FX Basics
In this article we will cover:
What is Forex?
A Brief History
Forex Components
How to Read a Quote
Advantages of FX trading
Disadvantages of FX trading
Definitions
What is Forex?
Foreign Exchange trading is the simultaneous exchange of one country's currency for another.
Forex is always traded in pairs.
There is no centralised market place (for example, the New York Stock Exchange is for US stocks only) - it is simply a global electronic network of banks, brokers and institutions.
All sorts of traders trade the FX market - from pennies to billions of dollars (or any other currency).
Some, like us retail traders, are there to make money for our own benefit to support our lifestyle - while other institutions may use it to hedge international corporational finance.
The reasons are varied.
One thing is for certain - the market is huge.
Trillions of dollars are traded 24 hours a day for 5 days a week around the world.
A Brief History
Foreign exchange trading used to be the preserve of only the largest banks.
Prior to WWII currencies were pegged to gold - countries were supposed to only issue enough currency to cover their gold reserves.
However, most countries began printing their own money and the connection to gold reserves was lost.
So, in 1944 a meeting was held in Bretton Woods, USA with all the most powerful countries (at the time) in attendance.
It was agreed to peg all currencies to the US Dollar which, in turn, was pegged to gold at $35 per troy ounce.
In 1971 that all changed.
The US President suspended the Gold Standard and by 1979 almost all the exchange rates were allowed to float freely.
Now, governments around the world issue fiat currencies - they are not backed by gold or any other commodity - and are valued purely on the status of the country from which it is issued.
The floating exchange system means that one currency is valued in terms of another currency.
Since 1971 Forex has been opened up to more and more players.
Volumes increased very quickly - and became particularly popular with retail traders as the internet allowed us to trade alongside the professionals - with real-time quotes readily available.
Forex Components
Forex trading is the simultaneous buying of one currency while selling another - so are always traded in pairs.
When trading FX you don't buy anything physical - although, in a way, you are buying a minute fraction of the country behind the currency.
If the country does well then its currency will get stronger.
If the country does badly then its currency will get weaker.
When you buy a pair you want the first country to be doing well so it gets stronger - while simultaneously the second country to do badly and get weaker (and the reverse if you are selling a pair).
When these two things happen together we get large moves - which can last months to years.
There are many factors which can alter the strength or weakness of a currency.
Mostly it will be down to economic data - although sentiment can play a part, too.
In addition, many countries try to manipulate exchange rates to their advantage - but even the richest countries cannot do this for long as the market is just too large.
Historically, interest rates were major indicators.
This is called the carry trade.
If a country has a high interest rate, then those with large funds will want to hold any spare cash there - and may even borrow at the lower rate currency to do so.
When interest rates are low, worldwide, this strategy becomes defunct.
There are many other economic factors which affect a currency's worth - employment data, inflation, political stability, the trade balance and so on.
It can be time-consuming to monitor all these factors so most retail traders (and many professional traders, too) rely on technical analysis (chart reading) rather than fundamentals (economic data and sentiment).
Most Traded Currencies
The US Dollar is the most traded currency, followed by the Euro. All the rest make up less than 5% of the volume traded.
The Majors are the most traded currencies:
USD (United States Dollar)
EUR (Euro member states)
JPY (Japanese Yen)
GBP (Great British Pound)
CHF (Swiss Franc)
CAD (Canadian Dollar)
AUD (Australian Dollar)
It's a good idea to take some time to learn these abbreviations - as you will need them to read charts and place your trades.
In addition, the most traded currency pairs are:
EURUSD
USDJPY
USDCHF
GBPUSD
It is very important to know which is the first (base) currency and which is the second (quote or counter) currency.
Within the country you trade they are not interchangeable (as a currency exchange rate would be if you were holidaying abroad).
So make sure you know the order they are quoted so your charts match your broker account.
The base currency is always 1 and the quote currency is how much of that currency you can purchase for one base currency.
For example, if EURUSD is 1.5650 then you would get $1.5650 for €1.
Pips
A PIP is the smallest unit of change in which a currency pair can move.
DT Tip: For stocks, the smallest unit is a tick or a point - but FX has its own terminology.
It is important to use the correct term as the fractional denomination is different.
Usually, the smallest denomination is to 4 decimal places.
But you will notice, especially if you trade outside the Majors, that it may vary.
Within the Majors, the USDJPY denomination is to 2 decimal places, for example 106.29 (which means for $1 you would buy ￥106.29).
In recent years charts and brokers have begun to display additional decimal places - but you can largely discount these.
Any orders you place should be to 4 (or 2) decimal places.
This is quite accurate enough for the purposes of a retail trader.
Bid and Ask
One of the advantages to the retail trader in trading FX is the lack of buying/selling commission costs.
However, in order to keep the system running the market makers/brokers have to make a little money from each trade.
This is reflected in the Bid and Ask price.
DT Tip: When you look at a chart the quoted amount will usually be the mid-price (halfway between Bid and Ask).
As the spread is small this is more than adequate for our needs.
In addition, if you use a software other than your broker, you may notice small discrepancies in price (as they will be taking data from elsewhere).
This should be small - however, remember that it is the broker's price you will be trading.
The spread between the Bid and Ask will vary depending on the time of day, the broker, the liquidity of the pair, or other variable.
For a highly liquid pair, such as EURUSD, it should just be a few pips.
You may see something like this:
EURUSD Bid 1.7956 Ask 1.7961
This means that
if you want to go long EURUSD then you buy the EUR (while selling the USD) and pay the Bid price
if you want to short EURUSD then you sell the EUR (while buying the USD) and you pay the Ask price
An easy way to remember it is: you always get the worse price for the direction you want it to move!
Advantages of Forex Trading
When Forex is trending there is no better market to trade.
It has many advantages.
High liquidity
High liquidity means that there is little slippage - positions will get triggered at the price you want
Orders are filled quickly
There are few gap ups or downs (especially for the Majors)
Spreads are low
Trade when you want
As the FX market is open 24 hours a day, 5 days a week, you can choose when to trade
Leverage
You can choose how much to risk per pip (if trading physical stocks you are limited to the amount of capital you have - and may not even be able to purchase just one of the more expensive stocks)
Margins are low (compared to stock trading)
Equality
No one entity can corner the market - sometimes central banks try to manipulate currencies but even they cannot afford to do it for long periods of time
No barriers of entry
You can start FX trading with just a few hundred dollars (or local equivalent) using a mini account
No commission
Most brokers make a fractional profit from the spread, rather than charging a dealing commission - they are usually very small
No short selling restrictions
As currencies are sold in pairs you can short the base currency (effectively buying the quote currency)
Shorting FX is very different to shorting the stock market - it has no added complications
Trade on pure technical
While fundamentals move the FX market, you can trade purely on technical analysis - just by analysing a chart
Disadvantages of Forex Trading
No centralised exchange
This allows brokers to make up their own pricing - as there is a lot of competition this is usually not too much of an issue, but you do have to keep an eye on spreads
Two sides to every trade
FX can move fast if one currency is doing well while the other is doing very badly - if you're on the wrong side of the trade this can cost you (so always use a stop loss - they are usually filled as set)
If only one country is moving the pair then news items can whipsaw you out of a trade
If the major countries are in similar (or unchanging) economic circumstances, FX opportunities will be few and far between
Some additional terminology
Minors: if it's not one of the seven Major currencies then it's a Minor
Exotics: smaller countries where liquidity is limited and central banks are able to manipulate currencies for longer
Cross currency: for crosses not including the USD (example, EURCHF) - although the price is calculated by using the value of each to USD
In summary...
When Forex is moving it's an exceptional market to trade.
Prolonged trends can develop and a small account can turn into a large account very quickly, with the help of leverage.
It's important to manage risk and make use of stop losses.
In quieter times, the liquidity is still there but a trader is usually required to be more active to make similar gains.
Due to the sheer number of participants in FX, most economic data is factored into price - which means technical analysis can be used.
This is very helpful to retail traders as interpreting the vast amount of fundamental data - for all the countries whose currencies we may want to trade - would be almost impossible!
Let’s go trade!
