Forex 101

What is Forex?

FOREX stands for foreign exchange (also known as the shortened FX), and is a global market in which currencies are simultaneously bought and sold. Currencies trade in pairs, like the Euro-US Dollar (EUR/USD) or US Dollar / Japanese Yen (USD/JPY). FOREX is the largest and most heavily traded market in the world whose volume exceeds those of commodities, financial futures, and stocks. Just the EURO currency volume alone exceeds the entire NYSE by more than five times. The industry estimates the average daily turnover for FOREX at $3.2 trillion.

Trading in this global market is conducted over-the-counter (OTC) through either electronic trading platforms or trading desk telephone. It is an interconnected telephone and electronic network comprised of bank traders, dealers, brokers, and fund managers, for the purpose of electronically transferring money from one account to another.

Whereas futures and futures options for different currencies can be traded on centralized boards of trade or exchanges, such as the CME Group, the OTC market has no centralized exchange or trading location. This OTC market has developed more recently and has opened trading opportunities to retail (smaller) investors.

The OTC is known as the secondary market. It has many of the same characteristics of the interbank market, the one in which huge banks, corporations, insurance companies, and other financial institutions manage the risks associated with currency fluctuations by trading in large quantities. It does not, however, provide the same prices due to the significantly smaller volume and smaller trades.

This OTC market also is referred to as the “spot,” “cash,” or “off-exchange” FOREX market. (A spot transaction specifically refers to a currencies exchange made at the prevailing market rate.)

Who trades currencies, and why?

• Foreign trade - Foreign trade represents five percent of the FOREX market. It is comprised of companies who do business on an international scale which necessitates their buying and selling currencies to enable them to buy and sell product in foreign countries. They then must go through the same process again in order to convert profits from foreign currency to domestic currency.
• Speculation – Speculation represents 95% of the FOREX market and refers to “FOREX traders,” those people who trade for profit.

Currencies are traded in pairs. There are seven currencies that represent the world’s most actively traded monies. They are known as the “majors” and include: the US Dollar (USD), the Japanese Yen (JPN), the Euro (EUR), the British Pound (GBP), Swiss Franc (CHF), Canadian Dollar (CAD) and Australian Dollar (AUD).

Hundreds of other currencies also can be traded and can include the New Zealand dollar or “kiwi,” and the Mexican peso.

What is the trading activity?

Five days a week, FOREX is a true 24-hour-day market. FOREX trading opens in Sydney. It then travels globally, first through Tokyo, then through London, and finally through New York. FOREX trading is tracked in Eastern Standard Time. Trading begins Sunday, 5:00 p.m., and runs through Friday, 5:00 p.m..

FOREX is a highly transparent market, meaning all current market data and news are widely accessible. Investors/traders can respond immediately to currency fluctuations day or night and generally can get in or out of the market without either having to wait for an opening bell or facing a market gap in liquidity.

How are currencies quoted?

Currencies are quoted and traded in pairs. A currency never can be traded by itself and it always must be compared with another currency.

Reading a foreign exchange quote, therefore, is simple. Just remember two things: 1. The first currency listed in the pair is the base currency. Its value always is 1. 2. The second currency listed in the pair is the counter (or “quote”) currency. Using the currency pair EUR/USD as an example, if a trader were to “go long” on the base currency, i.e., buy the Euro, he/she would buy the Euro (EUR) while simultaneously selling the U.S. dollar (USD).

The pair is quoted in terms of the number of units of the counter currency that are needed to get one unit of the base currency. So, for example, if the quote, EUR/USD is 1.285, that means it takes 1.285 U.S. dollars to purchase one Euro. In most cases, currency rates are carried out to four decimal places. The last decimal place is referred to as a “pip” (percentage in points), or a “point.” (Note: the Japanese Yen pip refers to the second decimal place.)

So in the above example, if the USD is the base currency and the quote goes up, that means USD has strengthened in value and the EUR has weakened. Rising quotes mean a US dollar now can buy more of the Euro than before.

What are BID and ASK prices?

The BID is the price at which you can SELL base currency.
The ASK is the price at which you can BUY base currency.

Currency pairs often are quoted as bid-ask spreads. The first part of the quote represents the amount of the quote money the investor/trader will get in exchange for one unit of the base currency and is known as the bid price. The second part of the quote represents the amount of the quote currency that must be spent to purchase one unit of the base currency and is known as the ask, or “offer” price.

So, using once again the above example, if the pair were quoted as a EUR/USD spread of 1.2850/1.2852, it would mean that an investor/trader could sell one Euro for $1.2850 and buy one Euro for $1.2852. The full exchange rate may not be quoted for both sides of the spread. Generally it would be quoted as 1.2850/52. The only number that is not the same for both sides of the spread is the last number.

Unlike the stock market, the FOREX market has no restriction on short selling, (no “uptick” rule), when the market is moving lower. Because FOREX trading involves buying one currency and selling another, traders have equal ability to trade in both rising and falling markets.

What are Leverage and Margin?

Leverage refers to a relatively small amount of money that enables the investor/trader to hold a FOREX position worth many times the account value. Since leverage allows the investor/trader to control a significantly larger amount of currency than the amount of money the investor/trader actually has on deposit, it magnifies the percentage amount of profits and losses. The dollar amount of profits and losses is not influenced by leverage.. The profit or loss is the same whether the leverage is 100:1, 25:1, or 1:1.

Margin refers to the required amount of money to be deposited before an investor/trader is permitted to trade FOREX. It also is known as a “security deposit” or as a “margin deposit.” Leverage trading, or trading on margin, means you aren't required to put up the full value of the position. FOREX trading offers more leverage than stocks or futures as FOREX accounts can be leveraged up to 200 times the value of the account.

Are there margin calls, as there are in equities, commodities and futures?

A margin call is an involuntary liquidation of an investor’s/trader’s positions should the account equity fall below the amount of margin set aside on deposit. There are no margin calls in Forex trading. So if the investor’s/trader’s account falls below required levels, the investor/trader automatically will be closed out of all positions for his/her protection. Risk is limited only to the amount of funds on deposit.

What to know before trading:

Only regulated entities (banks, broker-dealers or Futures Commissions Merchants {FCMs}) and affiliates of regulated entities may enter into off-exchange FOREX trades with retail customers. Always ask how a broker or firm is regulated and check with the regulator to verify both registration status and background.

The investor’s/trader’s relationship with a firm will be governed by his/her FOREX account agreement. No investor/trader should establish an account without first reading and understanding its guidelines.

Retail, off-exchange FOREX trades are not guaranteed by any clearing organization.

Two trading examples:

Scenario One: If the current bid/ask for EUR/USD is 1.4616/19, it means an investor/trader can buy 1 euro for 1.4619 or sell 1 euro for 1.4616.

So if an investor/trader makes the trade to buy 100,000 Euros, he/she will pay 146,190 dollars (100,000 x 1.4619). Remember, at 1% margin, the initial margin deposit would be approximately $1,461 for this trade.

As anticipated, the, Euro strengthens to 1.4623/26. Now in order to realize the profits, the investor/trader sells 100,000 Euros at the current rate of 1.4623, and receives $146,230.

So what happened here? The investor/trader bought 100,000 Euros at 1.4619, and paid $146,190. Then he/she sold 100,000 Euros at 1.4623, and received $146,230. That’s a difference of 4 pips, or in dollar terms ($146,190 – 146,230 = $40).

Total profit = US $40.

Scenario Two: Now, let's say that once again an investor/trader buys EUR/USD while trading at 1.4616/19. He/she buys 100,000 Euros and pays 146,190 dollars (100,000 x 1.4619).

The Euro, however, weakens to 1.46110/140. To minimize losses the investor/trader must sell 100,000 Euros at 1.4611. He/she will receive $146,110.

In summary: an investor/trader bought 100,000 Euros at 1.4619, and paid $146,190. He/she sold 100,000 Euros at 1.4611, and received $146,110. That's a difference of 8 pips, or in dollar terms ($146,190 - $146,110 = $80).

Total loss = US $80.

(Sources: PFGBest.com and Forex.com)