An Introduction to Forex

Section 1: An Introduction to Forex: Forex 101 – The Basics

So, what is the Forex Market?

  • Foreign Currency Exchange is the act of exchanging one country’s currency for that of another.
  • It is conducted by International banks, large financial institutions, large corporations and companies, and price action traders like you and I.
  • The Foreign Currency market is also known as the FOREX or “FX Market”.
  • The open market trades non-stop from Monday 8am to Saturday 8am, opening in New Zealand and Australia, and closing in the USA after Wall St Closes on Friday afternoon New York time.
  • Forex is the largest and most liquid market in the world with an average daily turnover averaging $5.3 trillion a day according to the Bank for International Settlements.
  • No Central Exchange – Foreign exchange is an ‘over the counter’ (OTC) market, that means that there is no central exchange and clearing house where orders are matched. Geographic trading centres exist around the world however and are: (in order of importance) London, New York, Tokyo, Singapore, Frankfurt, Geneva & Zurich, Paris and Hong Kong. Essentially foreign exchange deals are made between participants on the basis of trust and reputation to deliver on an agreement. In the case of banks trading with one another, they do so solely on that basis. In the retail market, customers demand a written legally accepted contract between themselves and their broker in exchange of a deposit of funds on which basis the customer may trade.
  • The primary reason the Forex market exists is to facilitate international trade and investment by giving businesses the ability to convert one currency into another. As an example, a U.S. business can import goods from Japan and pay in Japanese Yen, even though the business is based in America and operates in U.S. dollars. The Forex market also provides a medium for speculation which works to add deeper liquidity to the market, making exchange rates less volatile.
  • The “carry-trade” is facilitated via the Forex market, this is a trade in which investors can buy high-yielding currencies against low-yielding currencies and profit from the higher yielding interest rate.

Basic History of Forex

Ok, I admit, this part is going to be a little bit boring, but it’s important to have some basic background knowledge of the history of the Forex market so that you know a little bit about why it exists and how it got here. So here is the history of the Forex market in a nutshell:

In 1876, something called the gold exchange standard was implemented. Basically it said that all paper currency had to be backed by solid gold; the idea here was to stabilize world currencies by pegging them to the price of gold. It was a good idea in theory, but in reality it created boom-bust patterns which ultimately led to the demise of the gold standard.

The gold standard was dropped around the beginning of World War 2 as major European countries did not have enough gold to support all the currency they were printing to pay for large military projects. Although the gold standard was ultimately dropped, the precious metal never lost its spot as the ultimate form of monetary value.

The world then decided to have fixed exchange rates that resulted in the U.S. dollar being the primary reserve currency and that it would be the only currency backed by gold, this is known as the ‘Bretton Woods System’ and it happened in 1944 (I know you super excited to know that). In 1971 the U.S. declared that it would no longer exchange gold for U.S. dollars that were held in foreign reserves, this marked the end of the Bretton Woods System.

It was this break down of the Bretton Woods System that ultimately led to the mostly global acceptance of floating foreign exchange rates in 1976. This was effectively the “birth” of the current foreign currency exchange market, although it did not become widely electronically traded until about the mid-1990s.

(OK! Now let’s move on to some more entertaining topics!)…

Who Trades Forex?

  • Central banks (Governments), Commercial Banks, Large Financial Institutions, Insurers.
  • Commercial companies / Exporters and Importers (Mining and Car Companies etc.)
  • Hedgers (E.g., Airlines, Farmers etc. Lock in Currency Prices as well as hedge Products Via offshore commodity futures.)
  • Commercial Traders (Hedge Funds)
  • Retail Traders (You and I)
  • Travellers and Tourists

What is Forex Trading?

Forex trading as it relates to retail traders (like you and I) is the speculation on the price of one currency against another. For example, if you think the euro is going to rise against the U.S. dollar, you can buy the EURUSD currency pair low and then (hopefully) sell it at a higher price to make a profit. Of course, if you buy the euro against the dollar (EURUSD), and the U.S. dollar strengthens, you will then be in a losing position. So, it’s important to be aware of the risk involved in trading Forex, and not only the reward.

How are Forex Currency Rates Determined?

  • Economic factors – These include: economic policy made by government agencies and central banks, and economic conditions as described by and through economic reports as well as various economic indicators.
  • Political conditions – International, national, and regional political conditions and events can have a large impact on the Forex currency markets.
  • Market Psychology – The psychology of market participants can influence the foreign exchange market in numerous ways. Ultimately all economic variables are expressed through the filter of the human brain / trader psychology
  • Trading Algorithms – Electronic trading based on algorithms (or computer / robot trading) is becoming more and more popular, as a result algorithmic trading is starting to have a large effect on Forex currency rates.
  • All of these determining factors are reflected via the price action on a raw price chart. This is why price action is the best trading method; by learning to interpret and trade it, you are also taking into account all variables that move a market, in the simplest and clearest way possible.

What Are The Most Traded Forex Currencies?

Some of the Advantages of Trading the Forex Market:

  • Forex is the largest market in the world, with daily volumes exceeding $5 trillion per day. This means dense liquidity which makes it easy to get in and out of positions.
  • Trade whenever you want: There is no opening bell in the Forex market. You can enter or exit a trade whenever you want from Sunday around 5pm EST to Friday around 4pm EST (New York time)
  • Ease of access: You can fund your trading account with as little as $250 at many retail brokersand begin trading the same day in some cases. Straight through order execution allows you to trade at the click of a mouse.
  • Fewer currency pairs to focus on, instead of getting lost trying to analyze thousands of stocks.
  • Freedom to trade anywhere in the world with the only requirements being a laptop and internet connection.
  • Commission-free trading with many retail market-makers and overall lower transaction costs than stocks and commodities.
  • The greater liquidity found in the Forex market is conducive to long, well-defined trends that respond well to technical analysis and charting methods.
  • Traders can profit in any market condition. Also, there is no inherent structural market bias like the long bias of the stock market, so traders have equal opportunity to profit in rising or falling markets.
  • Due to these factors and others, the FX market has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks.

In the image below, it can be easily seen how the Forex market’s $5.3 trillion per day trading volume dwarfs the futures and equities markets. In fact, it would take thirty days of trading on the New York stock exchange (NYSE) to equal one day of Forex trading!

While the forex market is clearly a great market to trade, I would note to all beginners that trading carries both the potential for reward and risk. Many people come into the markets thinking only about the reward and ignoring the risks involved, this is the fastest way to lose all of your trading account money. If you want to get started trading the FX market on the right track, it’s critical that you are aware of and accept the risk involved in every trade you take and focus at least as much on risk, if not more, than you do on reward.

Misconceptions about Forex Trading

  • Q: Does the Forex have a higher level of risk than other markets?
  • A: No this is NOT true, in fact, the Forex market is probably the easiest market in which to control risk due to very high trading volumes and liquidity. This allows us to enter and exit instantly. Furthermore, forex trading allows us to input our entry and exit points into the computer before a position is even taken.
  • Of course, there is always an element of risk involved in any trade taken.

Please proceed to Section 2: Forex Jargon and Trading Times

 

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