What is Forex trading?
Forex trading is the buying and selling of currencies in an attempt to profit from the minute-by-minute, exchange rate differentials between the traded currencies.
By definition, forex trading involves trading currencies in pairs. You cannot trade a currency in isolation. You have to exchange one currency for another. The aim is to be in possession of a currency which you can resell to get a higher value than what you paid to acquire it.
Currencies are divided into major currencies, minor currencies and exotic currency pairs. The major currencies are the currencies of the 7 most traded currencies in the market. These are:
- a) Euro
- b) US Dollar
- c) British Pound
- d) Japanese Yen
- e) Australian Dollar
- f) New Zealand Dollar
- g) Canadian Dollar
Of these seven major currencies, the US Dollar and the Euro represent the most traded/tradable currencies. The EUR/USD currency pair has the highest liquidity, lowest spreads, and is easily the most traded currency pairing in the world. But how did these two currencies emerge as the most tradable global currencies? An explanation is provided below.
Why are the EUR and USD the most tradable currencies?
The EUR/USD currency pair is the most traded pairing in the forex market today, and has held this position for more than a decade. Many people would be wondering: what is it about the Euro or the US Dollar that makes these two currencies the most tradable in the forex market today? This is explained better in the paragraphs that follow.
1) The USD is the international currency of trade
The US Dollar emerged as the global reserve currency and currency of trade following the Bretton-Woods conference of 1944. This conference was held to define the post-World War 2 economic blueprint for the global economy. With the economies of Britain and most of Europe battered by the devastating effects of that war, the US found itself in a position where it was on an economically stronger footing than most, and with a much stronger currency. Thus, the initial gold peg featured the US Dollar at $35 an ounce. The value of every other global currency of importance was linked to this peg and this paved the way for the US Dollar to become the reference currency for global transactions and international trade. This situation persists today, with global commodity prices and the foreign reserves of many countries all defined in US Dollar terms.
The implications are obvious. Different countries have different currencies, but they all conduct international trade with each other using the US Dollars as the central currency in these transactions. Take for instance, an OPEC country that sells 2.4 million barrels of crude oil per day. Using a price benchmark of $50 per barrel, it means that there are buyers who are willing to spend a collective total of $120 million to pay for crude imports from this seller. This means that for this country’s product, there will be a daily demand of at least $144 million from the forex market. Now put together the global daily demand, which is nearly 100 million barrels of crude oil per day.
This means that on a day like November 26, 2018, there will be a demand of about 4.9 billion US Dollars in the FX market, simply to pay for crude oil alone. Now put together all the commodities and USD-denominated financial assets that are traded every day! You can only imagine the huge need for the US Dollar on a daily basis. Is there any wonder why it is the most traded currency in the world?
2) London and Europe: The seat of the world’s commodity trading
London is where most of the world’s FX, energy and spot metal transactions take place, and the time zone corresponds to the time zones in which European markets are open for trading. Some of the world’s biggest commodity-trading companies have sited their headquarters in either Geneva or London, and it is not a coincidence. This is to enable them stay open for business when the maximum trade volumes are in operation. Commodity trading is all about getting the products at the least possible cost. This can only be possible when transacting during the market hours which boast of high volume, large liquidity and lower spreads.
When the US markets open for trading, Asia is closed, but London and Europe are still open for business. Therefore, the most active currencies used in trades within this time period are the US Dollar and the Euro.
3) London and New York: Trading zones time overlap
The New York trading hours overlap with the London trading hours at a specific time period every trading day. This opens up Europe and the US to large transaction volumes in the FX market, especially with the release of US news on the economic calendar. During the overlap of the trading time zones, the two currencies that reflect the two trading zones are very actively traded, which results in very high trading volumes. Considering the sheer size of the FX market, this factor alone makes the US Dollar and the Euro the most tradable currencies in the world.
4) The US Markets are the world’s number 1 investment destination
Have you noticed that a US rate hike always prompts the US Dollar to rise in value in the lead up to such announcements? It doesn’t matter what returns are coming from other emerging market destinations. Once there is news of a US rate hike, all that investment money gets mopped up from the emerging markets and is sent to the US markets, where the various currencies must be converted into the greenback before they can be pushed into the various US investment vehicles. This creates volume-driven demand for the greenback.
The US financial markets are the biggest and safest investment environment for the world’s smart money. Most of the world’s top companies are listed on the US stock exchange, and the US offers an attractive investment environment. So naturally, the world’s smart money will gravitate towards this market, which puts a demand for the US Dollar as foreign investment money has to be converted into the local currency to be able to do business.
These are the reasons why the US Dollar and the Euro are the most traded currencies. Hopefully, you can capitalize on this information to understand how to trade them profitably.
