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Introduction to the Foreign Exchange

What is Forex?

FOREX, an acronym for Foreign Exchange, is the largest financial market in the world. With an estimated $4.5 trillion in currencies traded daily, Forex provides income to millions of traders and large banks worldwide. The market is so large in volume that it would take the New York Stock Exchange, with a daily average of under $20 billion, almost three months to reach the amount traded in one day on the Foreign Exchange Market.
Forex, unlike other financial markets, is not tied to an actual stock exchange. Forex is an over-the-counter (OTC) or off-exchange market.

Purpose

The foreign exchange market is the mechanism by which currencies are valued relative to one another, and exchanged. An individual or institution buys one currency and sells another in a simultaneous transaction. Currency trading always occurs in pairs where one currency is sold for another and is represented in the following notation: EUR/USD or CHF/YEN. The exchange rate is determined through the interaction of market forces dealing with supply and demand.

Foreign ExchangeTraders generate profits, or losses, by speculating whether a currency will rise or fall in value in comparison to another currency.

A trader would buy the currency which is anticipated to gain in value, or sell the currency which is anticipated to lose value against another currency. The value of a currency, in the simplest explanation, is a reflection of the condition of that country's economy with respect to other major economies. The Forex market does not rely on any one particular economy. Whether or not an economy is flourishing or falling into a recession, a trader can earn money by either buying or selling the currency. Reactive trading is the buying or selling of currencies in response to economic or political events, while speculative trading is based on a trader anticipating events.

Background

Historically, Forex has been dominated by inter-world investment and commercial banks, money portfolio managers, money brokers, large corporations, and very few private traders. Lately this trend has changed. With the advances in internet technology, plus the industry's unique leveraging options, more and more individual traders are getting involved in the market for the purposes of speculation. While other reasons for participating in the market include facilitating commercial transactions (whether it is an international corporation converting its profits, or hedging against future price drops), speculation for profit has become the most popular motive for Forex trading for both big and small participants.

Operation

The 8 Major Currencies:

Whereas there are thousands of securities on the stock market, in the FOREX market most trading takes place in only a few currencies; the U.S. Dollar ($), European Currency Unit (€), Japanese Yen (¥), British Pound Sterling (£), Swiss Franc (Sf), Canadian Dollar (Can$), and to a lesser extent, the Australian and New Zealand Dollars. These major currencies are most often traded because they represent countries with esteemed central banks, stable governments, and relatively low inflation rates.

Currencies are also always traded in pairs (i.e. USD/JPY or Dollar/Yen) at floating exchange rates.

A 24 Hour Market:

The foreign exchange market operates 24 hours a day, and, unlike the stock market, has no official openings or closings. It moves in response to geopolitical events, press releases from key central banks, and reports on the economy from government statistical bureaus, among many other factors. When traders are inactive in one part of the world due to nightfall, there are traders elsewhere who are actively engaging in trades as it is daytime in their locations.

The daily session "ends" at 5PM EST, but the market does not actually close. The Forex market only closes on Friday at 4PM EST for the weekend, and re-opens at 5 PM EST on Sunday. Each day, trading begins in Sydney, Australia, and progresses to the next major financial center (Tokyo, London, New York), as the business hours in that city's time zone begin.

Business Hours of Financial Centers:

Trading volumes in a given region are always highest during its primary business hours, when traders at financial institutions are busy filling and placing orders. The most active times, meaning the times of most liquidity and movement in the markets, is the London open (3 AM EST), and the overlap between London/Euro close and New York's open (8-11 AM EST).

The hours below correspond to someone living in the EST time zone.
New York session opens at 8:00 am and ends around 5:00 pm.
Sydney session starts at 5:00 pm and ends around 2:00 am.
Tokyo session begins at 7:00 pm and ends around 4:00 am.
Frankfurt session opens at 2:00 am and ends around 11:00 am.
London opens at 3:00 am and ends around 12:00 am.

Below is a figure showing business hours in the various regions, oriented for someone in the EST time zone. In this figure you can see the overlap between the European/London session and the New York session, between 8 am and 11 am EST. The currency markets experience the highest volatility and volume during that overlap, which also coincides with the release of important US economic figures.

Aspects of Trading

Most trades on the forex market are a result of traders speculating on price movements. Although good instincts and speculatory skills are invaluable to any trader, there are also other, more scientific indicators that traders use to decide whether they will buy or sell a certain currency. These are found by fundamental and technical analysis. A trader may utilize both technical and fundamental analysis before making any forex trades.

The Importance of Fundamental Analysis

Fundamental factors include economic and political events (i.e. elections, wars) that occur worldwide. Monetary and fiscal policy, government reports such as GDP, CPI, PPI, and measures such as the unemployment rate also fall in this category. A trader that makes his or her market decisions in response to these releases and events is using fundamental analysis. The value of a currency in the forex market is essentially an indication of the state of one nation's economy in comparison to another nation's.

A nation's political condition, along with its inflation and interest rates, impact the price of the nation's currency. Traders that use fundamental analysis can speculate on currency price movements by paying attention to the world news, economic reports, and indicators issued by the government. By interpreting that data, traders become more informed market participants. It is important to note that it is the outlook on an event that impacts the forex market, rather than the actual event itself. If the report or news matches expectations it should have already been factored into the present market price. If a report or news item is unexpected, or is different from the anticipated results, then there will be a reaction by the currency markets to "price in" this new information. For more details explore fundamental analysis.

The Importance of Technical Analysis

Traders have a second tool to use in trading. Technical analysis, which has become extremely popular in the last two decades, consists of using charts, trend lines, support and resistance levels, technical indicators, and pattern identification to study the market's behavior. Traders use these technical factors to identify buying and selling opportunities. Over long historical periods, currency behavior has produced trends and patterns that are identifiable. For more details explore the basics of technical analysis.