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Forex is the most liquid and largest financial market in the world with a daily capitalization of approximately $8 trillion, as of January 2021. The low initial investment and potentially high return are two key factors that involve more and more retail traders in the market. However, have you ever wondered what you are going to trade in the forex market? This article will help answer the question.
What is Traded in the Forex Market?
Forex (fully known as Foreign Exchange) trading is the process of selling one currency and simultaneously buying another for different purposes such as transnational travel, commercial activities, or profit generation. In other words, forex investors would trade currency pairs at a specified price that is commonly called an exchange rate.
The main participants in the forex market are large commercial banks and central banks, followed by hedge funds and investment management companies. Approximately 95% of the trading volume comes from those institutional players, so their operations and policies would profoundly affect exchange rates. Concurrently, prices are also impacted by economic indicators (e.g. gross domestic product (GDP) and interest rate) and the political stability of a country. Therefore, any price movements are signals for forex speculators to decide whether they should open a long (buy) or short (sell) position.
In the forex market, currencies are an asset that can be traded 24 hours a day and within 5 days a week (except holidays). Today, brokers allow their customers to participate in CFD (Contracts For Difference) forex trading. Unlike traditional trades in which direct exchanges between currencies are conducted, CFD forex trading enables traders to speculate on foreign currencies without ownership. Therefore, no physical trade takes place. In other words, investors are not delivering or receiving real currencies from others; instead, they always expect a pair’s value to move in their favor for making profits.
Further, there is no central location for trading as well. If you prefer speculating on forex trades for profits, you can participate in four trading sessions in different periods. Unfortunately, the market closes from 10 PM GMT+0 on Friday to 10 PM GMT+0 on Sunday as its key players make no transactions on trading desks on those days. Accordingly, you hardly open a position on weekends because the absence of such liquidity providers as banks leads to low liquidity and insecurity for your account balance.
The Definition of Currency Pairs
Generally speaking, a currency pair is the quotation of two different currencies and compares the value of one currency quoted against another. Of which, the first currency of a pair is commonly known as the base currency, whilst the second one is known as the quote (or counter) currency.
A currency pair is displayed in the abbreviations of currencies defined by ISO currency code or three-letter alphabetic code. For example, the ISO code for the US dollar is USD. Accordingly, a currency pair would be designated as, for example, EUR/USD. The slash that separates two codes can be omitted.
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A currency pair itself is regarded as an instrument that forex speculators may buy or sell. In case a trader buys a pair or opens a long position, it represents how many units of the quote currency are needed to purchase the base currency. For example, if you buy the EUR/USD pair which is priced at 1.18482, it means you have to sell 118,482 units of the US dollar to purchase 100,000 euros. In this case, 1.18482 is called the bid (buy) price which a buyer is willing to pay.
On the contrary, when the trader sells a pair or opens a short position, it means he or she sells the base currency to buy the quote currency at an ask (sell) price which a seller is willing to accept. That is, a pair indicates how much of the quote currency the trader can receive from selling a certain amount of the base currency.
According to the United Nations Treasury, there are a total of 154 currencies from 221 countries. However, not all currencies are traded in the forex industry where currency pairs are traded mainly for financial returns. This means if a company would like to purchase or sell products in any foreign country, they can swap the country’s native currency. Meanwhile, if you aim at speculating on foreign currencies for profits, forex brokers now limit the number of currency pairs. For instance, when you open an account with FiNMAXFX, only 58 currency pairs are traded on a trading platform.
Besides, currency pairs are also divided into three categories as major, minor and exotic pairs.
Major Currency Pairs
Major currency pairs are the most traded and highly liquid pairs in the world. Majors are made up of top eight currencies such as the US dollar (USD), Euro (EUR), Japanese yen (JPY), British pound (GBP), Swiss franc (CHF), Australian dollar (AUD), Canadian dollar (CAD) and New Zealand dollar (NZD). Of which, the US dollar always remains its dominant status, being on one side of 88% of forex trades, according to the BIS Survey in April 2019. Therefore, major currency pairs always contain the US dollar therein.
Accordingly, forex traders can open a position with one of the seven majors that include EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, AUD/USD, and NZD/USD. The EUR/USD currency pair is the most heavily traded as it represents the two biggest economies in the world, particularly the European Union and the United States. Any economic or political news such as interest rates issued by the European Central Bank (ECB) or the Federal Reserve (FED), the government debt crisis in Greece or the US election results can significantly affect the pair.
USD/CAD, AUD/USD, and NZD/USD are mostly called “commodity currencies” rather than “majors” due to the commodity-based economies of Canada, Australia and New Zealand. That is, the USD/CAD pair is significantly affected by oil, timber and natural gas, let alone the strong tie between the US and Canadian economies, which leads to the popularity of the pair. AUD/USD is also heavily influenced by the farming of beef, wheat and wool, as well as mining commodities. Meanwhile, NZD/USD is profoundly impacted by agriculture and tourism.
The price of major currency pairs is determined by supply and demand for the top eight currencies which are therefore considered free-floating. Meanwhile, supply and demand are identified by the current economic and political conditions of these countries, future expectations, and interest rates. Governments and central banks may intervene to prevent prices from moving in a way that harms their economies.
Due to high trading volumes and high liquidity, those major pairs offer tight spreads which are a difference between the bid and ask prices.
Minor Currency Pairs
Minor currency pairs are commonly called “cross pairs” or “crosses” that are formed by hard currencies, except for the US dollar. Accordingly, the two most popular crosses come from the euro and Japanese yen. As reported in the BIS Survey (2019), the euro continues to be the world’s second most traded currency, reflecting the market growth in EUR/JPY and EUR/CHF trading. Meanwhile, popular JPY crosses such as EUR/JPY and AUD/JPY show a margin increase in transactions over time.
This proves that although crosses have a wider spread than majors, the former is still sufficiently liquid to attract forex investors to trade. Similar to majors, the price of cross currency pairs are defined by the economic and political conditions of those countries as well as the amounts of the trading volume.
Additionally, other crosses also involve other high-yielding currencies such as the British pound, Australian dollar or New Zealand dollar.
Exotic Currency Pairs
Pairs that contain one currency from the above major economies and one from emerging markets on either side are called “exotics”. Of which, apart from developing countries, emerging markets also imply several developed countries that have a smaller-scale economy than the top eight countries, so their currencies are considered as an EME currency as well (e.g. NOK of Norway). Compared to majors and minors, exotics are highly volatile and lowly liquid, so having a wider spread. This is because those currency pairs are not heavily traded as majors or crosses.
However, the forex industry is witnessing the growing popularity of currencies from emerging market economies (EMEs). Accordingly, the global market share of EME currencies increased to 25% of total forex turnover in April 2019. The most notable is the renminbi (Chinese currency) with a daily turnover of $284 billion. Of which, 95% of all renminbi transactions are conducted to trade against the US dollar. The currency is followed by the Hong Kong dollar, Korean won, Indian rupee and Indonesian rupiah.
The Best Currency Pairs to Trade
For those who newly enter the forex market, the question of which currency pairs they should trade is frequently asked. The answer depends on different factors such as the economic and political conditions of countries whose currencies you plan to trade on, trading hours, or trading strategies.
Many investors see low-spread currency pairs such as EUR/USD and GBP/USD are the perfect options to save costs because spreads are what they pay market makers (or dealers). Although such pairs are not always ideal to trade all the time, they are more stable with high liquidity and low volatility. Therefore, beginners should consider choosing one major currency pair and one cross as the safest selection to protect their account balance from losing too much in the first trades. After being more experienced in forex trading, speculators may consider trading exotics as those pairs are more volatile and consequently give a higher chance of earning profits.
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