FOREX 101

Foreign Currency Trading Basics

FOREX 101
August 15, 2014

The Foreign Currency Market, often called the FOREX or FX market, is a marketplace for the buying and selling of currencies, which are considered a form of commodity. Investors make or lose money based on changes in the value of relative currencies.

Trades on the FOREX market are made in currency pairs – you are buying or selling one type of currency in exchange for another. The US dollar (USD) is the currency most often used as the base. Other commonly traded currencies are the Euro (EUR), Japanese Yen (JPY), British pound (GBP), Swiss Franc (CHF), and the Canadian, Australian, and New Zealand dollars (CAD/AUD/NZD).

Transactions occur in over-the-counter (OTC) markets throughout the world in major financial hubs such as New York, London, Singapore and Zurich. You place these trades through a broker, just as you would with stocks.

Quotes are listed in pairs, with the base currency first and the price following. For example, the quote USD/JPY = 102.71 means that you can buy 102.71 yen for every US dollar.

There will be a bid price and a higher ask price listed, which is the difference between the buy and sell points for the entity making the transaction. That difference, known as the spread, is how the frontline traders make their money. If you are selling a currency, you are concerned with the bid price for another currency; if buying, you need the ask price.

For example, the corresponding USD/JPY bid and ask prices to the above example may be $102.7150 and $102.7400 respectively, and the spread in that case is $0.025.

Currencies are generally less volatile than stocks, but they can rise or fall quickly depending on events or economic conditions within a given country. (For example, the Russian ruble has fallen 3% to the US dollar since the shooting down of a Malaysian jetliner several weeks ago.) Normally, however, daily currency fluctuations are less than 1 /100th of the base currency.

Under these circumstances, how does an investor make money on FOREX? The answer: leverage.

It is possible to make heavily leveraged purchases that are many multiples of the money you have in your account – essentially your broker is lending you this money – thus allowing you to make (or lose) significant amounts of money with a limited investment. It is also possible for you to lose money, zero out your account, and potentially go well into the red.

Typically, the FOREX is used either by hedgers who want to limit the risk of a currency change and ensure a predictable exchange rate for their international trade, or by speculators who are trying to profit on short-term changes in currency rates.

Most individual investors make trades on current exchange rates, referred to as the spot market. However, just as with stocks, there are futures markets where contracts are created to buy or sell a particular currency at a particular price at a particular time. These contracts are bought and sold just as they are for commodities.

The available types of orders are also similar to those of stocks. You can place market orders to trade at the current rates, limit orders that take effect at certain exchange rates, stop-loss orders to sell at a particular exchange rate to cut losses, and other orders that mimic equities.

Another similarity to the market is the use of both fundamental analysis (the basic health of the company/country) and technical analysis (using past performance and trends to spot likely changes) to decide what trades to make.

One also has to consider the format of the currency (is it free-floating or linked to another currency, such as the Chinese Yuan linkage to the US dollar), and the governmental forces that can affect policy – for example, is the central bank of the country strong, and what are their tendencies toward altering the money supply and monetary policy?

Are ready to try your hand at FOREX trading? You should not if this article constitutes your entire research. Fortunately, there are several excellent in-depth primers online. Investopedia has a nice set of tutorials on FOREX trading, but even that is not enough to get you started.

However, if you find the idea intriguing, do extensive research and some practice currency trading (without risking actual capital), and then set up an account with a broker you trust. You can then put your proverbial toe in the water, with smaller trades that involve little or no leverage until you understand the FOREX market better. Who knows? Perhaps George Soros will eventually be asking you for advice.

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