The foreign exchange market — most often called the forex
market, or simply the FXmarket — is the most traded finan-
cial market in the world. We like to think of the forex market as
the “Big Kahuna” of financial markets. The forex market is the
crossroads for international capital, the intersection through
which global commercial and investment flows have to move.
International trade flows, such as when a Swiss electronics
company purchases Japanese-made components, were the
original basis for the development of the forex markets.
Today, however, global financial and investment flows dominate
trade as the primary non-speculative source of forex market
volume. Whether it’s an Australian pension fund investing in
U.S. Treasury bonds, or a British insurer allocating assets to the
Japanese equity market, or a German conglomerate purchasing
a Canadian manufacturing facility, each cross-border transac-
tion passes through the forex market at some stage.
More than anything else, the forex market is a trader’s market.
It’s a market that’s open around the clock six days a week,
enabling traders to act on news and events as they happen.
It’s a market where half-billion-dollar trades can be executed
in a matter of seconds and may not even move prices notice-
ably. Try buying or selling a half billion of anything in another
market and see how prices react.
Getting Inside the Numbers
Average daily currency trading volumes exceed $2 trillion
per day. That’s a mind-boggling number, isn’t it?
$2,000,000,000,000 — that’s a lot of zeros, no matter how you
slice it. To give you some perspective on that size, it’s about
10 to 15 times the size of daily trading volume on all the
world’s stock markets combined.
Speculating in the
currency market
While commercial and financial transactions in the currency
markets represent huge nominal sums, they still pale in compar-
ison to amounts based on speculation. By far the vast majority
of currency trading volume is based on speculation — traders
buying and selling for short-term gains based on minute-to-
minute, hour-to-hour, and day-to-day price fluctuations.
Estimates are that upwards of 90 percent of daily trading
volume is derived from speculation (meaning, commercial or
investment-based FX trades account for less than 10 percent
of daily global volume). The depth and breadth of the specula-
tive market means that the liquidity of the overall forex
market is unparalleled among global financial markets.
The bulk of spot currency trading, about 75 percent by
volume, takes place in the so-called “major currencies,” which
represent the world’s largest and most developed economies.
Additionally, activity in the forex market frequently functions
on a regional “currency bloc” basis, where the bulk of trading
takes place between the USD bloc, JPY bloc, and EUR bloc,
representing the three largest global economic regions.
Getting liquid without
getting soaked
Liquidityrefers to the level of market interest— the level of
buying and selling volume — available at any given moment
for a particular asset or security. The higher the liquidity, or
the deeper the market, the faster and easier it is to buy or sell
a security.
From a trading perspective, liquidity is a critical consideration
because it determines how quickly prices move between
trades and over time. A highly liquid market like forex can see
large trading volumes transacted with relatively minor price
changes. An illiquid, or thin, market tends to see prices move
more rapidly on relatively lower trading volumes. A market
that only trades during certain hours (futures contracts, for
example) also represents a less liquid, thinner market.
Around the World in a Trading Day
The forex market is open and active 24 hours a day from the
start of business hours on Monday morning in the Asia-Pacific
time zone straight through to the Friday close of business
hours in New York. At any given moment, depending on the
time zone, dozens of global financial centers — such as
Sydney, Tokyo, or London — are open, and currency trading
desks in those financial centers are active in the market.
Currency trading doesn’t even stop for holidays when other
financial markets, like stocks or futures exchanges, may be
closed. Even though it’s a holiday in Japan, for example,
Sydney, Singapore, and Hong Kong may still be open. It might
be the Fourth of July in the United States, but if it’s a business
day, Tokyo, London, Toronto, and other financial centers will
still be trading currencies. About the only holiday in common
around the world is New Year’s Day, and even that depends on
what day of the week it falls on.
The opening of the trading week
There is no officially designated starting time to the trading
day or week, but for all intents the market action kicks off
when Wellington, New Zealand, the first financial center west
of the international dateline, opens on Monday morning local
time. Depending on whether daylight saving time is in effect in
your own time zone, it roughly corresponds to early Sunday
afternoon in North America, Sunday evening in Europe, and
very early Monday morning in Asia.
The Sunday open represents the starting point where currency
markets resume trading after the Friday close of trading in
North America (5 p.m. Eastern time). This is the first chance
for the forex market to react to news and events that may have
happened over the weekend. Prices may have closed New York
trading at one level, but depending on the circumstances, they
may start trading at different levels at the Sunday open.
Trading in the Asia-Pacific session
over 50 percent of total daily global trading volume, with
London alone accounting for about one-third of total daily
global volume, according to the 2004 survey.
The European session overlaps with half of the Asian trading
day and half of the North American trading session, which
means that market interest and liquidity is at its absolute
peak during this session.
News and data events from the Eurozone (and individual
countries like Germany and France), Switzerland, and the
United Kingdom are typically released in the early-morning
hours of the European session. As a result, some of the
biggest moves and most active trading takes place in the
European currencies (EUR, GBP, and CHF) and the euro cross-
currency pairs (EUR/CHF and EUR/GBP).
Asian trading centers begin to wind down in the late-morning
hours of the European session, and North American financial
centers come in a few hours later, around 7 a.m. ET.
Currency trading volumes in the Asia-Pacific session account
for about 21 percent of total daily global volume, according
to a 2004 survey. The principal financial trading centers are
Wellington, New Zealand; Sydney, Australia; Tokyo, Japan;
Hong Kong; and Singapore. In terms of the most actively
traded currency pairs, that means news and data reports from
New Zealand, Australia, and Japan are going to be hitting the
market during this session
Because of the size of the Japanese market and the importance
of Japanese data to the market, much of the action during the
Asia-Pacific session is focused on the Japanese yen currency
pairs (explained more in Chapter 2), such as USD/JPY – forex-
speak for the U.S. dollar/Japanese yen -- and the JPY crosses,
like EUR/JPY and AUD/JPY. Of course, Japanese financial insti-
tutions are also most active during this session, so you can fre-
quently get a sense of what the Japanese market is doing based
on price movements.
For individual traders, overall liquidity in the major currency
pairs is more than sufficient, with generally orderly price
movements. In some less liquid, non-regional currencies, like
GBP/USD or USD/CAD, price movements may be more erratic
or nonexistent, depending on the environment.
Trading in the European/Londonsession
About midway through the Asian trading day, European finan-
cial centers begin to open up and the market gets into its full
swing. European financial centers and London account for
over 50 percent of total daily global trading volume, with
London alone accounting for about one-third of total daily
global volume, according to the 2004 survey.
The European session overlaps with half of the Asian trading
day and half of the North American trading session, which
means that market interest and liquidity is at its absolute
peak during this session.
News and data events from the Eurozone (and individual
countries like Germany and France), Switzerland, and the
United Kingdom are typically released in the early-morning
hours of the European session. As a result, some of the
biggest moves and most active trading takes place in the
European currencies (EUR, GBP, and CHF) and the euro cross-
currency pairs (EUR/CHF and EUR/GBP).
Asian trading centers begin to wind down in the late-morning
hours of the European session, and North American financial
centers come in a few hours later, around 7 a.m. ET.
Trading in the North American session
Because of the overlap between North American and
European trading sessions, the trading volumes are much
more significant. Some of the biggest and most meaningful
directional price movements take place during this crossover
period. On its own, however, the North American trading ses-
sion accounts for roughly the same share of global trading
volume as the Asia-Pacific market, or about 22 percent of
global daily trading volume.
The North American morning is when key U.S. economic data
is released and the forex market makes many of its most sig-
nificant decisions on the value of the U.S. dollar. Most U.S.
data reports are released at 8:30 a.m. ET, with others coming
out later (between 9 and 10 a.m. ET). Canadian data reports
are also released in the morning, usually between 7 and 9 a.m.
ET. There are also a few U.S. economic reports that variously
come out at noon or 2 p.m. ET, livening up the New York after-
noon market. London and the European financial centers
begin to wind down their daily trading operations around
noon eastern time (ET) each day. The London, or European
close, as it’s known, can frequently generate volatile flurries of
activity.
On most days, market liquidity and interest fall off signifi-
cantly in the New York afternoon, which can make for chal-
lenging trading conditions. On quiet days, the generally lower
market interest typically leads to stagnating price action. On
more active days, where prices may have moved more signifi-
cantly, the lower liquidity can spark additional outsized price
movements, as fewer traders scramble to get similarly fewer
prices and liquidity. Just as with the London close, there’s
never a set way in which a New York afternoon market move
plays out, so traders just need to be aware that lower liquidity
conditions tend to prevail, and adapt accordingly.
Currencies and Other Financial Markets
As much as we like to think of the forex market as the be all
and end all of financial trading markets, it doesn’t exist in a
vacuum. You may even have heard of some these other mar-
kets: gold, oil, stocks, and bonds.
There’s a fair amount of noise and misinformation about the
supposed interrelationship among these markets and curren-
cies or individual currency pairs. To be sure, you can always
find a correlation between two different markets over some
period of time, even if it’s only zero (meaning, the two mar-
kets aren’t correlated at all).
Always keep in mind that all the various financial markets are
markets in their own right and function according to their
own internal dynamics based on data, news, positioning, and
sentiment. Will markets occasionally overlap and display
varying degrees of correlation? Of course, and it’s always
important to be aware of what’s going on in other financial
markets. But it’s also essential to view each market in its own
perspective and to trade each market individually.
Let’s look at some of the other key financial markets and see
what conclusions we can draw for currency trading.
Gold
Gold is commonly viewed as a hedge against inflation, an
alternative to the U.S. dollar, and as a store of value in times of
economic or political uncertainty. Over the long term, the
relationship is mostly inverse, with a weaker USD generally
accompanying a higher gold price, and a stronger USD coming
with a lower gold price. However, in the short run, each
market has its own dynamics and liquidity, which makes
short-term trading relationships generally tenuous.
Overall, the gold market is significantly smaller than the forex
market, so if we were gold traders, we’d sooner keep an eye
on what’s happening to the dollar, rather than the other way
around. With that noted, extreme movements in gold prices
tend to attract currency traders’ attention and usually influ-
ence the dollar in a mostly inverse fashion.
Oil
A lot of misinformation exists on the Internet about the sup-
posed relationship between oil and the USD or other curren-
cies, such as CAD or JPY. The idea is that, because some
countries are oil producers, their currencies are positively (or
negatively) affected by increases (or decreases) in the price of
oil. If the country is an importer of oil (and which countries
aren’t today?), the theory goes, its currency will be hurt (or
helped) by higher (or lower) oil prices.
Correlation studies show no appreciable relationships to that
effect, especially in the short run, which is where most cur-
rency trading is focused. When there is a long-term relation-
ship, it’s as evident against the USD as much as, or more than,
any individual currency, whether an importer or exporter of
black gold.
The best way to look at oil is as an inflation input and as a lim-
iting factor on overall economic growth. The higher the price
of oil, the higher inflation is likely to be and the slower an
economy is likely to grow. The lower the price of oil, the lower
inflationary pressures are likely (but not necessarily) to be.
We like to factor changes in the price of oil into our inflation
and growth expectations, and then draw conclusions about
the course of the USD from them. Above all, oil is just one
input among many.
Stocks
Stocks are microeconomic securities, rising and falling in
response to individual corporate results and prospects, while
currencies are essentially macroeconomic securities, fluctuat-
ing in response to wider-ranging economic and political devel-
opments. As such, there is little intuitive reason that stock
markets should be related to currencies. Long-term correla-
tion studies bear this out, with correlation coefficients of
essentially zero between the major USD pairs and U.S. equity
markets over the last five years.
The two markets occasionally intersect, though this is usually
only at the extremes and for very short periods. For example,
when equity market volatility reaches extraordinary levels
(say, the Standard & Poor’s loses 2+ percent in a day), the USD
may experience more pressure than it otherwise would — but
there’s no guarantee of that. The U.S. stock market may have
dropped on an unexpected hike in U.S. interest rates, while
the USD may rally on the surprise move.
Bonds
Fixed-income or bond markets have a more intuitive connec-
tion to the forex market because they’re both heavily influ-
enced by interest rate expectations. However, short-term
market dynamics of supply and demand interrupt most
attempts to establish a viable link between the two markets
on a short-term basis. Sometimes the forex market reacts first
and fastest depending on shifts in interest rate expectations.
At other times, the bond market more accurately reflects
changes in interest rate expectations, with the forex market
later playing catch-up.
Overall, as currency traders, you definitely need to keep an
eye on the yields of the benchmark government bonds of the
major-currency countries to better monitor the expectations
of the interest rate market. Changes in relative interest rates
(interest rate differentials) exert a major influence on forex
markets.
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