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Published On: Fri, Jan 17th, 2014

How Forex Trading Works

Forex

Another huge market is the Forex or foreign exchange market. It has not been in existence for the speculative trader as long as the stock markets, mainly because currency exchange rates used to be fixed, but also nowadays the Internet has made it much easier for an individual trader to take part.

History of Forex Trading

In the early part of the 20th century currencies were fixed to the price of gold, and the central bank of each country kept a supply of gold to cover the currency it issued. In theory, you could just get gold for your pounds sterling, take it to America and get US dollars, all in accordance with published rates. The First World War and later the Second World War cost so much that many countries could not afford to restrict their money supply to the amount of gold they had in hand, and consequentially “fiat currency” became the norm.

Fiat currency is simply paper currency, depending on public confidence for its value. Just look at the phrasing, “I promise to pay the bearer on demand…” on most banknotes. If you “demand”, all you will get is other fiat currency in exchange, whether coins or notes.

Sure, in 1944 there was the Bretton Woods Accord where all the countries agreed that an ounce of gold was worth US$35, and Fort Knox housed the precious metal. But that changed in 1971 when Pres. Nixon decided it was not sustainable, which led to the free-floating currencies that we have today, and incidentally the enormous overdraft that the US is currently running.

Size and Scope

This makes for a gigantic speculative market, which some experts reckon amounts to $4 trillion per day in turnover. As there is no central exchange or clearinghouse, this is an estimate of the total for all countries that have foreign currency markets.

For the individual trader, one of the attractions of the foreign exchange market is that it is open 24 hours a day, as there are always open markets and currency trading going on somewhere in the world. It closes at the weekend, so it is reckoned to be 24 hours/5 ½ days, enough for even the most avid trader.

The classic foreign exchange market deals in “lots” of 100,000 units of currency, say £100,000 or $100,000. You don’t need anything like that amount to trade a “lot”, and many Forex dealers allow you to have a gearing of 1:100, which means the base amount you need to trade a lot is £1000. You actually need more than that, because the slightest move against your trade would put you in financial trouble, which the dealers would not allow, but you can see that you get remarkable leverage for your money.

It’s worth pointing out again that leverage can work against you as well as for you, and also that your gain is another person’s loss, and vice versa. Unlike stocks, and companies, and sales figures, the concept is much simpler as all you have is one currency buying another currency for a varying price.

Even though the leverage you get is such a deal, the Forex dealers have worked to make it more accessible for the retail trader, inventing things called “mini lots” and “micro-lots”, which are 1/10th and 1/100th of a lot, and have therefore encouraged more public involvement. For ultimate flexibility, however, you can trade Forex with a spread betting provider, and decide exactly how much money you want to stake, rather than being stuck with standard sizes.

The Details

As mentioned above, Forex is simply the value of one currency compared to another. It is always quoted in currency pairs, such as the US dollar versus the pound sterling, or the euro versus the yen. Since you can take either side of the contract, you can trade on the value of one currency going either up or down against the other. This confuses some people, and you must make sure that you understand which of the two currencies you are backing anytime you trade.

Having said that, Forex is in principle much simpler than the stock market, and most Forex trading takes place on a handful of currency pairs, giving you far fewer combinations to research than you might fear. Each currency is represented by three letters, and there are only seven currencies you need to know to cover the majority of Forex trading. The currencies are British pounds sterling (GBP), US dollar (USD), Australian dollar (AUD), Canadian dollar (CAD), euro (EUR), Swiss Franc (CHF), and Japanese yen (JPY). Mostly fairly easy to remember, though note that the Swiss franc is CHF because CH stands for “Confoederatio Helvetica”, Latin for Swiss Confederation. The Swiss franc is the only franc left in Europe since the adoption of the euro by France, Belgium, etc.

The most popular pairs of currencies are GBP/USD, EUR/USD, USD/CAD, USD/CHF, USD/JPY, and USD/AUD. The fact that USD is the first currency named for many of these pairs reflects its international importance, though it’s nice to see that it is second to the pound in GBP/USD, which currency pair is nicknamed “cable”.

If you were to look up GBP/USD, you would see that the value is about 1.64. This means that £1 can buy $1.64. It’s always this way round, one unit of the first named currency buys the varying number of the second. So working from the list above, one euro buys so many US dollars, one US dollar buys so many Canadian dollars, etc.

That’s not to say that you can’t quote the currency pairs the other way around, if you really want to. You could have USD/GBP, which would have a value of about 0.61. It’s just not the usual way it is quoted.

The next thing to talk about is the “PIP”, which people say stands for various words (all mean the same). I prefer “percentage in point”. It’s basically a percent of a percent, which amounts to the fourth decimal place of a number. That’s how the Forex market is frequently quoted, with four decimal places. For instance, the GBP/USD might be quoted as 1.6363. If the value went up by one pip, then the quote would be 1.6364. If the value went up instead by 10 pips, the quote would change to 1.6373. Of course, the value could go down by any number of pips too.

This is the way that lots of Forex traders want to talk about how successful they are. They might say “I gained 150 pips going long on cable yesterday.” In the parlance, going long means you put money on the first named currency to increase in value, which means the quoted number goes up. Going short is the opposite. You won’t find many Forex traders who will tell you they gained a specific amount, say £1500, they just talk about pips. If you’re trading whole lots, each pip of movement amounts to 10 units of currency, £10 in this case, as 0.0001 x £100,000 is £10.

Just one note of exception. When you are trading against the yen the pip is 1/100th of a yen. This is for the simple practical reason that there are about ¥100 to each of the major currencies such as the pound sterling or the US dollar. The current value of USD/JPY is 104.31.

With Forex trading, you don’t normally pay a separate commission, but you are quoted slightly different prices depending whether you are going long (buying) or short (selling). The difference between the two prices is called the “spread”. The spread is usually a few pips, which might seem to be infinitesimally small, but remember the broker is dealing in lots of 100,000 units, so he collects a reasonable amount as commission.

What Moves the Markets?

Unlike trading on the stock market, where you can keep track of a company’s figures and therefore where you think the share price should go, the foreign exchange market has many more variables that can change the values. It is also harder to anticipate all the announcements from various sources that may impact the market. Obvious factors are the interest rate and in particular any difference in interest rate between the two countries; the economic outlook of both countries; the inflation rate in both countries – high inflation devalues the currency; other government policies such as restrictions on currency transactions; unemployment figures; and many other factors. You must become interested in all sorts of international affairs, if you want to stay in touch with the fundamentals.

Still, technical analysis works on all trading markets. The basics of technical analysis say that the fundamentals don’t really matter for trading purposes, and what you have to do is watch and analyse the prices to see what they tell you about how others are trading. That’s the beauty of technical analysis.

It can’t work all the time, for example if a government suddenly announces a change in policy that affects the currency value, there is nothing in the previous charts that could have forewarned you. Possibly if you study fundamentals you might have anticipated this, but technical analysis is based on the history of the price to date, so would only show this shift in advance if other traders had correctly anticipated it and traded appropriately.

Trading Forex is an stimulating intellectual exercise as it ensures that you take an interest in everything that is happening internationally, rather than concentrating mainly on domestic affairs. If you become interested in the markets, you should watch particularly for the dates and times of announcements such as unemployment figures, central bank interest rates, and trade deficits, as these are a major influence on the way a country’s currency is viewed.

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About the Author

- Robert is a private trader with over 15 years experience trading the financial markets.

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