1.20 and you expect it will fall to 1.15 – you could short-sell the pair and make a hefty profit of 500 pips (pips are the fourth decimal of an exchange rate).

What currencies are traded on Forex?

Now that you know what Forex is, let’s define what currencies are traded on it. Generally, currencies can be grouped into two categories: major currencies and exotic currencies.

Major currencies are the most actively traded currencies on the Forex market, meaning they’re the most liquid currencies as a large number of buyers and sellers are trading them around the world. There are eight major currencies: the US dollar (USD), euro (EUR), the British pound (GBP), the Swiss franc (CHF), the Japanese yen (JPY), the Canadian dollar (CAD), the Australian dollar (AUD), and the New Zealand dollar (NZD). If we expand this list to cover all G10 currencies, then the Norwegian krone (NOK) and Swedish krone (SEK) also make it to the list.

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Exotic currencies are all other currencies which are not actively traded on the Forex market. Examples of exotic currencies are the Turkish lira, Argentina peso, Mexican peso, South African rand, Russian ruble, Czech krone, and so on. Exotic currencies are way less liquid than majors (meaning there are less buyers and sellers), which makes them way more volatile than major currencies. While exotic currencies have significant profit potential, they should usually be avoided by beginners to prevent large losses.

Just like stocks, all currencies have their own personalities when it comes to trading. Some of them behave as safe-havens and appreciate when investors don’t want to take on risk on the market – examples being the Japanese yen and Swiss franc. Some currencies are heavily correlated with the price of commodities, such as the New Zealand dollar, Australian dollar, Canadian dollar, and most South American currencies. Traders need to know how currencies behave under certain conditions to make the most out of their Forex trading.

How are currencies quoted?

All currencies are quoted in pairs. This means, you’re actually trading two currencies simultaneously: in a long position, the first currency is bought and the second is sold; and in a short position, the first currency is sold and the second bought.

The first currency of a currency pair is called the base currency, while the second is called the counter currency. If we take EURUSD for example, euro would be the base currency, and the US dollar the counter   currency. If you want to buy the EURUSD pair, you’re actually buying the euro and selling the US dollar at the same time.

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Any pair that includes the US dollar and one of the remaining seven major currencies is called a major pair. On the other hand, pairs that include a combination of the remaining seven currencies (except the US dollar) are called cross-pairs. Finally, pairs that include exotic currencies are named exotic pairs. Major pairs usually have the lowest transaction costs on the Forex market.

The exchange rate of a currency pair represents the price of the base currency expressed in terms of the counter-currency. If the EUR/USD pair trades at 1.2000, this means that it takes 1.2000 US dollars to buy 1 euro. You’ll also notice that there are two exchange rates at which a pair is trading – those are called the bid price and the ask price, and the actual price you’re paying depends on whether your position is long or short. Bid and ask prices are usually very close together, especially with major currency pairs, and the difference between them represents your transaction cost or “spread”.

When are currencies traded?

The Forex market is an over-the-counter (OTC) market, which means that there is no centralised exchange for trading currencies. Instead, they’re traded during various Forex trading sessions, with some of the most important being the New York session, the London session, the Tokyo session, and the Sydney session. In the following table, you’ll find the trading hours for each of the sessions.

LOCAL TIME

EST

GMT

Sydney Open – 7:00 AM

Sydney Close  – 4:00 PM

3:00 PM

12:00 AM

8:00 PM

5:00 AM

Tokyo Open – 9:00 AM

Tokyo Close – 6:00 PM

7:00 PM

4:00 AM

12:00 PM

9:00 AM

London Open – 8:00 AM

London Close – 4:00 PM

3:00 AM

11:00 AM

8:00 AM

4:00 PM

New York Open – 8:00 AM

New York Close – 5:00 PM

8:00 AM

5:00 PM

1:00 PM

10:00 PM

 

Do you see how the New York session and London session overlap? This is called the NY-London overlap, and during these hours the majority of Forex trades are executed. These hours also provide the largest volatility in the market, as the United States and Europe publish their major news releases in these times, including the non-farm payrolls, unemployment rates, and inflation rates, for example.

How to analyse the Forex market

To find tradeable trade setups, you need to analyse the market. Every trader has their own approach to market analysis, but there still remain certain techniques that are widely popular among market participants.

The main ways to analyse the Forex market are fundamental analysis, and technical analysis.

Fundamental analysis involves the determination of the equilibrium, or “fair” value of a currency. To do so, traders follow important macro-numbers such as economic growth, unemployment rates, inflation rates, wage growth, and so on. It’s important to learn about fundamental analysis early in your trading career, as fundamental factors are what creates trends and reverses them.

Technical analysis, on the other hand, involves the analysis of pure price-charts to find trading opportunities. Technical analysis is based on three premises: (1) the price discounts all news, (2) markets like to trend, and (3) history repeats itself.

As you can see, pure technical analysts don’t pay much attention to news, as the market should have already priced-in all news. Since history repeats itself, according to technical analysis, traders follow the price-chart and look for familiar price patterns that have worked well previously. Even though technical analysis has a proven track record, the best results in trading are still achieved by combining technical and fundamental analysis and focusing on longer-term timeframes.

Conclusion: defining Forex

In this article, we defined Forex and covered all of the important aspects of the Forex market. To conclude, Forex is the largest financial market in the world and the marketplace of the world’s currencies. There are eight major currencies to trade on, followed by exotic currencies that account for a relatively small share of the total daily trading volume.

All currencies are quoted in pairs, consisting of the base and counter currency, and are traded during the four major Forex trading sessions using fundamental and technical analysis.

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