Introduction to Forex

Reading Quotes

Benefits vs. Risks

Trading Participant

Ready to Trade?

1) Introduction to Forex

Forex stands for the Foreign Exchange market, also abbreviated by "FX", and it is one of the most exciting, fast-paced markets around the world. It was established in 1971 when fixed currency exchange was introduced. Forex is when one currency is traded by another. The Forex market is the largest financial market in the world, with a daily turnover of $3.20 trillion. The major traders in this market are large banks, central banks, multinational corporations, governments and currency speculators. It is a true 24-hour market, operating from Sunday 5:00 PM ET to Friday 5:00PM ET.

Unlike other financial markets, investors can respond to currency fluctuations caused by economic, political events and psychological effects at the time they occur - day and night. Currencies are traded in pairs, usually against the US Dollar, such as Euro/US Dollar (EUR/USD) or US Dollar/Japanese Yen (USD/JPY).

The extreme liquidity and the availability of high leverage and margin trading have helped to spur the market's rapid growth and made it the ideal place for many traders. Any position can be opened and closed within minutes, or can be held for months and years. The price fluctuations of the currencies are based on objective considerations of supply and demand and cannot be manipulated easily because the size of the market does not allow even the largest players, such as central banks or governments, to move prices at will.

Until recently, trading in the Forex market had been the domain of governments, large financial institutions and corporations, central banks, hedge funds and extremely wealthy individuals. The emergence of new technologies such as the internet has changed all of this, and now it is possible for small time and home investors to buy and sell currencies easily with the click of a mouse through their home computer.

Currencies are important to most people around the world, whether they realize it or not, because currencies need to be exchanged in order to conduct foreign trade and business. If you are living in the U.S. and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French for the cheese in Euros (EUR). This means that the U.S. importer would have to exchange the equivalent value of U.S. Dollars (USD) into Euros. The same goes for traveling. An English tourist in Paris can't pay in Sterling to see the Louvre because it's not the locally accepted currency. As such, the tourist has to exchange the Sterling for the local currency, in this case the Euros, at the current exchange rate.

The need to exchange currencies is the primary reason why the Forex market is the largest, most liquid financial market in the world.

One unique aspect of this international market is that there is no central marketplace for currency exchange. Rather, trade is conducted electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, 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. As such, the Forex market can be extremely active any time of the day, with price quotes changing constantly.

Spot Market and Futures Markets
There are actually different ways that institutions, corporations and individuals trade Forex, among those ways are: the spot market and the futures market. The spot market always has been the largest market because it is the "underlying" real asset that the futures markets are based on. In the past, the futures market was the most popular venue for traders because it was available to individual investors for a longer period of time. However, with the advent of electronic trading, the spot market has witnessed a huge surge in activity and now surpasses the futures market as the preferred trading market for individual investors and speculators. When people refer to the Forex market, they usually are referring to the spot market. The futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.

Spots Markets
More specifically, the spot market is where currencies are bought and sold according to the current price. That price, determined by supply and demand, is a reflection of many things, including current interest rates, economic performance, sentiment towards ongoing political situations (both locally and internationally), as well as the perception of the future performance of one currency against another. It is a bilateral transaction by which one party delivers an agreed-upon currency amount to the counter party and receives a specified amount of another currency at the agreed-upon exchange rate value.

Futures Markets
In the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange. In the U.S., the National Futures Association regulates the futures market. Futures contracts have specific details, including the number of units being traded, delivery and settlement dates.



2) Reading Quotes

One of the biggest sources of confusion for those new to the currency market is the standard for quoting currencies. In this section, we'll go over currency quotations and how they work in currency pair trades.

When a currency is quoted, it is done in relation to another currency, so that the value of one is reflected through the value of another. Therefore, if you are trying to determine the exchange rate between the U.S. dollar (USD) and the Japanese yen (JPY), the quote would look like this:

USD/JPY = 105.25

This is referred to as a currency pair. The currency to the left of the slash is the base currency, while the currency on the right is called the quote or counter currency. The base currency (in this case, the U.S. dollar) is always equal to one unit (in this case, 1 USD), and the quoted currency (in this case, the Japanese yen) is what that one base unit is equivalent to in the other currency. The quote means that US$1 = 105.25 Japanese yen. In other words, US$1 can buy 105.25 Japanese yen.

Direct Quote vs. Indirect Quote
There are two ways to quote a currency pair, either directly or indirectly. A direct quote is simply a currency pair in which the domestic currency is the base currency; while an indirect quote, is a currency pair where the domestic currency is the quoted currency. So if you were looking at the Canadian dollar as the domestic currency and U.S. dollar as the foreign currency, a direct quote would be CAD/USD, while an indirect quote would be USD/CAD. The direct quote varies the foreign currency, and the quoted, or domestic currency, remains fixed at one unit. In the indirect quote, on the other hand, the domestic currency is variable and the foreign currency is fixed at one unit.

For example, if Canada is the domestic currency, a direct quote would be 0.85 CAD/USD, which means with C$1, you can purchase US$0.85. The indirect quote for this would be the inverse (1/0.85), which is 1.18 USD/CAD and means that USD$1 will purchase C$1.18.

In the Forex spot market, most currencies are traded against the U.S. dollar, and the U.S. dollar is frequently the base currency in the currency pair. This would apply to the above USD/JPY currency pair, which indicates that US$1 is equal to 119.50 Japanese yen.

However, not all currencies have the U.S. dollar as the base. The Queen's currencies - those currencies that historically have had a tie with Britain, such as the British pound, Australian Dollar and New Zealand dollar - are all quoted as the base currency against the U.S. dollar. The Euro, which is relatively new, is quoted the same way as well. This is why the EUR/USD quote is given as 1.55, for example, because it means that one euro is the equivalent of 1.55 U.S. dollars.

Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of the Japanese yen (JPY), which is quoted out to two decimal places.

Cross Currency
When a currency quote is given without the U.S. dollar as one of its components, this is called a cross currency. The most common cross currency pairs are the EUR/GBP, EUR/CHF and EUR/JPY. These currency pairs expand the trading possibilities in the Forex market, but it is important to note that they do not have as much of a following (for example, not as actively traded) as pairs that include the U.S. dollar, which also are called the majors.

Bid and Ask
As with most trading in the financial markets, when you are trading a currency pair there is a bid price (buy) and an ask price (sell). Again, these are in relation to the base currency. When buying a currency pair (going long), the ask price refers to the amount of quoted currency that has to be paid in order to buy one unit of the base currency, or how much the market will sell one unit of the base currency for in relation to the quoted currency.

The bid price is used when selling a currency pair (going short) and reflects how much of the quoted currency will be obtained when selling one unit of the base currency, or how much the market will pay for the quoted currency in relation to the base currency.

The quote before the slash is the bid price, and the two digits after the slash represent the ask price (only the last two digits of the full price are typically quoted). Note that the bid price is always smaller than the ask price. Let's look at an example:

USD/CAD = 1.1915/1.1920
BID = 1.1915
ASK = 1.1920

If you want to buy this currency pair, this means that you intend to buy the base currency and are therefore looking at the ask price to see how much (in Canadian dollars) the market will charge for U.S. dollars. According to the ask price, you can buy one U.S. dollar with 1.1920 Canadian dollars.

However, in order to sell this currency pair, or sell the base currency in exchange for the quoted currency, you would look at the bid price. It tells you that the market will buy US$1 base currency (you will be selling the market the base currency) for a price equivalent to 1.1915 Canadian dollars, which is the quoted currency.

Whichever currency is quoted first (the base currency) is always the one in which the transaction is being conducted. You either buy or sell the base currency. Depending on what currency you want to use to buy or sell the base with, you refer to the corresponding currency pair spot exchange rate to determine the price.

Spreads and Pips
The difference between the bid price and the ask price is called a spread. If we were to look at the following quote: EUR/USD = 1.5500/04, the spread would be 0.0004 or 4 pips, also known as points. Although these movements may seem insignificant, even the smallest point change can result in thousands of dollars being made or lost due to leverage. Again, this is one of the reasons that speculators are so attracted to the Forex market; even the tiniest price movement can result in huge profit.

The pip is the smallest amount a price can move in any currency quote. In the case of the U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese yen, one pip would be 0.01, because this currency is quoted to two decimal places. So, in a Forex quote of USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies trade within a range of 100 to 150 pips a day.

Currency Pairs in the Futures Markets
One of the key characteristics of the Forex markets is the way currencies are quoted. In the futures markets, foreign exchange always is quoted against the U.S. dollar. This means that pricing is done in terms of how many U.S. dollars are needed to buy one unit of the other currency. Remember that in the spot market some currencies are quoted against the U.S. dollar, while for others, the U.S. dollar is being quoted against them. As such, the futures market and the spot market quotes will not always be parallel one another.

For example, in the spot market, the British pound is quoted against the U.S. dollar as GBP/USD. This is the same way it would be quoted in the futures markets. Thus, when the British pound strengthens against the U.S. dollar in the spot market, it will also rise in the futures markets.

On the other hand, when looking at the exchange rate for the U.S. dollar and the Japanese Yen, the former is quoted against the latter. In the spot market, the quote would be 115 for example, which means that one U.S. dollar would buy 115 Japanese Yen. In the futures market, it would be quoted as (1/115) or .0087, which means that 1 Japanese Yen would buy .0087 U.S. dollars. As such, a rise in the USD/JPY spot rate would equate to a decline in the JPY futures rate because the U.S. dollar would have strengthened against the Japanese yen and therefore one Japanese yen would buy less U.S. dollars.

3) Benefits vs. Risks

In this section, we'll take a look at some of the benefits and risks associated with the Forex market. We'll also discuss how it differs from the equity market in order to get a greater understanding of how the Forex market works.

The Good and the Bad
We already have mentioned that factors such as the size, volatility and global structure of the Forex market have all contributed to its rapid success. Given the highly liquid nature of this market, investors are able to place extremely large trades without affecting any given exchange rate. These large positions are made available to traders because of the low margin requirements used by the majority of the industry's brokers. For example, it is possible for an investor to control a position of US$100,000 by putting down as little as US$1,000 up front and borrowing the remainder from his or her broker. This amount of leverage acts as a double-edged sword because investors can realize large gains when rates make a small favorable change, but they also run the risk of a massive loss when the rates move against them. Despite the risks, the amount of leverage available in the Forex market is what makes it attractive for many speculators.

The currency market is also the only market that is truly open 24 hours a day with decent liquidity throughout the day. For traders who may have a day job or just a busy schedule, it is an optimal market to trade in. The major trading hubs are spread throughout many different time zones, eliminating the need to wait for an opening or closing bell. As the U.S. trading closes, other markets in the East are opening, making it possible to trade at any time during the day.

While the Forex market may offer more excitement to the investor, the risks are also higher in comparison to trading equities. The ultra-high leverage of the Forex market means that huge gains can quickly turn to damaging losses and can wipe out the majority of your account in a matter of minutes. This is important for all new traders to understand, because in the Forex market - due to the large amount of money involved and the number of players - traders will react quickly to information released into the market, leading to sharp moves in the price of the currency pair.

By now you should have a basic understanding of what the Forex market is and how it works.

4) Market Participants

Unlike the equity market - where investors often only trade with institutional investors (such as mutual funds) or other individual investors - there are additional participants that trade on the Forex market for entirely different reasons than those on the equity market. Therefore, it is important to identify and understand the functions and motivations of the main players of the Forex market.

Governments and Central Banks
Arguably, some of the most influential participants involved with currency exchange are the central banks and federal governments. In most countries, the central bank is an extension of the government and conducts its policy in tandem with the government. However, some governments feel that a more independent central bank would be more effective in balancing the goals of curbing inflation and keeping interest rates low, which tends to increase economic growth. Regardless of the degree of independence that a central bank possesses, government representatives typically have regular consultations with central bank representatives to discuss monetary policy. Thus, central banks and governments are usually on the same page when it comes to monetary policy.

Central banks are often involved in manipulating reserve volumes in order to meet certain economic goals. For example, ever since pegging its currency (the Yuan) to the U.S. dollar, China has been buying up millions of dollars worth of U.S. treasury bills in order to keep the Yuan at its target exchange rate. Central banks use the foreign exchange market to adjust their reserve volumes. With extremely deep pockets, they yield significant influence on the currency markets.

Banks and Other Financial Institutions
In addition to central banks and governments, some of the largest participants involved with Forex transactions are banks. Most individuals who need foreign currency for small-scale transactions deal with neighborhood banks. However, individual transactions pale in comparison to the volumes that are traded in the interbank market.

The interbank market is the market through which large banks transact with each other and determine the currency price that individual traders see on their trading platforms. These banks transact with each other on electronic brokering systems that are based upon credit. Only banks that have credit relationships with each other can engage in transactions. The larger the bank, the more credit relationships it has and the better the pricing it can access for its customers.

Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the bid/ask price. One way that banks make money on the Forex market is by exchanging currency at a premium to the price they paid to obtain it. Since the Forex market is a decentralized market, it is common to see different banks with slightly different exchange rates for the same currency.

Hedgers
Some of the biggest clients of these banks are businesses that deal with international transactions. Whether a business is selling to an international client or buying from an international supplier, it will need to deal with the volatility of fluctuating currencies.

If there is one thing that management (and shareholders) detests, it is uncertainty. Having to deal with foreign-exchange risk is a big problem for many multinationals. For example, suppose that a German company orders some equipment from a Japanese manufacturer to be paid in yen one year from now. Since the exchange rate can fluctuate wildly over an entire year, the German company has no way of knowing whether it will end up paying more Euros at the time of delivery.

One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go into the spot market and make an immediate transaction for the foreign currency that they need.

Unfortunately, businesses may not have enough cash on hand to make spot transactions or may not want to hold massive amounts of foreign currency for long periods of time. Therefore, businesses quite frequently employ hedging strategies in order to lock in a specific exchange rate for the future or to remove all sources of exchange-rate risk for that transaction.

For example, if a European company wants to import steel from the U.S., it would have to pay in U.S. dollars. If the price of the euro falls against the dollar before payment is made, the European company will realize a financial loss. As such, it could enter into a contract that locked in the current exchange rate to eliminate the risk of dealing in U.S. dollars. These contracts could be either forwards or futures contracts.

Speculators
Another class of market participants involved with foreign exchange-related transactions is speculators. Rather than hedging against movement in exchange rates or exchanging currency to fund international transactions, speculators attempt to make money by taking advantage of fluctuating exchange-rate levels.

Some of the largest and most controversial speculators on the Forex market are hedge funds, which are essentially employ unconventional investment strategies in order to reap large returns. Given that they can place such massive bets, they can have a major effect on a country’s currency and economy.

5) Ready to Trade?

So, you think you are ready to trade? Make sure you read this section to learn how you can go about setting up an account to trade in the Forex along with what factors you should be aware of before you take this step. We will then discuss how to trade and the different types of orders that can be placed.

How to Trade
We will take a look at how exactly you can trade within your account. The two main ways to trade the currency market is the simple buying and selling of currency pairs, where you go long one currency and short another. The second way is through the purchasing of derivatives that track the movements of a specific currency pair. The most common way is to simply buy and sell currency pairs, much in the same way most individuals buy and sell stocks. In this case, you are hoping the value of the pair itself changes in a favorable manner. If you go long a currency pair, you are hoping that the value of the pair increases. For example, let's say that you took a long position in the USD/CAD pair - you will make money if the value of this pair goes up, and lose money if it falls. This pair rises when the U.S. dollar increases in value against the Canadian dollar.

The other option is to use derivative products, such as futures, to profit from changes in the value of currencies. A futures contract creates the obligation to buy the currency at a set point in time. This trading is usually only used by more advanced traders, but it is important to at least be familiar with it.

Types of Orders

For trader looking to open a new position:

This trade will can use either a Market Order or a Pending Order.

A Market Order:

This order gives a trader the ability to obtain the asset at whatever price it is currently trading at in the market.

A Pending Order:

This order allows the trader to specify a certain entry price. A trader can enter a sell or a buy trade as using limit orders as follows:

Sell Limit: An order to sell a specified quantity of a currency at a specified that is above the current market bid price.

Sell Stop: An order to sell a specified quantity of a currency at a specified that is below the current market bid price.

Buy Stop: An order to buy a specified quantity of a currency at a specified that is above the current market ask price.

Buy Limit: An order to buy a specified quantity of a currency at a specified that is below the current market ask price.

For traders that already hold an open position:

This trader has also two types of order which are a Take profit order or a Stop loss order.

Take-profit order:

This order allows the trader to lock in profit. Say, for example, that a trader is confident that the GBP/USD rate will reach 1.7800, but is not as sure that the rate could climb any higher. A trader could use a take-profit order, which would automatically close his or her position when the rate reaches 1.7800, locking in their profits.

Stop-loss order:

This order allows traders to determine how much the rate can decline before the position is closed and further losses are accumulated. Therefore, if the GBP/USD rate begins to drop, an investor can place a stop-loss that will close the position (for example at 1.7787), in order to prevent any further losses.

Opening an Account
Trading the Forex requires you to open up an account. Please follow the link to the “Open Live Account” for the complete instructions.