What is Forex?
Liquidity, Volatility and Currency Pairs: What you need to know to understand foreign currencies trading
Foreign Exchange (Forex or FX) is the trade of global currencies. Investors trade major currencies of the world 24-hour a day, 5-day a week around the world, only stopping on weekends and major holidays.
Forex trading is attractive to both novice and experienced traders for a number of reasons:
- Global forex market trades nearly $6 trillion daily
- Larger than the NYSE, equities markets, and futures markets combined
- Forex exchanges allow higher leverage than typical trading accounts
- Open 24-hours a day, 5-days a week (closed for Forex Holidays)
- Lower fees than other markets
Liquidity and Volatility
Liquidity is determined by the volume of transactions and the number of people trading. Forex markets are considered highly liquid due to the depth of the market and 24-hour trading. Liquidity has several effects. In almost all cases high liquidity is better.
- Higher liquidity means a small spread. The spread is the difference between seller's asking price and the buyers offer. The difference between these two prices is the transaction fee. Higher liquidity means lower transaction fees.
- Higher liquidity also results in lower volatility. Volatility is how quickly the price moves. If there are more buyers and sellers then prices tend to move more slowly and smoothly. There can be large dips or jumps in price on the forex markets, especially when markets open at he beginning of the week or after big global political or financial news. However, large fluctuations in price are rare compared to other assets like stocks. Lower volatility means less risk but also less potential upside.
- High liquidity also means your trades will be filled faster. Less waiting around to find a buyer or seller. In times of high liquidity matching will occur very quickly.
Illiquidity means you are unable to sell your asset on demand. This can result in large price jumps. If you are on the wrong side of a big move it may be difficult to find a buyer. This can make a bad situation even worse.
When is the market most liquid?
Liquidity depends on a number of factors. Financial and political activity can have a big impact. However, there are a few predictable trends to liquidity:
- Beginning of the week
- After banking holidays
- Liquidity fluctuates throughout the week as markets in the U.S., Europe, and Asia open and close.
Our Forex Calendar is a great tool for staying informed about holidays around the world that make impact trading. Trading during the optimal Forex Hours can also help you find higher liquidity times. The best forex trading hours are during the overlap between trading hours in different regions of the world. For example, when European markets are nearing close and U.S. markets are just opening up can be a good time to trade major pairs like USD/EUR and USD/GBP.
Currency Pairs: Majors, Minors, Exotic and Commodity pairs
Currencies are traded as pairs. All major pairs include USD because it is the largest currency in the world. USDxxx indicates selling US Dollars for another currency. xxxUSD indicates selling some other currency for US Dollars.
The major currency pairs are:
- EUR/USD - called the Fiber or Euro
- Faster growing U.S. economy strengthens the US Dollar against the Euro and a faster growing EU economy strengthens the Euro against the Dollar.
- JPY/USD - called the Ninja
- This is the most common pair linking western financial markets with the east.
- GBP/USD - called the Cable
- Names due to steal cable that once ran across the ocean floor connecting the two countries. This is a highly liquid market with a low bid-ask spread.
- CHF/USD - called the Swissie
- This currency pair is popular due to the perceived stability of the Swiss Franc. In times of international conflict the Swiss Franc is historically seen as more stable than other currencies.
Minor Currency Pairs:
When a currency pair does not include the US Dollar is is considered "minor" or a "cross-currency pair." Most minor pairs consist of the Euro, Japanese Yen, and British Pound. This is not an exhaustive list. There are other popular minor pairs.
Commodity Currency Pairs:
Forex traders may want to increase their exposure to volatility in commodity markets (mainly oil). Some countries with abundant natural resources, such as Russia, Saudi Arabia and Venezuela, are highly regulated by their domestic government and trade very lightly. This makes those currency pairs poor for forex trading. Canada, Australia, New Zealand are stable, free markets with large reserves of natural resources. These pairs tend to correlate with the price of a barrel of oil. These commodity pairs are usually considered "major" pairs.
- CAD/USD - called the Loonie
- AUD/USD - called the Aussie
- NZD/USD - called the Kiwi
Exotic Currency Pairs:
Exotic pairs match major currencies with currencies of countries in the developing world. Exotic pairs are less common than the minor pairs so they will have lower liquidity and higher bid-ask spreads. Due to the large spread arbitrage opportunities may exist. Trading costs may also be higher because of lower liquidity.
The secondary currency in the exotic currency pair is usually an emerging market or strong but smaller economy. Common exotic pairs include European countries outside the Euro Zone, Hong Kong, or Singapore. Exotic pairs include:
- EUR/TRY - Euro / Turkish Lira
- USD/HKD - US Dollar / Hong Kong Dollar
- USD/SGD - US Dollar / Singapore Dollar
- USD/SEK - US Dollar / Swedish Krona
- USD/NOK - US Dollar / Norwegian Krone
- USD/ZAR - US Dollar / South African Rand
- USD/MXN - US Dollar / Mexican Peso
And the even more exotic...
- JPN/NOK - Japanese Yen / Norwegian Krone
- NZD/SGD - New Zealand Dollar / Singapore Dollar
- AUD/MXN - Australian Dollar / Mexican Peso
Reading Forex Quotes
As you have seen, all currencies are quoted as a pair. For a pair XXX/YYY, this means you are selling XXX and buying YYY.
For example EUR/USD = 1.166 means that for €1 you get $1.166.
Forex trades use a bid-ask system. This means quotations will often be represented as two prices: the bid price and the ask price. The bid is the maximum a market maker is willing to pay for a security and the ask price is the minimum at which they are willing to sell. The difference between the bid and the ask is the spread.
A smaller spread indicates higher liquidity. The buyer and seller are closer to making a deal so trades happen faster. The spread is the market maker's profit. This is the cost of placing a trade.
The spread for major pairs is often just a few hundredths of a percent (called pips - percentage in points). However the spread can be much larger for exotic pairs. Exotic pairs may have a spread of as high as 50 pips or 0.5%. This is expensive to trade a make take some time to fill.
How to Trade Forex?
Forex is not trading on traditional markets like common stocks. Instead you trade through a broken who is part of a network of dealers. When you make a trade on your brokers website they will match your trade with other users. The broken then may trade with other dealers in their network in order to maintain enough reserve on-hand.
When you start trading it is a good idea to start with a practice account. This lets you practice making trades to see if your strategy works. Also this ensures you know how the website works before you start trading. Forex trading is fast paced. There are lots of options and it can be easy to make a mistake. A simple mistake could mean losing serious money.
Consider using a website like tradingview.com to track current and historic pricing and to discuss strategy with an active community of traders.
Forex vs Crypto
The fundamentals of cryptocurrency trading are very similar to forex trading—currency is right in the name. Crypto trading is also conducted by trading "currency pairs." Traders swap multiple currencies hoping to gain from the change in relative values over time. Crypto traders may trade:
- Cryptocurrencies (Bitcoin, Ethereum, etc.)
- Altcoins (Litecoin, Dash, Monero, Zcash, etc)
- Tokens (ERC-20 tokens build on top of Ethereum or other smart-contract platform)
- Stable-coins (Tether or Gemini Dollars)
- Fiat currencies (USD, Euro, etc.)
Despite the similar concepts, there are important differenced between traditional forex trading and crypto trading. Investors must be wary. Cryptocurrencies are notorious for their extreme volatility. It is not uncommon for cryptocurrencies to fluctuate 10-20% or more in the span of hours. Altcoins can fluctuate significantly more.
This high volatility is due to multiple factors including:
- Low liquidity for some currency pairs
- Highly speculative investing (See: Greater Fool Theory)
- Price manipulation through "pump-and-dump" schemes
- Immature assets without widely agreed upon methods for price evaluation
Crypto markets, because of the distributed nature, are difficult to regulate. Markets are wrought with fraud and price manipulation.
However, savvy investors can make money forex trading crypto. Crypto trading is legal in most jurisdictions including the United States, most of Europe, and parts of Asia. Regulations are changing constantly. You are responsible to knowing the law in your jurisdiction. Laws may change and this article will not be updated as quickly.
If you do choose to trade crypto, many of the same concepts and strategies from traditional forex apply to crypto. Generally, it is accepted that it's better to trade during times of high volume and high liquidity. Cryptocurrency is trading more heavily by retail traders. Retail traders do not adhere to typical trading hours and market holidays the way institutional investors do. Crypto markets are open 24/7/365. They never close (historically markets have only closed due to technical or legal issues).
Learn more about cryptocurrency trading hours.