The Forex (Foreign Exchange) market is the world’s largest and most liquid market (also known as the foreign exchange, currency or FX market) where one country’s currency is traded in exchange for another currency. The EUR/USD (euro against the dollar) is the most traded currency pair.
- 1 What is Forex trading and how does it work?
- 2 Forex Major Currency pairs
- 3 Best Currency Pairs to trade
- 4 Pips and Lots Forex
- 5 Pip definition in Forex
- 6 How to Calculate Pips in Forex
- 7 What is a Lot in Forex
- 8 How to calculate Lot Size in Forex trading
- 9 What is the US dollar index and what does it mean
What is Forex trading and how does it work?
Forex trading is basically speculating on the movement of one currency against another currency. That is, on the price changes of its exchange rate.
Characteristics of the Forex market:
- It is open 24 hours a day, 5 days a week.
- It is an organised market.
- It offers high leverage.
- It is highly volatile.
- You can start with a small account.
- Its location is decentralised.
- Many people and institutions around the world trade in Forex, which generates a huge volume of daily transactions. It is the biggest money market in the world.
- It is not advisable for novices to start in this market as it is complicated to trade in this market. The market eats up small investors and beginners, so you can lose all your money in a matter of days. However, with a lot of practice and patience, it is possible to be profitable in Forex.
- Its main focus is for intraday, although it can be used for longer periods.
- Spreads should be checked, as they can sometimes be very wide.
Arguably the forex market is the most popular market in the world, especially daytraders and scalpers, due to the combination of volatility, liquidity, difficulty and timing, which generates many daily opportunities for speculation.
With regard to its timetable, it is necessary to clarify that the Forex market is open 24 hours a day because the exchanges on which the currencies are quoted rotate around the world (it is a delocalised market), the first being the London Stock Exchange, then the New York Stock Exchange and finally the Tokyo Stock Exchange. Each time zone corresponds to each stock exchange and these time zones are called sessions, which are GMT (Greenwich Mean Time):
- Asian session (Tokyo Stock Exchange): from 0 to 9 a.m. GMT
- European session (London Stock Exchange): 8 a.m. to 5 p.m. GMT
- American session (New York Stock Exchange): from 1pm to 10pm GMT.
As you can see, there are times when the markets coincide at certain times, i.e. they overlap, and these times are very active. For a day trader or scalper these times are of great importance, because the market generates more opportunities to trade. This is not the case for a medium or long term trader, as the hours are not so important.
This is why the best times for very short term trading are those with the highest trading volume and liquidity, with the European session being the most active at the open. The European session is heavily traded by traders from all over the world. This is followed by the opening of the American session, which, due to the time of day, overlaps with the close of the European session, generating a high volume of transactions. On the NYSE, there can also be sharp movements during the session due to events such as FED announcements, industry data, employment data and anything else that concerns the US economy, impacting the currency market. This information can be viewed on the economic calendar on any of the websites we recommend in the Resources section, so that you can take them into account in your trading. Lastly, there is the Asian session, which usually has little volatility and little movement. It does not generate many opportunities and also, on repeated occasions, the market corrects part of the gains and losses of the European and American sessions.
In addition to the timetables, it can be said that statistically the days with the sharpest trends and movements are on Tuesdays and Wednesdays, while the quietest days are from Friday afternoon to Sunday evening. This is a point to keep in mind.
Forex Major Currency pairs
Forex is organised by currency pairs and you win or lose by the difference between the two currencies in the pair. A currency pair is a financial asset made up of two currencies that are related to each other.
We will use the above-mentioned EUR/USD as an example, since it is the most traded currency pair in the world:
- If we buy on this pair (bullish), we are speculating that the euro will rise against the dollar.
- If we want to speculate on a downward appreciation, we are speculating that the euro will fall against the dollar. This would be the opposite of the previous trade.
Currency pairs have a ticker and to interpret it you must bear in mind that the currency on the left is the base and the currency on the right is the quoted currency.
Continuing with the example, let’s assume that today the quote for this pair is EUR/USD=1.12. This means that with 1 euro we can buy 1.12 dollars.
The base currency is always 1 unit (in this case 1 euro) and the quoted currency will depend on the current rate, indicating how many units of that currency we can buy with 1 unit of the base currency.
The quoted currency will not always be a number greater than 1; the opposite may be true, as in the case of the pound sterling. For example, today the quotation is EUR/GBP = 0.86. In this case, the base is still the euro but with respect to the British pound sterling, and it indicates that with 1 euro we can buy 0.86 pounds. Therefore, the pound is more expensive than the euro.
To sum up:
- When the quoted currency is greater than 1, it is cheaper than the base currency.
- When the quoted currency is less than 1, it is more expensive than the base currency.
IMPORTANT NOTE: All currencies are abbreviated with three abbreviations, according to the international standard ISO 4217, the first two letters being the abbreviation of the country and the third the abbreviation of the currency.
For this reason, the US dollar is USD, the Canadian dollar is CAD, the Australian dollar is AUD, the Japanese yen is JPY, and so on. In the resources section, section “News portals and interesting websites”, you will find a website that we recommend to see all the abbreviations by country.
Best Currency Pairs to trade
Within Forex there are currency pairs, called major currency pairs or forex majors, which concentrate the largest volume of transactions, moving almost 90% of the total of the total money in the market, so they are the best to trade and the most liquid. These pairs are composed of:
- US dollar (USD)
- Pound sterling (GBP)
- Euro (EUR)
- Japanese yen (JPY)
- Swiss franc (CHF)
- Australian dollar (AUD)
- New Zealand dollar (NZD)
- Canadian dollar (CAD)
The major currency pairs are as follows (when we put dollar only, we mean US dollar):
- GBP/USD (pound sterling/dollar)
- CAD/USD (Canadian dollar/dollar)
- EUR/USD (euro/dollar)
- USD/JPY (dollar/yen)
- CHF/USD (Swiss franc/dollar)
- AUD/USD (Australian dollar/dollar)
- NZD/USD (New Zealand dollar/dollar)
Then there are the minor currency pairs or forex minors, which move a small amount of money. Almost all of these pairs have very low trading volumes. The number of these pairs depends on each broker, but generally they are as follows:
- AUD/CAD (Australian dollar/Canadian dollar)
- AUD/CHF (Australian dollar/Swiss franc)
- AUD/JPY (Australian dollar/Japanese yen)
- AUD/NZD (Australian dollar/New Zealand dollar)
- CAD/CHF (Canadian dollar/Swiss franc)
- CAD/JPY (Canadian dollar/Japanese yen)
- CHF/JPY (Swiss franc/Japanese yen)
- EUR/AUD (euro/Australian dollar)
- EUR/CAD (euro/Canadian dollar)
- EUR/CHFT (euro/Swiss franc)
- EUR/GBP (euro/UK pound sterling)
- EUR/JPY (euro/Japanese yen)
- EUR/NZD (euro/New Zealand dollar)
- GBP/AUD (British pound sterling/Australian dollar)
- GBP/CAD (British pound sterling/Canadian dollar)
- GBP/CHF (GBP/CHF (British pound sterling/Swiss franc)
- GBP/JPY (New Zealand dollar/Japanese yen)
- GBP/NZD (British pound sterling/New Zealand dollar)
- NZD/CAD (New Zealand dollar/Canadian dollar)
- NZD/CHF (New Zealand dollar/ Swiss franc)
- NZD/JPY (New Zealand dollar/Japanese yen)
Finally, there are the exotic currency pairs, which correspond to countries with few trading relationships (usually very small countries, with less developed economies or with little currency movement). Most of these pairs are crosses with the euro or the dollar, and these crosses are the most traded within this group of currency pairs. They are not best traded as they are very speculative. The number of these pairs depends on each broker, but generally they are as follows:
- EUR/DKK (euro/Danish krone)
- EUR/HUF (euro/Hungarian forint)
- EUR/ILS (euro/Israeli Shekel)
- EUR/NOK (euro/Norwegian krone)
- EUR/PLN (euro/Polish zloty)
- EUR/SEK (euro/Swedish krona)
- EUR/TRY (euro/New Turkish lira)
- EUR/ZAR (euro/South African rand)
- GBP/SGD (British pound sterling/Singapore dollar)
- GBP/TRY (British pound sterling/New Turkish lira)
- USD/CNH (US dollar/Chinese foreign currency)
- USD/DKK (US dollar/Danish krone)
- USD/HKD (US dollar/HKD (Hong Kong dollar)
- USD/HUF (US dollar/Hungarian forint)
- USD/ILS (US dollar/Israeli Shekel)
- USD/MXN (US dollar/Mexican peso)
- USD/NOK (US dollar/Norwegian krone)
- USD/PLN (US dollar/Polish zloty)
- USD/RUB (US dollar/Russian rouble)
- USD/SEK (US dollar/Swedish krona)
- USD/SGD (US dollar/Singapore dollar)
- USD/TRY (US dollar/Turkish lira)
- USD/ZAR (US Dollar/South African Rand)
Pips and Lots Forex
Pips and lots are related to the amount of money we can/should risk on each trade. Understanding what each one is is useful in calculating the size of the trade, the risk taken and the profit or loss we can make on a particular trade. We will look at each of them and then an example to relate the two concepts.
Pip definition in Forex
A pip is, in the value of a currency pair, the smallest difference that can change. It is the last decimal place in the quote.
For example, the EUR/USD currency pair is usually between 1 to 3 pips. If the EUR/USD moves from 1.2350 to 1.2351 that means 1 PIP (0.0001).
Knowing this value is important to know how much of a disadvantage we will start the trade with, as in almost all Forex CFD brokers, the spreads are expressed in pips. That is to say that if the broker charges us 2 pips spread, we will start with 2 pips disadvantage in the operation.
Important considerations to keep in mind about pips:
1. They do not all have the same value.
This is because each currency pair has its own value, as not all currency pairs are expressed in the same currencies and do not have the same decimal point difference. This is why the value of a pip must be calculated for each particular currency.
2. They are expressed in the base currency.
In the EUR/USD example, the pips are in euros, but in the USD/EUR pair, the pips are in dollars.
3. Decimals influence the pip price.
They may seem insignificant, but they are not.
– Let’s look at some examples to understand the difference in decimals.
How to Calculate Pips in Forex
Let’s start with the example of EUR/USD which has 4 decimal places. Let’s suppose that the price of this pair is at 1.2351 and we need to calculate the value of one pip.
The operation would be 0.0001/1.2351=0.000080965 of euro which is the base currency.
This means that each pip has a cost in the EUR/USD that is quite insignificant, but that will be what we will gain or lose according to how the market moves.
If we wanted to know in dollars, rather than euros or whatever currency you are looking at, the value of a pip, we would do:
EUR (or whatever currency you are looking at) x quote.
In our example, it would be 0.000080965×1.2351= 0.00009999.
We round it to 0.0001.
Now let’s look at the example of USD/JPY which has 2 decimal places. Let’s suppose that the price of this pair is at 113.80 and we need to calculate the value of one pip.
The operation would be 0.01/113.80=0.000087873 of a dollar, as the dollar is the base currency. We use 0.01 because in this case, that is what 1 Pip is worth. And again, while it seems like an insignificant number, this is relative to the lot size.
What is a Lot in Forex
The forex market trades in lots, which means that you buy or sell lots that are equivalent to 100,000 units of the currency you are buying or selling. There are also mini-lots equal to 10,000 units and micro-lots equal to 1,000 units.
The unit will depend on the pair, which is why we mention that they are units of the currency. Following the example of the EUR/USD, if we trade one lot of this currency pair we will be trading with 100.000€ and 100.000$ (depending if our trade is bullish or bearish).
As currencies are measured in pips, which are the smallest increment possible, to make a profit from these small increments, you need to trade large sums of a given currency to make any significant profit or loss.
How to calculate Lot Size in Forex trading
Following on from the examples above, we will look at how to calculate how much each pip in a lot is worth (we will use the standard):
We had calculated that a pip was worth: 0.0001/1.2351=0.000080965
Now we multiply 0.00008080965 by 100,000 units (the equivalent of 1 lot) of euro in this case. The result tells us that each pip in a lot is worth 8.0965 euros.
We had calculated that one pip was worth: 0.01/113.80=0.000087873
Now we multiply 0.000087873 by 100,000 units of dollars. The result tells us that each pip in a lot is worth $8.7873.
Depending on the broker, there may be some differences in calculating the value of a pip relative to the size of a lot. However, as market prices change, so will the value of a pip according to the currency you are using.
What is the US dollar index and what does it mean
In Forex there is an index called the US Dollar Index that works like the indices we have already seen such as IBEX 35, SP 500, among others.
The US Dollar Index measures the evolution of the dollar, against a basket of currencies from around the world (and not just one currency pair). It shows how strong the dollar is against the rest of the world’s economy.
This index is composed of 6 currencies of 25 countries with different percentages in their composition:
- Euro (EUR) accounts for 57.6%.
- Yen (JPY) accounts for 13.6% of the total
- Pound (GBP) accounts for 11.9% of the total.
- Canadian dollar (CAD) represents 9.10% of the total.
- Swedish krona (SEK) accounts for 4.2% of the total.
- Swiss franc (CHF) represents 3.6%.
How is the US dollar index calculated:
- If the price is above 100, the dollar is appreciating against the other currencies in the basket.
- If the price is below 100, the dollar is depreciating against the rest of the currencies in the basket.
As we already know, whether the dollar appreciates or depreciates is related to and influenced by events in the US economy and the Fed’s interest rate decisions.
US Dollar Index from 1986 to 2019 in monthly candlesticks
The index started in 1973, when the gold standard was abandoned and many governments let their exchange rates float, with a base of 100, and since then the values are relative to this base. Only once has the composition of the basket of currencies changed, which was when the euro replaced several European currencies that made up the index, around 1999.
As you can see in the image, the index has gone up and down throughout its history. Its peak was in 1985 and its trough in 2008.