Forex

What is forex?

“Forex” stands for “foreign exchange” and foreign exchange is the process of trading different currencies. The Forex market is the “place” where currencies are traded. The Forex market is commonly known as the FX market, the Forex Market, the foreign exchange market or the currency market.

Why do people trade currency?

Trading currency is the basis of any international trade. For example, If you are living in the U.K. and want to buy a car from a German car maker, either you or the dealership that you buy the car from, has to pay the Germans for the car in Euros (EUR). This means that the U.K. dealership would have to exchange the value of the car in Pounds (GBP) into Euros. The same would apply for buying Italian shoes (EUR), Japanese video games (YEN), American films (USD), French wine. Similarly, If a British football club wanted to buy a player from a Spanish football club, they could not pay for the transfer in pounds, they would have to pay in Euros. Therefore, the British club would have to exchange their Pounds for Euros to complete the transaction.

Another example of a currency or foreign exchange trade is if you were going on holiday. If you were from the U.K. and you were going to to the U.S.A., you wouldn’t be able to buy anything with your pounds. You have to exchange your Pounds for Dollars at your bank, post office or local bureau de change.

Now try and imagine how many of these foreign exchange trades happen globally on a daily basis. In 2012 the Bank for International Settlements reported that the forex market traded in excess of $4.9 trillion per day. That’s $4,900 billion every day! Now, due to all of these trades constantly taking place, the value of currencies in the forex market constantly changes as well. This is due to supply and demand (If lots of people are buying a currency, the price will go up. Equally, and if lots of people are selling a currency the price will go down.) It’s the differences in these prices that traders take advantage of and make profit.

Before Brexit, £1000 was worth $600.

After Brexit, £1000 was worth $800

If I had exchanged my dollars for pounds (GBP/USD) before Brexit was announced and then, after Brexit, exchanged them back from dollars I would have made $xxx (£xxx). All from simply taking advantage of the fluctuations in the value of the different currencies.

Where is the forex market?

Unlike the other markets, the Forex market has no central marketplace. Forex trading is conducted electronically using a process called Over-The-Counter (OTC). This means that all trades are completed via computer networks between traders around the world, rather than on one centralized exchange. Think of it as the Forex market is like shopping online, and the other markets are like physically going to the shops. The reason for this is that there are so many trades happening in the Forex market, globally, every day that the only way to accurately keep track of every trade is to use a global network of computers. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney – across almost every time zone. This means that when the trading day in the U.S. ends, the forex market begins anew in Tokyo and Hong Kong.

How a forex trade is conducted

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 trader’s 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 rollover a position where the difference in interest rates works in the trader’s 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.