Before the late 1990’s, there were very few individual traders in the FOREX markets. The original intention of the forex markets was for use by bankers and large institutions. Following the rise of the internet however, online forex trading firms began offering trading accounts to individual retail traders. The forex markets are an over the counter market which means that there is not a centralized exchange where all trades are made. For this reason, the price that someone gets when trading forex has traditionally varied depending on the size of the transaction and the sophistication of the entity or individual making the transaction.
Interbank Markets
The first level of the forex markets is known as the Interbank market. When an FX Trader refers to the Interbank markets they are really referring to the 10 of the largest banks that make markets in forex despite the fact that, technically, any bank is part of the Interbank markets. These institutions contribute over 75% of the $3 Trillion dollars traded in FX on any given day. There are two main factors which divide institutions with direct Interbank access from other players;
Access to the tightest prices
Simply comprehend that for every 1 Million in currency traded, the players that have direct access to the Interbank market save roughly $100 per trade or more compared with the next level of participants.
Access to the best liquidity
Like other markets there is a particular amount of liquidity or amount that can be traded at any one price. If more than what is available at the current price is traded, then the price adjusts until the point where more liquidity enters the market. As the forex markets is over the counter, liquidity is divided among different providers, with the banks making up the Interbank markets having access to the largest amount of liquidity and then declining levels of liquidity available at different levels moving away from the Interbank markets.
Conversely with individuals who must deposit funds into their account in order to trade, institutions trading in the Interbank markets trade through credit lines. To be able to get a credit line from a top bank to trade in the foreign exchange you must be a very large and financially stable institution, as bankruptcy would translate to the firm that provided you with the credit line assuming the liability of your trades.
Hedge Funds
The next level of participants is made up of hedge funds, brokerage firms, and smaller banks that are not quite large enough to have direct access to the Interbank market. As just discussed the distinction here is that the transaction costs for the trade are higher and the liquidity available is lower than at the Interbank level.
Financial Institutions
The next level of participants has traditionally been smaller financial institutions and corporations who make foreign exchange trades, but not at a high enough level to merit better pricing. Traditionally the smaller the market participant, the higher the transaction costs paid to trade, and the smaller the liquidity available. This still rings true today and a good everyday example is currency exchange which takes place at airports.
To provide a picture of the size of the difference that exists between participants in the Interbank market and an individual trading currencies for the purposes of travel, Interbank market participants pay approximately $.0001 to exchange Euros for Dollars whereas individuals in the airport can pay $.05 or more. This may not seem like a sizeable difference when first looked at, but to put this into perspective it is useful to note that on $10,000 that is exchanged, the Interbank participant pays only $1 while the individual pays $500.
Internet Forex Markets
The introduction of internet forex markets trading has leveled the playing field for individual traders in terms of access to pricing and liquidity. Prior to this very few individuals traded foreign exchange as they had no access to price levels that would provide them a reasonable opportunity to make profits once transaction costs were taken into account. The internet introduced two main features into the equation which were not present before.
Streaming Quotes
The Internet has provided firms with the ability to stream quotes directly to traders and then have them execute trades based on these quotes directly from their computer rather than having to deal over the phone. This automated trade processing has therefore made it easier for firms to offer FX trading to individuals and still remain profitable.
Automatic Margin Calls
Another less obvious feature but what is maybe even more significant is that the internet allowed for automated margin calls to be built into platforms. This has provided firms with the ability to take cash deposits from clients rather than having to go through the process of trading via a credit line. As previously discussed, it is extremely difficult to get a credit line to trade FX and for those few able to do so it would mean a great deal of paperwork before they could commence trading. This would have made it impossible to provide FX trading to smaller individuals due to fact that the cost involved would not make it worthwhile.
As electronic platforms provided clients with the ability to deposit funds and then automatically cut them out of positions if their funds declined too much, this negated the need for credit lines and meant that the work required to open an individual account was a worthwhile proposition for the forex markets broker from a profit point of view.
At this point, it is simply important that you understand that what these firms did was take all the traders who were not big enough in their own right and provide access to good pricing by routing their order flow through an entity that was. This allowed these firms access to much tighter pricing than would otherwise have been available and this was then passed along, less a little for the brokers, to the end client. You should understand that while the forex markets have been around for a relatively long time, individuals have only recently started to trade the market.
The Forex Markets
There are numerous advantages to trading FOREX. Here are just some of the reasons why so many people are choosing to trade in this market:
No commissions
No clearing fees, no exchange fees, no government fees, no brokerage fees. Brokers are compensated for their services through the bid-ask spread.
No middlemen
Spot currency trading cuts out the need for middlemen, and provides you with the opportunity to trade directly with the market responsible for pricing on a particular currency pair.
Low transaction costs
The retail transaction cost (the bid/ask spread) is normally less than 0.1 percent under normal market conditions. With some larger dealers, the spread is sometimes as low as .07 percent. This will depend on your leverage and this will be explained further in later lesson.
A 24-hour market
The market begins at 3PM (Eastern Time) on Sunday and closes at 5PM on Friday. This makes it easy to trade, no matter what time zone you are located in.
No one can corner the market
The foreign exchange market is so vast and there are so many participants, which means that no single entity (not even a central bank) can control the market price for an extended period of time.
Leverage
In forex markets trading, a small margin deposit can allow a much larger total contract value. Leverage provides the trader with the ability to make good profits, and at the same time keep risk capital to a minimum. For example forex brokers offer 100 to 1 leverage, which means that a $100 dollar margin deposit would enable a trader to buy or sell $10,000 worth of currencies. Similarly, with $500 dollars, one could trade with $50,000 dollars and so on. But leverage can work both ways. If traders do not manage their risk properly, this high degree of leverage can lead to large losses as well as gains.
High Liquidity
As the forex markets are so vast, it is also extremely liquid. This means that under normal market conditions, you can instantaneously buy and sell at will straight from your computer. You are never “stuck” in a trade. You can even set up your trade on your online trading platform to automatically close your position at your desired profit level (a limit order), and/or close a trade if a trade is going against you (a stop loss order).
Free demo accounts, news, charts, signals and analysis
Most online forex brokers provide free ‘demo’ accounts, allowing traders to practice trading, and offering breaking forex news and charting capabilities. These are extremely useful resources for “poor” and smart traders who would like to sharpen their trading skills without using real money before opening a live trading account and risking real money.
Mini” and “Micro” Trading
Most people assume that to get started as a currency trader would cost a large amount of money. In reality, in comparison with trading stocks, options or futures, it really does not. Online forex brokers offer “mini” and “micro” trading accounts, some with a minimum account deposit of $1. While we’re not saying you should open an account with the bare minimum, it does make the forex market that much more accessible to the average individual who does not possess a lot of start-up trading capital.
Trading internationally
With the forex market, you can trade from anywhere in the world, with anyone in the world. As long as you have a PC and a connection to the internet, you’re ready to start.
You can make money, either way
Even if the economy is not at its strongest, there is still the ability to make money in the forex market. In contrast, with the stock market it is very difficult, if not impossible, to make decent returns during a hard-hit economy. With forex currency exchange rates continue to fluctuate continuously, which means that there is a higher chance to profit.
Simplicity
Yet again, in comparison with the stock market, the forex markets do not have many currency pairs. Therefore, it is much easier to keep track of things. With the stock market, there are literally thousands of stocks, which make matters much more complicated.