What Are You Really Trading?

The short answer is nothing. The retail FX market is purely a speculative market. No physical exchange of currencies ever takes place. All trades exist simply as computer entries and are netted out depending on market price. For dollar-denominated accounts, all profits or losses are calculated in dollars and recorded as such on the trader's account.

The primary reason the FX market exists is to facilitate the exchange of one currency into another for multinational corporations that need to continually trade currencies (i.e., for payroll, payment for goods and services from foreign vendors, and mergers and acquisitions). However, these day-to-day corporate needs compose only approximately 20% of the market volume. Eighty percent of trades in the currency market are speculative in nature conducted by large financial institutions, multi-billion-dollar hedge funds, and individuals who want to express their opinions on the economic and geopolitical events of the day.

Since currencies always trade in pairs, when a trader makes a trade, that trader is always long one currency and short the other. For example, if a trader sells one standard lot (equivalent to 100,000 units) of EUR/USD, they would have exchanged euros for dollars and would now be short euros and long dollars. To better understand this dynamic, an individual who purchases a computer from an electronics store for $1,000 is exchanging dollars for a computer. That individual is short $1,000 and long one computer. The store would be long $1,000, but now short one computer in its inventory. The same principle applies to the FX market, except that no physical exchange takes place. While all transactions are simply computer entries, the consequences are no less real.

Although some retail dealers trade exotic currencies such as the Thai baht or the Czech koruna, the majority of dealers trade the seven most liquid currency pairs in the world, which are the four "majors":

• EUR/USD (euro/dollar)
• USD/JPY (dollar/Japanese yen)
• GBP/USD (British pound/dollar)
• USD/CHF (dollar/Swiss franc)

and the three commodity pairs:

• AUD/USD (Australian dollar/dollar)
• USD/CAD (dollar/Canadian dollar)
• NZD/USD (New Zealand dollar/dollar)

These currency pairs along with their various combinations (such as EUR/JPY, GBP/JPY, and EUR/GBP) account for more than 95% of all speculative trading in FX. Given the small number of trading instruments—only 18 pairs and crosses are actively traded—the FX market is far more concentrated than the stock market.