I got a question today that I’m sure others have as well. Someone asked where the prices in the forex market come from. It’s a good question, especially since the foreign exchange market isn’t centralized through an exchange like most other markets. The answer, though, is actually very similar for all markets.
As you are no doubt aware, all financial markets (and really anything involving trade) is based on a bid-offer pricing process. The bid is what someone is willing to pay. The offer (or ask) is what someone is willing to sell at. The question about where prices comes from really speaks to where those bids and offers come from. The answer is the market makers.
This is a term you might be familiar with. All markets have market makers. In the definition most folks are aware of, they are the folks who provide liquidity to the market by standing ready to buy and sell. They do it constantly throughout the trading day, earning the spread each time the buy at the bid and sell at the offer. Normally, they don’t hold any positions for directional trades. They just repeatedly grab the spread.
Now, when you think market maker you probably imagine the guy in the futures trading pit or on the floor of the stock exchange. They certainly fit the bill, but they aren’t the only one. In the over-the-counter (OTC)Â market the dealers are the market makers. In terms of stocks, that can mean brokerage houses in some cases. In markets like fixed income (bonds, etc.) that is generally the major investment banks. The same is true for forex via the interbank market.
Technically, market makers can set the prices to be whatever they want. Of course there is competition and great information flow these days, so you generally will see prices kept very close regardless of whether we’re talking an exchange-based or OTC market. So when you see prices changing, what you see is the result of the market makers reacting to supply and demand in the market, seeking to find the level at which the most action will take place (and thus the greatest opporunity for them to capture the spread as frequently as they can). [For more information on how this auction process plays out in prices I highly recommend reading Mind Over Markets.]
Now the advent of direct access and electronic trading (e-contracts) has allowed the individual trader to become something of a market maker unto themselves. We can enter our own bids and offers, which may or may not get hit. The difference, of course, is that we don’t trade the same volume in most cases, and are generally looking to play directional moves, not just grab the spread.
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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
** See John’s full bio.
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