To understand the forex market, you need to understand the following market participants and their motivations:
- Reserve banks
- Hedge funds
- Individual traders
Banks comprise a large portion of the total turnover. They use the foreign exchange market to buy and sell currencies that are needed for foreign exchange for their customers, to hedge or protect against market movements on behalf of their customers (for example when an importer may wish to protect against adverse currency movements) as well as for trading purposes.
These are government owned organisations that are responsible for managing the economy of their countries by setting interest rates and they also may take positions on foreign exchange in an attempt to regulate or smooth exchange rates. Examples include the Bank of England, the Bank of Japan, the Federal Reserve and the Reserve Bank of Australia.
For example, the Bank of Japan may enter the market to sell Japanese Yen and buy Euros if they believe that Japanese Yen are priced too high relative to Euros.
Reserve banks are typically active in their own currency. They may make enormous trades that can quickly result in significant short term market movements. Usually the actions of reserve banks can be seen when there are sudden spikes or dips in a currency.
In addition, reserve banks often manage the release of key economic statistics. This information is eagerly awaited by market participants and results in immediate price movements if the statistics differs from the consensus view.
Hedge funds are professional investment firms that usually manage funds on behalf of high net worth investors. They may invest in a variety of financial instruments, including foreign currencies. Their motivation is speculative profit for their investors, as they earn their money from a percentage of profits earned.
Individual traders are increasingly active in the FX markets. This is driven by the ready access to the market through the Internet and the opportunities available to earn significant profits with a relatively low capital investment.
Individual traders are often unsuccessful. In fact, about 90% of individual traders lose money during their time in the FX markets. Individual traders often don’t have systems, and don’t manage risk well.
In addition, individual traders face higher transaction costs than professional traders as they don’t have direct access to the market and have to use a broker. Also, individual traders can’t watch the market all the time as they usually have other committments such as work or family life.
These factors are a disadvantage, but the advantage is that the individual trader can choose whether to participate in the market at any given point in time. Professional traders are pretty much obliged to trade all the time by the nature of their jobs which means that they may not be able to be as selective about the trades that they enter.
What a Forex Broker does? Brokers provide access to the FX market to individual traders. Typically banks and hedge funds have direct access to the market as they are a part of the market.
A broker will provide account keeping services, execute trades and usually provides some software to place orders and allow you to look at current prices and charts.
Brokers earn their profit by charging a spread. This is a difference between the buying and selling price. For example to buy EUR/USD, the price may be quoted 15/19, which means that the broker makes a spread of 4 basis points per trade. A trade is either buying or selling a foreign currency position.