What is Forex?

The Foreign-Exchange Market, or Forex for short, is the world's largest market. Many investors, especially many in Western countries, are more familiar with the stock and equity markets. Forex is an important element in the ever-changing connection between international trade.

A Forex trade – even if you are not aware of it – has probably already been placed. Have you ever withdrawn money from an ATM in a foreign country and had to pay in another currency? Yes, that was a Forex trade. If you have flown into an international airport and seen blinking rates, those are all bids and offers to place foreign exchange trades.

No doubt you have purchased an item on Amazon or a Black Friday Sale from a foreign company. Yes, there was a Forex transaction behind that sale.

The trading of stock and currency, popularly known as Forex, is like oil for the cogs of global trade. In today's global economy, currency transactions has never been more vital, and as globalisation has taken hold of the world, the necessity for FX to facilitate those trading relationships has never been higher.

Many Japanese car manufacturers want to sell their cars in the United States. If they want to do this, they will need to think about the exchange rate between US dollars and Japanese yen. If the dollar has strengthened, so the Japanese company can bring back more money from each car sold in America, given that the dollar is stronger. If the exchange rate weakens, this car company may lose money on the sale of that car. It is because there was a 'bad trade' of its currency.

Exchange rates are things that change over time. If you ignore these changes, it can be risky for your business. Many companies trade in currency markets. It is hard to know the value of your money because it changes. So these companies trade their currency to keep up with this change.

In many situations, the auto manufacturer will outsource this work to one of the big banks, which places a high emphasis on foreign exchange transactions. Given the risk of wild price swings, and given that these markets have a high level of volatility, many hedge funds or pension funds with a speculative inclination will flock to them.

The vast majority of professional traders and institutional investors have chosen to trade directly on the futures market, which is where FX as a whole derives its name. This activity from these "major" market participants is what makes Forex  the world's biggest market.

How to Trade Forex

Many people trade in Forex every day without knowing it.

The goal, however, is very straightforward for those that do intentionally trade FX: profit - just like with any other market-based investment.

Let's assume you've just arrived in New York after a long red-eye flight from London and need to change some of your British Pounds into US dollars to have some pocket money for transactions. However, you're not sure how much you'll need, so you take everything out of your wallet and convert it into US dollars; and lo and behold, £400 is exactly what you have. Bid Ask 1.2400 / 1.2500 (price at which you can sell) (price at which you can buy).

The airport kiosk was offering a rate of 1.2400 x 1.2500 for transactions from the British Pound to the U.S. Dollar at the time of the exchange, according to their exchange. The ‘spread' is the difference between the two prices – this will be similar to a Forex quotation with a relevant bid and ask, followed by the ‘bid-ask spread.' The first price is the amount a kiosk would be prepared to buy GBPUSD from you, while the higher or second price is the rate at which they'd be ready to sell.As a result, you purchase at a higher cost and resell at a lower price. The kiosk in the airport always has the edge and earns the spread.

Another way to read this quote from the airport kiosk would be: ‘We are willing to give you 1.2400 in U.S. Dollars for every one British Pound you have. – If you want to buy British pounds from us, you will have to pay 1.2500 GBP for every 1 GBP that you want.’ The difference between these two numbers is the ‘spread’.

You exchange £400.00 for $496.00 (400 x 1.24), and then depart the airport to go sightseeing in New York City. 

You realize that a large portion of the city is prepared to take credit cards. So you don't need any of your money, and the $496.00 stays in your wallet for the rest of your journey. Now it's time to go back home, and you want to exchange your GBP so that you can actually use your cash at home. You go to the same airport kiosk, but now costs have changed because the British Pound has decreased in value since you arrived in New York. GBPUSD Rate Bid Ask 1.2200 / 1.2300 (price at which you can sell) (price at which you can buy).

So you take out your $496 and hand it to the agent at the kiosk, and they return £403.25, resulting in a net profit of almost £3.25 on the transaction – almost a 1% return in just a single week!

When you traded in your British Pounds, they were valued at $1.2500 per pound. However, given the fact that the British Pound has depreciated in value with each British Pound now returning $1.2300, you made a profit on the trade.

It's not difficult to see how speculating on currencies might be a viable "endeavour" based on the daily fluctuations in a currency's value or price, as astute observation and timing may result in profit.

The majority of the $7 trillion per day in FX trading takes place in a profit-oriented, loss-aversion atmosphere.

Why Do So Many Traders Move to Forex?

Market participants are finding particular aspects of the FX market attractive, including:

What Drives the Forex Market?

The common currency market is, in essence, a large exchange where currencies are bought and sold. In other words, like many other asset classes such as stocks or bonds or commodities, currencies trade on the open market. Throughout the trading day, prices of currencies will go up and down based on supply and demand.

Investors will generally respond with more purchasing when something "good" happens for an economy. When demand at a specific level of supply is increased, this drives up price until supply and demand are again roughly equal. If a currency's supply increases, its price will drop until buyers intervene to provide support, and we'll have balance in the supply and demand for that currency at that time.

Let's take the Brexit vote as an example. In June 2016, people voted to leave the EU. The immediate reaction to the British public's vote to leave the European Union was one of dread, as investors dumped GBP-based assets. All of those orders to sell rapidly filtered into the GBP/USD quote, which dropped by more than 15 pence (1,500 pips) against the US Dollar in a single night, from 1.50 down to 1.35.

Interest rates, or their ramifications, are the driving force behind currency rate changes.

When an economy performs well, interest rates will typically be increased to control inflation. But it's the rising rates that really pique currency traders' interest, since they might lead to a complementary relationship that may go on for months or even years. As interest rates rise, the desire to invest in that economy will generally increase, as will the need for higher rates of return. As interest in the local currency increases, so does demand for it, driving up exchange rates to match local capital markets.

Investors may even make money (or pay) interest while in a forex trade, which is represented by the ‘swap rate.' This is the difference between the representative economies' interest rates in a Forex quote.

Deciding What to Buy and Sell

To be more accurate, interest rates are one of the most frequent reasons for currency fluctuations, but it's even more precise to say that it is ‘expectations for possible changes in interest rates' that matters. Consider a scenario like this: if data suggests an economy is growing at a rapid rate.

This one GDP number, on its own, may not be enough to push the Bank of England to raise interest rates. Inflation as a result of a stronger economic position may also be considered. It's that heightened price pressure that might push the BoE to raise rates sooner than planned. So this would be expected to cause expectations for higher interest rates, which would prompt traders and investors to buy the British Pound (and local assets) on the hope that the return on investment will improve in the near future.

At this time, when the British Pound is stronger and the US Dollar weaker, a bullish outlook would be appropriate. This reflects an accelerating trend in light of increased GDP and rate expectations. If data continue to improve, this ‘bullish' price movement may be maintained. The price/value of a currency may rise significantly if it is maintained long enough. The end result might be a genuine "bullish" up-trend in the value/price of the currency.

The prediction that interest rates will drop is more likely to cause the currency to fall if the scenario were reversed, with expectations for lower rates. Following the June 2016 Brexit referendum, it was clear that people had certain preconceived notions about what might happen if Britain left the European Union. In a little over a week, sellers returned to push the value of the British pound even further downward, from 1.3500 before the ‘advisory,' to around 1.2000 in the months afterward.

This is the simplified version of the relationship that drives most FX market trading decisions.

Reading a Forex Quote

The Forex market's quote convention is one of the few things about it that differs significantly from other markets, but after a little research, most investors will find it to be rather simple.

One of the most significant terms that is specific to FX, PIP.

A pip is a measurement that represents a percentage in point. It's the most basic unit of measurement in an exchange quote. The third and fourth digits following the decimal point in a U.S. Dollar denominated-quote in which USD is the ‘quote currency' (any pairing where 'USD' comes after) will show how many ‘pips' are contained in that quote.

If GBP/USD is trading at 1.2345, this is the same as saying ‘one British pound is worth one dollar, 23 cents, and 45/100th’s of a cent’. If the price in GBPUSD increases to 1.2355, that would be a gain of 10 pips (1/10th of a cent). If price were to rise to 1.2445, that would be a 100-pip (one cent) gain from the prior value of 1.2345. GBPUSD ‘The Value of One British Pound, quoted in terms of U.S. Dollars’ GBP is the base, or transaction currency in the pair USD is the quote, or counter currency in the pair.

When the value of GBPUSD rises, it indicates that the British Pound is stronger, and the U.S. Dollar is weaker.

When the value of GBPUSD falls, it indicates that the British pound is declining in value and that the U.S. dollar is increasing in value, i.e. stronger.

Every Forex quote comes as a pair so that you can see what the base currency's price is being compared against.

The USDGBP pair is one of the most common, and it's also known as the value of British Pounds quoted in US dollars. The EURGBP pair is another popular pairing, and this represents the value of one Euro in British Pounds.

Two-Sided Pairs, Two-Sided Trades

The base currency is the first currency in the pair, and it's being quoted in that price; whereas the counter currency is the second currency in the pair, and it's being quoted in terms of the base. For example, the value of GBP/JPY might be denoted as ¥140.00 to indicate that one British Pound is worth 140 Japanese Yen (¥).

The value of two currencies can shift independently, even if an exchange merely rises and falls. The Euro is going up and down every day, as are the US Dollar and Japanese Yen. Traders should look for combinations that would give them the greatest leverage to back their view on where things will go. If the investor wanted to buy British Pounds because they are optimistic about the currency's future, they would want to do so against a weak counterpart.

If an investor predicted that the Australian economy would be weaker, they might buy GBP/AUD; or British Pounds versus Australian Dollars.

Going Short

It may be difficult to open a short position in the stock market. You must locate a broker who will allow you to borrow the stock before you can put the trade together. Then, once a trade is completed, there will almost always be some limitations on the position, such as the "uptick rule." Even if you satisfy all of these criteria, you'll almost certainly have to pay interest on ‘borrowing' the shares at 'brokers call' rates that are usually greater than discount or prime rates.

It's not as simple to bet against equities as it is to buy them.

The difference between forex and other asset markets is that in every quotation, each trade, investors are always ‘long' one currency and 'short' another.

Pip Values

This is a crucial aspect of the Forex market to grasp, and it's all about the value of a pip from quote to quote. The counter currency is used to determine the value of each currency pair. If the currency pair is USD/EUR, for example, it means that the second currency in the quote is being compared to US Dollars.

In addition, if you're ever unsure, read the quote out loud as "the value of (first currency) is priced in terms of (second currency).

Lot sizing

Traders are not usually enthusiastic about a few pence or cents. This can be a dangerous thing. With leverage and lot sizing, just a few cents' movement may result in significant profit (or loss) for a trader's account.

All currency pairs are denominated in ‘base lot sizes,' which have a 'pip value' for each pip's worth of movement in that pair. The minimum margin requirement is the amount of risk capital required to maintain the position on each lot.

Margin Trading

The margin is the amount of money that a broker must keep in reserve in order to take a position. The size of a trade generally varies by currency pair, but will be a percentage of the overall size of the transaction.

Assume a margin factor of 2% for positions.

Let's also assume the trader wanted to acquire 50,000 GBP/USD. The trade's "lot size" would be that quantity.

Then, let's assume a cross rate of 1.2400 in GBP/USD in this example.

In old English, this quote is talking about how much money one dollar is worth in terms of the British Pound. If the going rate is 1.2400, that means each British Pound is worth $1.00 and 24 cents, according to this formula. So the trade to exchange £50,000 would be worth $62,000 (50,000 X 1.24 = 62,000). This is the trade's notional value.

The minimum margin requirement for this trade, if using a 2% margin factor, would be $1,240 ($62,000 x .02).

When our trader makes a trade, this money is taken from the account and set aside as ‘margin' for this position. When the trade is closed, the margin is returned to the trader's account, where it may be utilized again. However, if the position's value drops below the trader's equity, a "margin call" will be issued because there would not be enough cash in the account to keep supporting the position.

Margin Call – When a trader's account value falls below the margin requirement of open positions.

The account is liquidated by the broker as a result of this, known as the dreaded "Margin Call."

Leverage

The amount of money borrowed from or utilized through the broker is known as leverage. Assume that our trader in the preceding example opened an account with £2,000 and is now trading a £50,000 position.

This is a 25:1 leverage trade. To put it another way, the trader has £25 of capital for every £1 in their account.

Remember, before it was ever carried out, the margin had to be put up to secure the trade, and that sum was $1,240 (or £1,000). Our trader has £1,000 in "free margin," or capital that isn't currently locked-up in securing a position. This is cash that may be utilized to either enter into new positions or assist presently held ones.

Anatomy of a Forex Transaction

Assume you're opening an account with a bid/ask spread of 1.1000 x 1.1005, a margin factor of 2%, and $2,000 in cash.

You want to place a short EUR/USD trade for €20,000.

Because the price is expressed in terms of US dollars, €20,000 would be equivalent to $22,000.

(We're using the bid price, which is first in the quote, since our trader is establishing a short position.) The notional size of the lot would be $22,000.

The margin to open the position would be $440, which is 0.2 percent of the total price (22,000 x 0.02). Our trader now has $1,560 in ‘free' or ‘available' margin after executing this trade.

Because this is a U.S. dollar denominated account and we're trading a pair based in US dollars, the position's pip value would be $2.00 per pip, or $20 per contract. So, the trader's $1,560 in free margin allows for a loss of 780 pips before a margin call is triggered ($1,560/2 = 780).

Next Steps

By now, you've probably picked up a few of the fundamental concepts that will help you adapt to any market, including Forex. For many professional traders, markets are seen as a lifelong learning experience, very comparable to driving. Driving on abandoned roads at first may be hazardous and terrifying, especially when driving slowly. However, as the fundamentals of driving a car become more intuitive, we may travel by cars on the highway with nothing but confidence.

After you've learned about the market and how to trade, you're ready to use that knowledge to make better decisions.