Introduction to Forex
In this tutorial we will be going over the most important concepts related to Forex and the online currency trading industry. Retail traders will want to familiarize themselves with these concepts before they begin trading.
WHAT MAKES FOREX UNIQUE?
Foreign exchange, also known as Forex, is defined as the exchanging of currencies on the global marketplace. While a currency exchange is typically thought of in the context of trading one currency for another while travelling abroad, Forex refers to large scale trading on a global level. With worldwide trading volume averaging $5.3 trillion every day, the Forex market is perhaps the largest and most liquid in the world.
Forex has several distinct characteristics that distinguish it from traditional financial trading. In the stock market, traders purchase a stock when they think it will increase in value, and then sell it when they feel like either the price has peaked, or it will start decreasing. Forex traders predict not only whether a currency will increase or decrease in value, but whether it will increase or decrease relative to a second currency it is paired with – the Currency Pair.
For example, if a trader is working with the US dollar- Japanese Yen currency pair, (USD/JPY), he would need to determine whether the US dollar will increase or decrease in value relative to the Yen. If the pair is expected to increase, a buy position is placed. If it is forecasted to decrease, a sell position is placed.
Additionally, the Forex market operates in a completely decentralized environment, with trades being conducted electronically. In other words, there is no one exchange where all Forex trades are recorded, like say for companies listed for trading on the New York Stock Exchange. The decentralized nature of Forex trading means that there is no one overarching body governing how trading needs to be conducted.
As currencies from all over the world are being traded against each other at any given time, the Forex market operates 24 hours a day, 6 days a week. With trading being done on such a massive and global scale, market manipulation is nearly impossible. As such, Forex trading is often called “the market closest to the ideal of perfect competition”.
HOW A FOREX TRADE IS CONDUCTED?
As was previously touched upon, Forex is a unique form of online trading with its own rules and methodologies. Unlike the equities markets, where a trader simply has to determine if a company’s stock will increase or decrease, (and buy or sell accordingly), the Forex trader has to determine if a currency will increase or decrease in value in relation to another currency. While this may seem confusing, a quick overview of how a Forex trade is conducted will help simplify things.
INTERPRETING A CURRENCY PAIR
Retail customers typically conduct their trading via a Forex broker. These brokers act as an intermediary between traders and the banks that are executing the positions. That means that the trader does not need to be concerned with physically purchasing or trading a currency. The only thing they need to do is determine whether the currency pair they are working with will move up or down. With every broker offering unique features to their clients, it is important to understand how trading works before investing any funds.
Forex trades are always conducted in pairs, with the first currency referred to as the base currency, and the second referred to as the quote currency. For example, in the USD/JPY pair, the US dollar (USD) is considered the base currency, while the Japanese yen (JPY) is the quote currency. The price of the pair is quoted in Japanese yen, meaning that if the pair is listed at a price of 106.92, 1 US dollar would be equal to 106.92 Japanese yen.
Currency pairs will always be listed with two prices. The bid price is the price traders will buy the base currency vs. the quote currency, while the ask price is the price traders will sell the base currency vs. the quote currency. The difference between the bid and ask prices is called the spread, which is measured in pips and is the cost of opening a position. Going back to our example of the USD/JPY, if the bid price is 106.840 and the ask price is 106.855, the cost of opening a position for this pair would be .015 pips.
MARGIN TRADING AND MONEY MANAGEMENT
In addition to understanding how to read a currency pair, traders should familiarize themselves with several other aspects of the retail Forex market, including margin requirements needed to open a position and leverage. A margin requirement is the minimum amount of money needed in a trading account in order to open a position. Because the value of Forex pairs are calculated in pips, which are only equal to a fraction of a cent, traders are able to leverage their positions for a significantly higher amount than the actual margin required. Leverage can range from anywhere between 100:1, meaning that for every $1 in the trading account $100 can be traded, to 400:1, meaning that for every $1 in the trading account, $400 can be traded.
Leverage has both advantages and disadvantages. When working with 100:1 leverage, clients are able to trade positions up to $100,000 with only a $1,000 deposit. That means that every pip is worth 100 times its real value. Now obviously this can work in the traders favor or against it, with both profits and losses amplified by the increased value of the position. Because leverage has the ability to generate rapid fluctuations in the margin of an account, employing a proper money management strategy should be a top priority for any trader. By knowing in advance how much margin to invest in any single position, traders are able to ensure their long-term survival in the Forex market.
ROLLOVER AND THE CARRY TRADE
For beginners to the world of Forex, the many different techniques and rules associated with trading currencies can seem overwhelming at first. While there are, in fact, many different things to consider while trading, these concepts are fairly simple to master and can provide you with the skills and knowledge needed to become a successful trader. Here we will be talking about rollover, a concept that when effectively mastered can be applied to what is called the carry trade, which is a fantastic way to further increase your trading margin.
In Forex, all trades are settled at the end of each trading day at 17:00 EST. Traders have the option of carrying, or rolling, their trades over into the next day by simultaneously closing and opening them at the rate listed when markets start the new day. Because the trade is being closed, interest on both currencies in the pair is either paid or collected by the trader, depending on whether the position was a buy or sell.
For example, on a EUR/USD buy position, the euro is purchased against the US dollar. Every time that position is rolled over into the next trading day, the trader collects interest on the euro while paying interest on the US dollar. If the position is a sell, the trader would pay interest on the euro while collecting it on the US dollar. Interest rates are determined by the respective central bank associated with each currency. If the interest rate on the currency being purchased is higher than the one being quoted, the trader would collect the difference in interest rates.
Let’s examine the concept of rollover further by going back to our EUR/USD example. If the EU interest rate is higher than the US interest rate, and the trader rolls over a buy position, the difference between the EU and US interest rates, relative to the size of the position, would be collected by the trader. Conversely, if the position is a sell order, the difference between the EU and US interest rates, relative to the size of the position, would be debited from the traders account.
In Forex, the carry trade is a common method used by traders to collect money on both the movement a currency pair takes, as well as the interest collected when that position is rolled over. The goal of this trade is not only to roll over a position where the difference in interest rates works in the traders favor, but to do it when the difference in interest rates is forecasted to increase.
Going back to our EUR/USD example, if either the EU is forecasted to increase interest rates or the US is forecasted to decrease rates, the spread on interest rates would increase, and rolling over a buy EUR/USD position would net the trader an additional profit.