The structure of the forex market

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In this chapter, we will learn about the structure of the forex market.

The structure of a typical stock market is as shown below −

But the structure of the forex market is rather unique because major volumes of transactions are done in Over-The-Counter (OTC) market which is independent of any centralized system (exchange) as in the case of stock markets.

The participants in this market are −

• Central Banks

• Major commercial banks

• Investment banks

• Corporations for international business transactions

• Hedge funds

• Speculators

• Pension and mutual funds

• Insurance companies

• Forex brokers

Hierarchy of Participants

The forex market structure may be represented as shown below −

Market Participants

In the above diagram, we can see that the major banks are the prominent players and smaller or medium sized banks make up the interbank market. The participants of this market trade either directly with each other or electronically through the Electronic Brokering Services (EBS) or the Reuters Dealing 3000-Spot Matching.

The competition between the two companies – The EBS and the Reuters 3000-Spot Matching in forex market is similar to Pepsi and Coke in the consumer market.

Some of the largest banks like HSBC, Citigroup, RBS, Deutsche Bank, BNP Paribas, Barclays Bank among others determine the FX rates through their operations. These large banks are the key players for global FX transactions. The banks have the true overall picture of the demand and supply in the overall market, and have the current scenario of any current. The size of their operations effectively lay down the bid-ask spread that trickles down to the lower end of the pyramid.

The next tier of participants are the non-bank providers such as retail market makers, brokers, ECNs, hedge funds, pension and mutual funds, corporations, etc. Hedge funds and technology companies have taken significant chunk of share in retail FX but very less foothold in corporate FX business. They access the FX market through banks, which are also known as liquidity providers. The corporations are very important players as they are constantly buying and selling FX for their cross-border (market) purchases or sales of raw or finished products. Mergers and acquisitions (M&A) also create significant demand and supply of currencies.

Sometimes, governments and centralized banks like the RBI (in India) also intervene in the Foreign Exchange market to stop too much volatility in the currency market. For instance, to support the pricing of rupees, the government and centralized banks buy rupees from the market and sell in different currencies such as dollars; conversely, to reduce the value of Indian rupees, they sell rupees and buy foreign currency (dollars).

The speculators and retail traders that come at the bottom of the pyramid pay the largest spread, because their trades effectively get executed through two layers. The primary purpose of these players are to make money trading the fluctuations in the currency prices. With the advancement of technology and internet, even a small trader can participate in this huge forex market.

Currency pair

If you are new to the forex market and have just started trading Forex online, you may find yourself overwhelmed and confused both at a time by the huge number of available currency pairs inside your terminal (like the MetaTrader4, etc.). So what are the best currency pairs to trade? The answers is not that straightforward as it varies with each trader and its terminal window or with what exchange (or OTC market) he is trading. Instead, you need to take the time to analyse different pairs of currencies against your own strategy to determine the best forex pairs to trade on your accounts.

The trade in Forex market occurs between two currencies, because one currency is being bought (buyer/bid) and another sold (seller/ask) at the same time. There is an international code that specifies the setup of currency pairs we can trade. For example, a quote of EUR/USD 1.25 means that one Euro is worth $1.25. Here, the base currency is the Euro(EUR), and the counter currency is the US dollar.

Commonly Used Currency Pair

In this section, we will learn about a few commonly used currency pair.

The most traded, dominant and strongest currency is the US dollar. The primary reason for this is the size of the US economy, which is the world’s largest. The US dollar is the preferred base or reference currency in most of the currency exchange transactions worldwide. Below are some of the most traded (high liquidity) currency pairs in the global forex market. These currencies are part of most of the foreign exchange transactions. However, this is not necessarily the best currency to trade for every trader, as this (which currency pair to choose) depends on multiple factors −

• EUR/USD (Euro – US Dollar)

• GBP/USD (British Pound – US Dollar)

• USD/JPY (US Dollar – Japanese Yen)

• USD/CHF ( US Dollar – Swiss Franc)

• EUR/JPY ( Euro – Japanese Yen)

• USD/CAD (US Dollar – Canadian Dollar)

• AUD/USD (Australian Dollar – US Dollar)

As prices of these major currencies keep changing and so do the values of the currency pairs change. This leads to a change in trade volumes between two countries. These pairs also represent countries that have financial power and are traded heavily worldwide. The trading of these currencies makes them volatile during the day and the spread tends to be lower.

EUR/USD Currency Pair

The EUR/USD currency pair is considered to be the most popular currency pair and has the lowest spread among modern world forex brokers. This is also the most traded currency pair in the world. About 1/3rd of all the trade in the market is done in this currency pair. Another important point is that this forex pair is not too volatile. Therefore, if you do not have that much risk appetite you can consider this currency pair to trade.

The following diagram shows some of the major currency pairs and their values −

Note − The above currency pair quotes were taken from www.finance.google.com.

The Bid-Ask Spread

The spread is the difference between the bid price and the ask price. The bid price is the rate at which you can sell a currency pair and the ask price is the rate at which you can buy a currency pair (EUR/USD).

Whenever you try to trade any currency pair, you will notice that there are two prices shown, as shown in the image below −

The following image shows the spread between USD and INR (US Dollar – Indian Rupees) pair.

(Source: Above data is taken from nseindia.com)

The lower price (67.2600 in our example) is called the “Bid” and it is the price at your broker (through which you’re trading) is willing to pay for buying the base currency (USD in this example) in exchange for the counter currency (INR in our case). Inversely, if you want to open a short trade (sell), you will do so at the price of 67.2625 in our example. The higher price (67.2625) is called the ‘Ask’ price and it is the price at which the broker is willing to sell you the base currency (USD) against the counter currency (INR).

What are Bullish and Bearish Markets?

The term “bull” (bullish) and “bear” (bearish”) are often used to describe how the overall financial market is performing in general – whether there is an appreciation or depreciation. Simply put, a bull (bullish) market is used to describe conditions where market is rising and a bear (bearish) market is the one where market is going down. It is not, a single day which describes if the market is in bullish or bearish form; it is a couple of weeks or months which tell us if the market is in the bull(bullish) or the bear(bearish) grip.

What happens in a Bull Market?

In a bull market, the confidence of the investor or the traders is high. There is optimism and positive expectations that good results will continue. So in all, bull market occurs when the economy is performing well – unemployment is low, GDP is high and stocks marketsare rising.

The bull market is generally related with the equity (stock) market but it applies to all financial markets like currencies, bonds, commodities, etc. Therefore, during a bull market everything in the economy looks great - the GDP is growing, there is less unemployment, the equity prices are rising, etc.

All this leads to rises not only in stock market but also in FX currencies such as Australian Dollar (AUD), New Zealand Dollar (NZD), Canadian Dollar (CAD) and emerging market currencies. Conversely, the bull market generally leads to a decline in safe-haven currencies such as US dollar, the Japanese yen or the Swiss franc (CHF).

Why does it Matter to You?

Forex trading is always done in pairs, where if one currency is weakening the other is strengthening. As you can trade both ways means you can take a long (buy) or short (sell) view in either currency pair, thereby allowing you to take advantage of rising and falling markets.

In forex market, bull and bear trends also determine which currency is stronger and which is not. By correctly understanding the market trends, a trader can make proper decisions of how to manage risk and gain a better understanding of when it is best to enter and exit from your trades.

What happens in a Bear Market?

A bear market denotes a negative trend in the market as the investor sells riskier assets such as stock and less-liquid currencies such as those from emerging markets. The chances of loss are far greater because prices are continually losing value. Investor or traders are better off short-selling or moving to safer investments like gold or fixed-income securities.

In a bearish market, investor generally moves to safe-haven currencies like Japanese Yen (JPY) and US Dollar (USD) and sold off riskier instruments.

Why does it Matter to You?

Because a trader can earn great profit during bull and bear market considering you are trading with the trend. As forex trading is always done in pairs, buy the strength and sell the weak should be your trade.

What is Lot size?

Let us now learn what a lot size is.

A lot is a unit to measure the amount of the deal. Your value of your trade always corresponds to an integer number of lots (lot size * number of lots).

Trading with the proper position or lot size on each trade is key to successful forex trading. The position size refers to how many lots (micro, mini or standard) you take on a particular trade.

The standard size for a lot is 100,000 units of base currency in a forex trade, and now we have mini, micro and nano lot sizes that are 10,000, 1,000 and 100 units respectively.

What is long in forex trade?

Whenever you purchase (buy) a currency pair, it is called going long. When a currency pair is long, the first currency is purchased (indicating, you are bullish) while the second is sold short (indicating, you are bearish).

For example, if you are purchasing a EUR/INR currency pair, you expect that the price of Euro will go high and the price of Indian rupees (INR) will go down.

What is short in forex trade?

When you go short on a forex, the first currency is sold while the second currency is bought. To go short on a currency means you sell it hoping that its prices will decline in future.

In forex trade, whether you are making “long” (buying a currency pair) or “short” (selling a currency pair) trades, you are always long on one currency and short on another. Therefore, if you sell, or go short on USD/INR, then you are long on INR and short on USD. It means you expect the prices of INR (Indian rupees) will rise and the price of the USD (US dollar) will fall.

What are Pending Orders in Forex Trade?

A pending order in any trade is an order that was not yet executed thus not yet becoming a trade. Generally, while trading we place the order with a limit, means our order (pending trade) will not get executed if the price of a financial instrument does not reach a certain point.

A large section of traders follows technical analysis, so if anyone (traders or investors) wants to place an order at the support or resistance level but currently market is not on these levels, then he/she can place pending order rather than waiting. Pending order will automatically get executed once price reaches to the pending order position. The following are the four types of pending order −

Buy Limit

A pending order to buy a currency at a lower price (whatever price trader wants to buy) than the current one.

Buy Stop

A pending order to buy a currency at a higher price (whatever price trader wants to execute) than the current one.

Sell Limit

A pending order to sell a currency pair at a higher price (whatever price trader wants to sell) than the current price.

Sell Stop

A pending order to sell a currency pair at a lower price (buy high, sell low).

What is Leverage and Margin?

In this chapter, we will learn about leverage and margin and how these influence the financial market.

What is Leverage?

Forex trading provides one of the highest leverage in the financial market. Leverage means having the ability to control a large amount of money using very little amount of your own money and borrowing the rest.

For example, to trade a $10,000 position (traded value of security); your broker wants $100 from your account. Your leverage, which is expressed in ratios, is now 100:1.

In short, with mere $100, you are controlling $10,000.

Therefore, if during the trade $10,000 investment rises in value to $10,100, it means a rise in $100. Because you are leveraged 100:1, your actual amount invested is $100 and your gain is $100. This in turn your return to a groovy 100%.

In such case, the trade goes in your favor. What if, you have ended up with a -1% return ($10,000 position). -100% return using 100:1 leverage.

Therefore, risk management of leverage position is very important for every trader or investor.

What is Margin?

Margin is the amount of money your trading account (or broker needs) should have as a “good faith deposit” to open any position with your broker.

So consider the leverage example in which we are able to take position of $100,000 with an initial deposit amount of $1000.

This $1000 deposit amount is called “margin” you had to give in order to initiate a trade and use leverage.

Your broker to maintain your position uses it. The broker collects margin money from each of its client (customer) and uses this “super margin deposit” to be able to place trades within the interbank network.

Margin is expressed as a percentage of the full amount of the position. Your margin may vary from 10% to .25% margin. Based on the margin required by your broker, you can calculate the maximum leverage you can yield with your trading account.

For example, if your broker required 5% margin, you have the leverage of 20:1 and if your margin is 0.25%, you can have leverage of 400:1.

Hedging

Hedging is basically a strategy which is intended to reduce possible risks in case prices movement against your trade. We can think of it with something like “insurance policy” which protects us from particular risk (consider your trade here).

To protect against a loss from a price fluctuation in future, you usually open an offsetting position in a related security. Traders and investors usually use hedging when they are not sure which way the market will be heading. Ideally, hedging reduces risks to almost zero, and you end up paying only the broker's fee.

A trader can utilize hedging in the following two ways −

To open a position in an off-setting instrument

The offsetting instrument is a related security to your initial position. This allows you to offset some of the potential risks of your position while not depriving you of your profit potential completely. One of the classic example would be to go long say an airline company and simultaneously going long on crude oil. As these two sector are inversely related, a rise in crude oil prices will likely cause your airline long position to suffer some losses but your crude oil long helps offset part or all of that loss. If the oil prices remain steady, you may profit from the airline long while breaking even on your oil position. If the prices of oil goes down, the oil long will give you losses but the airline stock will probably rise and mitigate some or all your losses. So hedging helps to eliminate not all but some of your risks while trading.

To buy and/or sell derivative (future/forward/option) of some sort in order to reduce your portfolio’s risk as well as reward exposure, as opposed to liquidating some of your current positions. This strategy may come handy where you do not want to directly trade with your portfolio for a while due to some market risks or uncertainties, but you rather not liquidate part or all of it for other reasons. In this type of hedging, the hedge is straightforward and can be calculated precisely.

Stop Losses

A stop-loss is an order placed in your trading terminal to sell a security when it reaches a specific price. The primary goal of a stop loss is to mitigate an investor’s loss on a position in a security (Equity, FX, etc.). It is commonly used with a long position but can be applied and is equally profitable for a short position. It comes very handy when you are not able to watch the position.

Stop-losses in Forex is very important for many reasons. One of the main reason that stands out is no one can predict the future of the forex market every time correctly. The future prices are unknown to the market and every trade entered is a risk.

Forex traders can set stops at one fixed price with an expectation of allocating the stoploss and wait until the trade hits the stop or limit price.

Stop-loss not only helps you in reducing your loss (in case trade goes against your bet) but also helps in protecting your profit (in case trade goes with the trend). For example, the current USD/INR rate is 66.25 and there is an announcement by the US federal chairperson on whether there will be a rate hike or not. You expect there will be a lot of volatility and USD will rise. Therefore, you buy the future of USD/INR at 66.25. Announcement comes and USD starts falling and suppose you have put the stop-loss at 66.05 and USD falls to 65.5; thus, avoiding you from further loss (stop-loss hit at 66.05). Inversely in case USD starts climbing after the announcement, and USD/INR hit 67.25. To protect your profit you can set stop-loss at 67.05(assume). If your stop-loss hit at 67.05(assume), you make profit else, you can increase your stop-loss and make more profit until your stop-losses hit.