By Craig Erlam
Sometimes referred to as the market that never sleeps – though it does, in fact, at the weekend – the foreign exchange (forex) market is the largest financial market in the world and has a wide-reaching impact on global economic activity. In 2022, trading hit a record $7.5 trillion in average daily turnover, according to the Bank for International Settlements.
Today, thanks in large part to online trading, the market is accessible to a wider range of participants than in the past: from financial institutions, governments and corporations, through to individual traders. But before deciding whether forex trading might be right for you, it’s important to understand the essential aspects of the market.
In this article, I unpack three key characteristics of the forex market and what drives it.
- The market is liquid – and volatile
Many traders are drawn to the forex market because it is highly liquid, which means low spreads. In particular, major currency pairs such as EUR/USD, USD/JPY, and GBP/USD are typically the most liquid. But the market is also fast-paced and volatile.
Compared to trading stocks, there is a much higher frequency of events that impact currencies and move the forex market – it’s not uncommon to see half a dozen data releases during the space of one week that all influence the way a single currency moves. For short-term traders, that’s a real plus: if a market doesn’t move, it doesn’t offer as much opportunity. However, a fast-moving market with the potential for significant price swings brings with it the possibility for significant losses, too.
- Economic data is king
Macroeconomic factors, including interest rates, the labour market and inflation, all have a significant impact on the forex market. Geopolitics and political events also have an impact, particularly in less stable economies.
As a result, economic data – which effectively tells us whether an economy is doing well or not – is a vital tool for those in the market, who closely monitor releases in order to make trading decisions. Interest rates are a particularly important factor in forex, as higher rates in developed markets – and therefore yields – are often associated with stronger currencies, and vice versa..
In major economies such as the US, UK and within the Eurozone, there is a steady flow of economic data that traders can use. However, discerning which economic data releases are important, and which aren’t, can be tricky and may change. An economic calendar can be useful in breaking this down.
- Fundamentals drive the market
The major driving force of the forex market is ultimately fundamentals – data such as interest rates, GDP and inflation – which significantly influence how currencies move over time. Essentially, the market is made up of a large community of individuals and entities that speculate on the price movements of currencies based on those fundamental factors. For example, if the US Federal Reserve is raising rates faster than others and the economy is still performing relatively well, it would be understandable that the US dollar would outperform other currencies.
Many traders use a combination of both technical and fundamental analysis, but – particularly on a longer-term basis – having an in-depth understanding of how fundamental factors impact the market can be an extremely valuable part of your forex trading strategy, allowing you to better anticipate how the market might move.
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