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.


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2) What is Forex?

The foreign exchange market is the "place" where currencies are traded. 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. It dwarfs other markets in size, even the stock market, with an average traded value of around U.S. $3.2 billion per day.

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, five and a half days a week, 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 the Forwards and Futures Markets
There are actually three ways that institutions, corporations and individuals trade Forex: the spot market, the forwards market and the futures market. The spot market always has been the largest market because it is the "underlying" real asset that the forwards and 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 forwards and 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.

Spot Market
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. When a deal is finalized, this is known as a "spot deal". 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. After a position is closed, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present (rather than the future), these trades actually take two days for settlement.

Forwards and Futures Markets
Unlike the spot market, the forwards and futures markets do not trade actual currencies. Instead they deal in contracts that represent claims to a certain currency type, a specific price per unit and a future date for settlement.

In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves.

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, and minimum price increments that cannot be customized. The exchange acts as a counterpart to the trader, providing clearance and settlement.

Both types of contracts are binding and are typically settled for cash for the exchange in question upon expiry, although contracts can also be bought and sold before they expire. The forwards and futures markets can offer protection against risk when trading currencies. Usually, big international corporations use these markets in order to hedge against future exchange rate fluctuations, but speculators take part in these markets as well.

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3) 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. In these cases, it is called a direct quote. 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. In these cases, the U.S. dollar is the counter currency, and the exchange rate is referred to as an indirect quote. 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/JPY = 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 Forwards and Futures Markets
One of the key technical differences between the Forex markets is the way currencies are quoted. In the forwards or 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 forwards/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 forwards and futures markets. Thus, when the British pound strengthens against the U.S. dollar in the spot market, it will also rise in the forwards and 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.

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4) 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.

Though currencies don't tend to move as sharply as equities on a percentage basis (where a company's stock can lose a large portion of its value in a matter of minutes after a bad announcement), it is the leverage in the spot market that creates the volatility. For example, if you are using 1:100 leverage on $1,000 invested, you control $100,000 in capital. If you put $100,000 into a currency and the currency's price moves 1% against you, the value of the capital will have decreased to $99,000 - a loss of $1,000, or all of your invested capital, representing a 100% loss. In the equities market, most traders do not use leverage, therefore a 1% loss in the stock's value on a $1,000 investment, would only mean a loss of $10. Therefore, it is important to take into account the risks involved in the Forex market before trading.

Differences between Forex and Equities
A major difference between the Forex and equities markets is the number of traded instruments: the Forex market has very few compared to the thousands found in the equities market. The majority of Forex traders focus their efforts on seven different currency pairs: the four majors, which include (EUR/USD, USD/JPY, GBP/USD, USD/CHF); and the three commodity pairs (USD/CAD, AUD/USD, NZD/USD). All other pairs are just different combinations of the same currencies, otherwise known as cross currencies. This makes currency trading easier to follow because rather than having to cherry-pick between 10,000 stocks to find the best value, all that FX traders need to do is “keep up” on the economic and political news of eight countries.

The equity markets often can hit a lull, resulting in shrinking volumes and activity. As a result, it may be hard to open and close positions when desired. Furthermore, in a declining market, it is only with extreme ingenuity that an equities investor can make a profit. It is difficult to short-sell in the U.S. equities market because of strict rules and regulations regarding the process. On the other hand, Forex offers the opportunity to profit in both rising and declining markets because with each trade, you are buying and selling simultaneously, and short-selling is, therefore, inherent in every transaction. In addition, since the Forex market is so liquid, traders are not required to wait for an uptick before they are allowed to enter into a short position - as they are in the equities market.

Due to the extreme liquidity of the Forex market, margins are low and leverage is high. It just is not possible to find such low margin rates in the equities markets; most margin traders in the equities markets need at least 50% of the value of the investment available as margin, whereas Forex traders need as little as 1%. Furthermore, commissions in the equities market are much higher than in the Forex market. Traditional brokers ask for commission fees on top of the spread, plus the fees that have to be paid to the exchange.