TOPIC TWO
Market Structure & Language
Understand how this multi-trillion a day industry operates behind the scenes. Many people may believe that like the other markets such as stocks/shares, there is one exchange somewhere. This is not the case.
Topic One
Topic Five
Topic Nine
Topic Thirteen
MARKET STRUCTURE & LANGUAGE
Topic Two
Topic Six
Topic Ten
Topic Fourteen
Topic Three
Topic Seven
Topic Eleven
Topic Fifteen
Topic Four
Topic Eight
Topic Twelve
Topic Sixteen
Unlike the London Stock Exchange, the New York Stock Exchange or any stock exchange, there is no central exchange or physical floor the FX market operates from.
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Where is forex traded?
The FX market is traded on what is known as the interbank market or Over-the-Counter (OTC), meaning everything is run 24 hours electronically between networks of large financial institutions/banks. This is what makes the market spread globally and contributes to the fact it is the world’s largest. There are no clearing houses to secure the trades and all participants trade with one another based on credit agreements that are set up.
As traders do not need to go through a centralised exchange, there is no single price for a given currency which is why you will see slightly varying price quotes on different broker platforms. Each broker receives their prices/liquidity from usually more than one source and has differing agreements, whether with banks or other financial institutions.
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Liquidity is passed down from the original sources to the traders via a number of ways. The most common path starts from the largest banks in the inter-bank market which use systems such as the Electronic Broker Services (EBS) to trade between each other. The rates at this level are very tight and not like the ones eventually passed down to retail traders.
Brokers and hedge funds need to mark-up spreads to make profit from the rates they receive from the commercial banks. Before the close of the century the growth of electronic execution played a crucial role in reducing barriers to enter, increasing the participants utilising the market. Previously, only those who had millions to trade with were able to participate.
INVESTMENT/MAJOR BANKS
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ELECTRONIC BROKER SERVICES (EBS)
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SMALL/MEDIUM BANKS
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BROKERS/MARKET MAKERS/RETAIN ECNs/HEDGE FUNDS
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RETAIL TRADERS
A lot of trading processed on margin through brokers is known as ‘speculative’ trading, meaning traders are speculating on the movement of currencies to gain profit. The buying and selling of these currencies intraday creates the largest portion of the volume made in the forex world.
The USD and dollar index
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The US dollar (USD) is the most traded currency on the planet, comprising of more than 80% of all transactions. The USD is the reserve currency of the world with the largest and therefore most liquid financial market in the world. The euro has risen to a strong second since its creation is the 1990’s, however volume traded is still only about half of the U.S. dollar (2017).
With its status of being the common currency to be compared against, a U.S. Dollar Index (USDX) was created. Just like stock exchanges have an index to represent the overall movement of the market, so does the USD. Indexes are based on weighted averages of several components, usually the top shares or top currencies in this case. The US dollar index is derived from a basket of six other major foreign currencies against the dollar. While only six other currencies are used to derive the index, it is universally used to determine USD strength.
The six other currencies and their weight contributed to make up the USDX are euro (57.6%), Japanese yen (13.6%), British pound (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%) and the Swiss franc (3.6%). Given the euro’s large contribution in weight, many have argued that this index is too heavily influenced by the movement of the euro. As a result, we often see the EUR/USD charts to be fairly inverse to what the U.S. Dollar Index is doing (when one goes up, the other tends to be going down at a similar rate).
Forex language & lingo
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Given the size of the FX trading industry, it is no surprise it has its own language and lingo. Hearing traders use sentences such as ‘I shorted five lots of dollar swissy last night!’ should soon make complete sense. The translation, ‘I placed five standard contracts of 100,000 units for the U.S. dollar to weaken against the Swiss franc last night’.
Additional terms such as majors, minors, currency crosses and exotics are used for different types of forex currency pairs.
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Majors: most traded currencies, often considered pairs against the USD
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Minors/Currency Crosses: usually refer to any of the remaining, non USD pairs (covered in following topics)
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Exotics: a currency pair which is less commonly traded globally, for example the EUR/SEK (euro against the Swedish krona). Pairs such as this are known to have significantly larger spreads due to lower liquidity.
Long v short, bull v bear, base v quote... What do they all mean?
There are several terms used to describe market movements. Ultimately they all refer to either prices moving up/down, buying/selling or the left/right side of a currency pair.
Base & Quote/Term
Refers to which side a specific currency sits, right or left. The base currency is the currency on the left and the quote/term currency is on the right. This means that 1 of the base currency on the left buys [exchange rate] of the quote currency on the right. For example, if AUD/USD = 0.8412, this means that 1 Australian dollar will buy 0.8412 US dollars (approximately 84 cents US). This can also be read as 1 AUD / 0.8412 USD. Base/Quote.
Bullish & Bearish
A very common term used to identify a rising or falling market. Bullish means the market is heading upwards (price is appreciating), while bearish means it is heading down (price is depreciating). An easy way to remember which is which is to think of how that animal attacks. When a bull attacks, it strikes with its horns in an upward direction to throw its prey up in the air. On the other hand when a bear attacks with its paws, it starts high and tries to lash downwards at its prey. Bull = upwards, bear = downwards.
Long & Short
Unlike the animals, long and short are terms often used in options trading positions. Being long, you believe the market is going up and when short, you believe it is going down. Shorting the market or going short is a term often used when you have a position to make money when the market drops.
Buyers & Sellers
Just like in basic economics of supply and demand, when there are more buyers in the market, the price tends to rise. Similarly, when there are more sellers in the market trying to get rid of their stock/positions the market price will drop. A buyers’ market therefore shows a rising price and sellers’ market shows a falling price.
The spread - bid & ask prices
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The price spread is simply the difference between the bid and the ask prices (buy and sell prices). Bid and ask prices differentiate the price offered to buyers and the price offered to sellers of the currency. Bids and asks are from a broker’s perspective, not yours. Below image source "TradeForex.NG."
The ‘bid price’ is what the market/broker is willing to ‘buy’ the base currency (on the left) for. The ‘ask price’ (offer price) is what the market would ‘sell’ the base currency for against the other. A currency pair showing both the bid and ask prices will always show the bid price on the left and it will always be smaller than the ask price, on the right. This is known as the spread, which is how the platform providers take a slice of the action.
Most platform providers and brokers compete against each other by claiming to offer lower spreads which is more beneficial for traders. Lower spreads in price means trades have to move fewer pips in the preferred direction to turn profitable.
For instance, an 8 pip (pip explained in following topics) spread would mean the trade placed would have to move 8 pips before it broke even. If the spread was only 2 pips, this would allow the trader to break even much sooner.
Currencies movements are measured by pips, which is the fourth decimal [0.0001 (1 pip)] of the price. Many platforms have added pipettes (a 5th digit on the price for added accuracy).
Airport spreads versus platform spreads
Someone who has just arrived to the US from Europe (carrying €200) might go up and see the following: EUR/USD: 1.3248 / 1.3848
They can then take their €200 and exchange at the ‘bid’ price of 1.3248 receiving US$264.96 (200*1.3248). If that traveller went back to the same counter (assuming the prices haven’t changed at all) with the US$264.96 and needed to change back to euros, they would sell the quote (USD) currency at the 'ask' price. The same USD$264.96 exchanged would only get back €191.33 ($264.96/1.3848). This is a difference or spread taken of €8.66.
In this example we are looking at a 600 pip spread (1.3848 – 1.3248 = 0.0600 [a 600 PIP SPREAD!?]). We can therefore assume the wholesale market rate for EUR/USD at this time is the indicative mid-point of 1.3548. Meaning they are charging an average added margin to each side of 300 pips. Given customers of local banks or airports are only exchanging a few hundred /thousand dollars and not trading contracts worth 100,000 units, the only way to make a profit is to charge incredible spreads.
On a trading platform this spread would be astronomically too high for trading due to the leverage. A two-pip spread on EUR/USD showing 1.3548 / 1.3550 can also be written as 1.3548/50.
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Order definitions (placing trades on a platform)
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Placing an order on the market means a trader wants to enter the market, either long or short, at a price level different to the current price. This price level to enter the trade can either be higher than the current market price or lower. There are several terms used which can at first be a little confusing. Most platforms make it quite easy to determine where your trades are being ordered to go, however there are some platforms which will use these terms and it is important to know which one means what when looking at placing trades on order.
Buy: Place order for market to go up ↑
Sell: Place order for market to go down ↓
Limit: Level indicated to take profit at a predefined level or better
Stop: Placed at a predefined level to limit loss (order to close the position if hit)
Buy Limit Order: Going long ↑ - Buy, price drops to level below market price (cheaper)
Buy Stop Order: Going long ↑ - Buy, price breaks above market price (confirm direction)
Sell Stop Order: Going short ↓ - Sell, when price drops to a level below market price
Sell Limit Order: Going short ↓ - Sell, when price exceeds to a level above market price
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Shorting the market - profiting from a falling price
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Trading short/down during a falling market is an effective use of modern platform functionality. If a trader suspects the price is about to fall, a short (sell) trade can be made without initially buying an asset, making money as the price falls. Shorting currency is easier to understand as traders are essentially simultaneously buying the opposite currency in the pair.
With stocks, it is similar to borrowing a stock, selling it in the market today with a plan to buy it back cheaper tomorrow.
Let's look at a very simplified example. If a trader is confident the price of Stock A will drop, they could make money from this drop. E.g. Stock A is worth $100 per share. There is no use buying the stock if it may be worth less in the future. Instead, they can borrow Stock A from someone who owns it, with a promise to give it back at a particular time.
The trader then immediately sells at the current market price of $100 and now holds $100 cash. Three days later when they need to return Stock A to the owner, the trader returns to the market and buys it back. Given the price has dropped down to say $75 per share, the trader can buy it back at $75 and return the share, keeping the difference of $25 profit.
If however the trader was wrong and instead the share price increased to $120, they would have to buy it back at a higher price and would be $20 worse off.
While this example is not how the market technically works when shorting, it illustrates the concept.
Historical psychology forces us to think only securities with rising prices will add value because things are better if they are valued higher. Remember to never underestimate the power of trading short. The market has seen many times to take the stairs on the way up, and the elevator on the way down!
Due to panic/herd mentality, when a price starts to drop, people can panic and want to get rid of the asset quickly. This sell-off can make a price plummet much faster in fear of holding onto something that will be worth much less. Remember this when finding opportunities to trade on a falling market.
