Foreign Exchange Market

The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another. It is by far the largest market in the world, in terms of cash value traded, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. Retail traders (small speculators) are a small part of this market. They may only participate indirectly through brokers or banks and may be targets of forex scams.

Contents Market size and liquidity Trading characteristics Market participants Banks Commercial Companies Central Banks Investment Management Firms Hedge Funds Retail Forex Brokers Speculation Reference See also External links

Market size and liquidity

The foreign exchange market is unique because of:

• its trading volume,
• the extreme liquidity of the market,
• the large number of, and variety of, traders in the market,
• its geographical dispersion,
• its long trading hours - 24 hours a day (except on weekends).
• the variety of factors that affect exchange rates,

Average daily international foreign exchange trading volume was $1.9 trillion in April 2004 according to the BIS study Triennial Central Bank Survey 2004

• $600 billion spot
• $1,300 billion in derivatives, ie
  • $200 billion in outright forwards
  • $1,000 billion in forex swaps
  • $100 billion in FX options.

Exchange-traded forex futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts. Forex futures volume has grown rapidly in recent years, but only accounts for about 7% of the total foreign exchange market volume, according to The Wall Street Journal Europe (5/5/06, p. 20).

Top 10 Currency Traders

% of overall volume, May 2005

Rank	Name	% of volume
1	Deutsche Bank	17.0
2	UBS	12.5
3	Citigroup	7.5
4	HSBC	6.4
5	Barclays	5.9
6	Merrill Lynch	5.7
7	J.P. Morgan Chase	5.3
8	Goldman Sachs	4.4
9	ABN AMRO	4.2
10	Morgan Stanley	3.9

The ten most active traders account for almost 73% of trading volume, according to The Wall Street Journal Europe, (2/9/06 p. 20). These large international banks continually provide the market with both bid (buy) and ask (sell) prices. The bid/ask spread is the difference between the price at which a bank or market maker will sell ("ask", or "offer") and the price at which a market-maker will buy ("bid") from a wholesale customer. This spread is minimal for actively traded pairs of currencies, usually only 1-3 pips. For example, the bid/ask quote of EUR/USD might be 1.2200/1.2203. Minimum trading size for most deals is usually $1,000,000.

These spreads might not apply to retail customers at banks, which will routinely mark up the difference to say 1.2100 / 1.2300 for transfers, or say 1.2000 / 1.2400 for banknotes or travelers' cheques. Spot prices at market makers vary, but on EUR/USD are usually no more than 5 pips wide (i.e. 0.0005). Competition has greatly increased with pip spreads shrinking on the majors to as little as 1 to 1.5 pips.

Trading characteristics

There is no single unified foreign exchange market. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currency instruments are traded. This implies that there is no such thing as a single dollar rate - but rather a number of different rates (prices), depending on what bank or market maker is trading. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs.

Top 6 Most Traded Currencies

Rank	Currency	ISO 4217 Code	Symbol
1	United States dollar	USD	$
2	Eurozone euro	EUR	€
3	Japanese yen	JPY	¥
4	British pound sterling	GBP	£
5-6	Swiss franc	CHF	-
5-6	Australian dollar	AUD	$

The main trading centers are in London, New York, and Tokyo, but banks throughout the world participate. As the Asian trading session ends, the European session begins, then the US session, and then the Asian begin in their turns. Traders can react to news when it breaks, rather than waiting for the market to open.

There is little or no 'inside information' in the foreign exchange markets. Exchange rate fluctuations are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in GDP growth, inflation, interest rates, budget and trade deficits or surpluses, and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers order flow. Trading legend Richard Dennis has accused central bankers of leaking information to hedge funds. [1]

Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX currency is expressed. For instance, EUR/USD is the price of the euro expressed in US dollars, as in 1 euro = 1.2045 dollar.

On the spot market, according to the BIS study, the most heavily traded products were:

• EUR/USD - 28 %
• USD/JPY - 17 %
• GBP/USD (also called cable) - 14 %

and the US currency was involved in 89% of transactions, followed by the euro (37%), the yen (20%) and sterling (17%). (Note that volume percentages should add up to 200% - 100% for all the sellers, and 100% for all the buyers). Although trading in the euro has grown considerably since the currency's creation in January 1999, the foreign exchange market is thus still largely dollar-centered. For instance, trading the euro versus a non-European currency ZZZ will usually involve two trades: EUR/USD and USD/ZZZ. The only exception to this is EUR/JPY, which is an established traded currency pair in the interbank spot market.

Market participants

According to the BIS study Triennial Central Bank Survey 2004

• 53% of transactions were strictly interdealer (ie interbank);
• 33% involved a dealer (ie a bank) and a fund manager or some other non-bank financial institution;
• and only 14% were between a dealer and a non-financial company.

Banks

The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account.

Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems, such as EBS, Reuters Dealing 3000 Matching (D2), the Chicago Mercantile Exchange, Bloomberg and TradeBook(R). The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.

Commercial Companies

An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

Central Banks

National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves, to stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high - that is, to trade for a profit. Nevertheless, central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.

The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives, however. The combined resources of the market can easily overwhelm any central bank. Several scenarios of this nature were seen in the 1992-93 ERM collapse, and in more recent times in South East Asia.

Investment Management Firms

Investment Management firms (who typically manage large accounts on behalf of customers such as pension funds, endowments etc.) use the Foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager with an international equity portfolio will need to buy and sell foreign currencies in the spot market in order to pay for purchases of foreign equities. Since the forex transactions are secondary to the actual investment decision, they are not seen as speculative or aimed at profit-maximisation.

Some investment management firms also have more speculative specialist currency overlay units, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. The number of this type of specialist is quite small, their large assets under management (AUM) can lead to large trades.

Hedge Funds

Hedge funds, such as George Soros's Quantum fund have gained a reputation for aggressive currency speculation since 1990. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.

Retail Forex Brokers

Retail forex brokers or market makers handle a minute fraction of the total volume of the foreign exchange market. According to CNN, one retail broker estimates retail volume at $25-50 billion daily, [2]which is about 2% of the whole market. CNN also quotes an official of the National Futures Association "Retail forex trading has increased dramatically over the past few years. Unfortunately, the amount of forex fraud has also increased dramatically."

All firms offering foreign exchange trading online are either market makers or facilitate the placing of trades with market makers.

In the retail forex industry market makers often have two separate trading desks- one that actually trades foreign exchange (which determines the firm's own net position in the market, serving as both a proprietary trading desk and a means of offsetting client trades on the interbank market) and one used for off-exchange trading with retail customers (called the "dealing desk" or "trading desk").

Many retail FX market makers claim to "offset" clients' trades on the interbank market (that is, with other larger market makers), e.g. after buying from the client, they sell to a bank. Nevertheless, the large majority of retail currency speculators are novices and who lose money , so that the market makers would be giving up large profits by offsetting. Offsetting does occur, but only when the market maker judges its clients' net position as being very risky.

The dealing desk operates much like the currency exchange counter at a bank. Interbank exchange rates, which are displayed at the dealing desk, are adjusted to incorporate spreads (so that the market maker will make a profit) before they are displayed to retail customers. Prices shown by the market maker do not neccesarily reflect interbank market rates. Arbitrage opportunities may exist, but retail market makers are efficient at removing arbitrageurs from their systems or limiting their trades.

A limited number of retail forex brokers offer consumers direct access to the interbank forex market. But most do not because of the limited number of clearing banks willing to process small orders. More importantly, the dealing desk model can be far more profitable, as a large portion of retail traders' losses are directly turned into market maker profits. While the income of a marketmaker that offsets trades or a broker that facilitates transactions is limited to transaction fees (commissions), dealing desk brokers can generate income in a variety of ways because they not only control the trading process, they also control pricing which they can skew at any time to maximize profits.

The rules of the game in trading FX are highly disadvantageous for retail speculators. Most retail speculators in FX lack trading experience and and capital (account minimums at some firms are as low as 250-500 USD). Large minimum position sizes, which on most retail platforms ranges from $10,000 to $100,000, force small traders to take imprudently large positions using extremely high leverage. Professional forex traders rarely use more than 10:1 leverage, yet many retail Forex firms default client accounts to 100:1 or even 200:1, without disclosing that this is highly unusual for currency traders. This drastically increases the risk of a margin call (which, if the speculator's trade is not offset, is pure profit for the market maker).

According to the Wall Street Journal (Currency Markets Draw Speculation, Fraud July 26, 2005) "Even people running the trading shops warn clients against trying to time the market. 'If 15% of day traders are profitable,' says Drew Niv, chief executive of FXCM, 'I'd be surprised.' "

In the US, "it is unlawful to offer foreign currency futures and option contracts to retail customers unless the offeror is a regulated financial entity" according to the Commodity Futures Trading Commission. Legitimate retail brokers serving traders in the U.S. are most often registered with the CFTC as "futures commission merchants" (FCMs) and are members of the National Futures Association (NFA). Potential clients can check the broker's FCM status at the NFA. Retail forex brokers are much less regulated than stock brokers and there is no protection similar to that from the Securities Investor Protection Corporation. The CFTC has noted an increase in forex scams

Forex Money Management

Put two rookie traders in front of the screen, provide them with your best high-probability set-up, and for good measure, have each one take the opposite side of the trade. More than likely, both will wind up losing money. However, if you take two pros and have them trade in the opposite direction of each other, quite frequently both traders will wind up making money - despite the seeming contradiction of the premise. What's the difference? What is the most important factor separating the seasoned traders from the amateurs? The answer is money management.

Like dieting and working out, money management is something that most traders pay lip service to, but few practice in real life. The reason is simple: just like eating healthy and staying fit, money management can seem like a burdensome, unpleasant activity. It forces traders to constantly monitor their positions and to take necessary losses, and few people like to do that. However, as Figure 1 proves, loss-taking is crucial to long-term trading success.

Amount of Equity Lost	Amount of Return Necessary to Restore to Original Equity Value
25%	33%
50%	100%
75%	400%
90%	1000%

Figure 1 - This table shows just how difficult it is to recover from a debilitating loss.

Note that a trader would have to earn 100% on his or her capital - a feat accomplished by less than 1% of traders worldwide - just to break even on an account with a 50% loss. At 75% drawdown, the trader must quadruple his or her account just to bring it back to its original equity - truly a Herculean task!

The Big One

Although most traders are familiar with the figures above, they are inevitably ignored. Trading books are littered with stories of traders losing one, two, even five years' worth of profits in a single trade gone terribly wrong. Typically, the runaway loss is a result of sloppy money management, with no hard stops and lots of average downs into the longs and average ups into the shorts. Above all, the runaway loss is due simply to a loss of discipline.

Most traders begin their trading career, whether consciously or subconsciously, visualizing "The Big One" - the one trade that will make them millions and allow them to retire young and live carefree for the rest of their lives. In FX, this fantasy is further reinforced by the folklore of the markets. Who can forget the time that George Soros "broke the Bank of England" by shorting the pound and walked away with a cool $1-billion profit in a single day? But the cold hard truth for most retail traders is that, instead of experiencing the "Big Win", most traders fall victim to just one "Big Loss" that can knock them out of the game forever.

Learning Tough Lessons

Traders can avoid this fate by controlling their risks through stop losses. In Jack Schwager's famous book "Market Wizards" (1989), day trader and trend follower Larry Hite offers this practical advice: "Never risk more than 1% of total equity on any trade. By only risking 1%, I am indifferent to any individual trade." This is a very good approach. A trader can be wrong 20 times in a row and still have 80% of his or her equity left.

The reality is that very few traders have the discipline to practice this method consistently. Not unlike a child who learns not to touch a hot stove only after being burned once or twice, most traders can only absorb the lessons of risk discipline through the harsh experience of monetary loss. This is the most important reason why traders should use only their speculative capital when first entering the forex market. When novices ask how much money they should begin trading with, one seasoned trader says: "Choose a number that will not materially impact your life if you were to lose it completely. Now subdivide that number by five because your first few attempts at trading will most likely end up in blow out." This too is very sage advice, and it is well worth following for anyone considering trading FX.

Money Management Styles

Generally speaking, there are two ways to practice successful money management. A trader can take many frequent small stops and try to harvest profits from the few large winning trades, or a trader can choose to go for many small squirrel-like gains and take infrequent but large stops in the hope the many small profits will outweigh the few large losses. The first method generates many minor instances of psychological pain, but it produces a few major moments of ecstasy. On the other hand, the second strategy offers many minor instances of joy, but at the expense of experiencing a few very nasty psychological hits. With this wide-stop approach, it is not unusual to lose a week or even a month's worth of profits in one or two trades. (For further reading, see Introduction To Types Of Trading: Swing Trades.)

To a large extent, the method you choose depends on your personality; it is part of the process of discovery for each trader. One of the great benefits of the FX market is that it can accommodate both styles equally, without any additional cost to the retail trader. Since FX is a spread-based market, the cost of each transaction is the same, regardless of the size of any given trader's position.

For example, in EUR/USD, most traders would encounter a 3 pip spread equal to the cost of 3/100th of 1% of the underlying position. This cost will be uniform, in percentage terms, whether the trader wants to deal in 100-unit lots or one million-unit lots of the currency. For example, if the trader wanted to use 10,000-unit lots, the spread would amount to $3, but for the same trade using only 100-unit lots, the spread would be a mere $0.03. Contrast that with the stock market where, for example, a commission on 100 shares or 1,000 shares of a $20 stock may be fixed at $40, making the effective cost of transaction 2% in the case of 100 shares, but only 0.2% in the case of 1,000 shares. This type of variability makes it very hard for smaller traders in the equity market to scale into positions, as commissions heavily skew costs against them. However, FX traders have the benefit of uniform pricing and can practice any style of money management they choose without concern about variable transaction costs.

Four Types of Stops

Once you are ready to trade with a serious approach to money management and the proper amount of capital is allocated to your account, there are four types of stops you may consider.

1. Equity Stop

This is the simplest of all stops. The trader risks only a predetermined amount of his or her account on a single trade. A common metric is to risk 2% of the account on any given trade. On a hypothetical $10,000 trading account, a trader could risk $200, or about 200 points, on one mini lot (10,000 units) of EUR/USD, or only 20 points on a standard 100,000-unit lot. Aggressive traders may consider using 5% equity stops, but note that this amount is generally considered to be the upper limit of prudent money management because 10 consecutive wrong trades would draw down the account by 50%.

One strong criticism of the equity stop is that it places an arbitrary exit point on a trader's position. The trade is liquidated not as a result of a logical response to the price action of the marketplace, but rather to satisfy the trader's internal risk controls.

Forex Broker Guide

Introduction

The following is a list of questions you may like to consider before opening an account. You can use this checklist to narrow down your selection of companies that fit your requirements. You may also wish to refer to the forex broker ratings page on this site to read about traders unique experiences with particular brokers.

Important Note to Traders: GoForex recommends you do not open an account with a U.S. based forex broker regulated by the CFTC and NFA, due to excessive and over-bearing regulation imposed on retail forex brokers including reduced leverage levels, the "no-hedging" rule and the FIFO (first-in, first-out) rule which affects the way you trade.

The following links will also give you some background information on U.S. FCM's (Futures Commission Merchants).

• Selected Financial Data for FCM's
• NFA Background Affiliation Status

1. Word of Mouth

• What do other traders say about the broker? See Forex Broker Ratings & Forex Broker Reviews
• What is their customer service like?

2. Customer Protection

• Is the broker regulated?
• What regulatory organisation are they registered with and what protections does it afford the client?
• Are client funds protected against fraud?
• Are client funds protected against bankruptcy?

3. Execution

• What business model do they operate? i.e. Are they a Market Maker[?], ECN[?] or no-dealing desk broker[?]?
• How fast is their order execution?
• Are orders manually or automatically executed? [?]
• What is the maximum trade size before you have to request a quote?
• Are all clients trades offset?

4. Spread [?]

• How small is the spread?
• Is it fixed or variable?

5. Slippage [?]

• How much slippage can be expected in normal and fast moving markets?

6. Margin [?]

• What is the margin requirement? e.g. 0.25% margin = max 400:1 leverage [?]), 0.5% margin = max 200:1 leverage, 1% margin = max 100:1 leverage, 2% margin = max 50:1 leverage, etc.
• Does the margin requirement change for different currency pairs or days of the week?
• At what point does the broker issue a margin call?
• Is required margin the same for standard and mini accounts? [?]

7. Commissions

• Does the broker charge commissions? (Most market makers commissions are built into the spread)

8. Rollover Policy [?]

• Is there a minimum margin requirement in order to earn rollover interest?
• What are the swap rates like for going long or short in a particular currency pair?
• Are there any other conditions for earning rollover interest?

9. Trading Platform

• How intuitive and functional is it to use?
• Are there many disconnections during trading hours?
• How reliable is it during fast moving markets and news announcements?
• How many different currency pairs are available to trade?
• Does the broker offer an Application Programming Interface (API) to allow clients to automate their trading systems?
• Does the broker offer any other special features? (e.g. One click dealing, trading from the chart, trailing stops, mobile trading etc.)

10. Trading Account

• What is the minimum balance required to open an account?
• What is the minimum trade size?
• Can clients adjust the standard lot size traded? [?]
• Can clients earn interest on the unused margin in their account?