Forex Basics I

Over the next few weeks, we’ll be taking a look at the Forex market in detail with a three part series that explores the basics of currency trading, the life of a Forex trade and the world of currency arbitrage. In this week’s article, we’ll be building some basic understanding for how the currency markets work, what happens when trades go wrong and how the leverage of the Forex markets can literally make or break a trader’s career. Let’s get started…

What is Forex? The term Forex stands for the Foreign Exchange Market, also sometimes referred to as the FX market. The Forex market is the most liquid exchange in the world as it trades a cash turnover of nearly 1.9 trillion dollars per day. The Forex market liquidity is approximately 30 times larger than all of the US domestic equity markets combined. When we talk about trading, most laypeople understand the idea of buying and selling a particular stock or commodity. The trader is placing a long or short speculation on a single trading instrument. When we begin working with the Forex market, we need to shift gears because we are now trading what is called a currency pair. The Forex market is the speculation on the relationship between two countries respective currencies. For example, a Forex trader can speculate on the relationship between the Eurodollar versus the Japanese Yen (EUR/JPY) and the Swiss Franc versus the US Dollar (CHF/USD). Whenever we think about the Forex market, we need to think about two instruments (pairs) compared to a single stock like MSFT or DELL.

There are two primary reasons why currencies are traded. Governments or companies that sell goods or services in countries other than their own must have a vehicle to covert any profits made from the other countries currency back to their own. This type of transactions typically makes up approximately 5% of the Forex market. Currencies are also traded for the goal of speculation by institutions, companies and proprietary traders. This approach to the Forex market makes up approximately 95% of all transactions on the Forex market. Because such a large percentage is geared on the latter, we’ll be focusing our attention on that demographic.

The Forex market is unique in many ways. While US markets are open for a set amount of time per day, the Forex market trades 24 hours a day, 5 ½ days per week. Forex trading begins on Sunday morning and closes on Friday afternoon (PST). Trading begins in Sydney, Australia and moves around the globe as various financial markets open around the world. Because this is a global market, there isn’t a centralized exchange like the NYSE or CME. With so many countries and respective currencies available, many traders narrow their focus to a few select currency pairs that offer the highest amount of liquidity. These pairs are called the “Majors”. The majors include currencies such as the US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar

Now that we have the concept of currency pairs, let’s take a look at what happens when a trader places a trade in the Forex market. As this transaction is purely electronic, let’s use an example to convey the principle. A trader with $10,000 walks into a bank with the speculation that the US dollar will weaken compared to the British Pound (also referred to as the British Cable or Sterling). The trader sells his/her US dollars to buy British Pounds. The trader then receives an equal amount of currency in the form of the British Pound (the amount received is dependant upon the current exchange rate).  The trader leaves the bank with a pocket full of British Pounds. Over the next several days and weeks, the British Pound continues to gain strength against the weakening US Dollar. Once the trader feels that the British Pound may be topping out, they once again proceed to the bank and sell their British Pounds and buy back their US Dollars. Because the British Pound has increased in strength and/or the US Dollar has continued to weaken, they now receive considerably more US Dollars in return. They have made a tidy profit simply by selling their US Dollars and buying another currency that has moved upward.

From a trading standpoint, there are several intricacies to this market that any well informed FX trader should understand before putting their money on the line. One of these intricacies is the minimum tick increment of currency pairs. Stocks trade in pennies, futures trade in fractions and currencies trade in pips. A “pip” stands for Percentage In Point. All currency pairs in the Forex market trade out to four decimal places. For example, if a bottle of shampoo was sold in a drugstore, it may sell for $3.50. If the bottle of shampoo was priced like a currency pair, the price would be $3.5000. The one currency pair that does not trade four decimal places is the Japanese Yen. The Japanese Yen has not been revalued since World War II therefore, 1 Japanese Yen is approximately equivalent to $.08 in US Dollars. So when we think about the USD/YEN currency pair, trading is only extended to the 1/100th rather than 1/1000th of other currencies.

One of the attractive aspects of the Forex market is the amount of currency that be leveraged with a relatively small amount of money. With stocks, many pattern day traders enjoy the additional buying power of 4-1. This translates to a trader being able to utilize margin to buy or sell shares that they may not be able to otherwise afford. If a pattern day trader of stocks has $100,000 in their account, the brokerage house will allow that trader to buy, sell & carry $400,000 worth of equities. This equates to a nice profit margin or a margin call depending on whether or not the trade moves their way. In the Forex market, this margin ability is magnified through 100-1 leverage. This means that a trader can control $1,000,000 in a foreign currency by leveraging a $10,000 account.

If a trader believes the British Pound is headed up against the US Dollar, they leverage $1,000,000 with their $10,000 of up front capital utilizing the complete 100-1 ratio. This allows them to control the equivalent of $1,000,000 US Dollars of the British Pound. They purchase the British Pound at 1.6500. Over the next two months, the British Pound continues to gain strength against the dollar, the trader then sells the British Pound at 1.8500. With the power of 100-1 margin, the trader has made a profit of $121,212 (over 1200%) with an investment of $10,000.

There are several economic and geopolitical components to this market that can dramatically affect the trading in the currencies. In the next post (Forex Basics II), we’ll begin to illustrate some other examples of leverage and outline the life of a traditional Forex trade as well as expand upon some of these influencing forces.

Trade Smart.....

~Duane Gott

Comments

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