Forex Basics

What is Forex?

The off-exchange retail foreign currency market (“FOREX”) describes the purchase of a particular currency from an individual or institution and the simultaneous sale of another currency at the equivalent value or current exchange rate. Essentially, the process of exchanging one currency for another is a simple trade based on the current rates of the two currencies involved.

At the core level of the world’s need for money exchange is the international traveler. When traveling from the US to England, for example, you will of course need the local currency to pay for transportation, food, and so on. Upon arrival at the airport you will surrender (sell) your USD in order to receive (buy) the equivalent in GBP. In this example, you sold the USD and bought the GBP. Conversely, the FOREX counter bought the USD and sold the GBP. The prices at which you buy and sell currencies are known as exchange rates. This rate or price fluctuates based on demand and on political and economic events surrounding each country’s currency.

Forex Market Hours?

Unlike other financial markets, the FOREX market operates 24 hours a day, 5.5 days a week, through an electronic network of banks, corporations and individual traders exchange currencies. Though as the market is primarily used as a means for speculative investing, actual physical delivery of currencies is almost never intended. FOREX trading begins every day in Sydney, moves to Tokyo, followed by Europe and finally the Americas.

Bid vs. Ask

FOREX prices, or quotes, include a “Bid” and “Ask” similar to other financial products. Bid is the price at which a trader is able to sell a currency pair. The Bid price or sell price of a currency pair is always the lower price in a quote. Ask, sometimes referred to as “Offer”, is then the price at which traders are able to buy a currency pair. In other words, FOREX traders always buy at the high and sell at the low of a price quote. The difference between the Bid and Ask is called the “Spread,” which is the Trader’s cost per trade or per transaction. There are typically no additional broker commissions involved in trading the FOREX market, as there might be when trading other investment markets.

Why Do Currencies Move?

FOREX markets and prices are mainly influenced by international trade and investment flows. The FOREX market is also influenced, but to a lesser extent, by the same factors that influence the equity and bond markets: economic and political conditions, especially interest rates, inflation, and political stability, or as if often the case, political instability. Though economic factors do have long term affects, it is often the immediate reaction that causes daily price volatility, which makes FOREX trading very attractive to intra-day traders. Currency trading can offer investors another layer of diversification from traditional investments. You should bear in mind that trading in the off-exchange foreign currency market is one of the riskiest forms of trading and you should only invest risk capital in this market.

The Majors

Most currency transactions involve the “Majors” consisting of the British Pound (GBP), Euro (EUR), Japanese Yen (JPY), Swiss Franc (CHF) and the US Dollar (USD). Many traders are beginning to add the Canadian Dollar (CAD) and the Australian Dollar (AUD) to this category as well.

Why Are There Two Currency Pairs?

Often new traders struggle to grasp the concept of trading currencies in pairs. “Why not just buy the Euro?” they might ask. Why does it have to be paired with the US Dollar? The reason is that the currency on the right side of the pair is there to establish a comparative value. Without it how could the base currency (currency on the left side of the pair) have any certain value? In other words, if currencies were not paired, what would a single currency gain or lose value against? By pairing two currencies against each other a fluctuating value can be established for the one versus the other. So, how is the Euro doing against the Dollar, or how many Dollars does it take to buy one Euro?

What is Margin?

In the FOREX market the term margin is most often referring to the amount of money required to open a leveraged position, or a contract in the market. It may also be used to describe the type of account, i.e. margin account; meaning that an account is being traded on borrowed funds. It is generally safe to assume that all off-exchange retail FOREX traders are trading within margined accounts.

Without leverage, or the ability to trade on borrowed funds, a trader placing a standard lot trade in the market would need to post the full contract value of $100,000 in order to have his or her trade executed. Trading with a margined account allows traders to utilize leverage, meaning that the same $100,000 contract can be placed for an amount of margin determined by the set level of leverage. An account at 100:1 leverage would require $1,000 of margin to place a $100,000 trade.

*100:1 is the entry leverage value. Since most brokerages will have margin calls set at different level, exact leverage may vary.

Simply stated, trading FOREX on margin increases your buying power. As an example: a trader with $10,000 in a margin account that allows 100:1 leverage, would be able to purchase a maximum of $1,000,000 in currency contracts (10 standard lots). At 100:1 leverage 1% of the contract value is required as collateral.

By trading on margin, traders can potentially increase their total return on investment with less cash outlay. Trading on margin should be used wisely as it magnifies both your potential profits AND potential losses. A good rule of thumb to follow is the higher the margin, the greater the risk.

Contract Size

Understanding contract sizes (lots) is a necessary precursor to understanding the need for high leverage in the FOREX market. Each standard lot traded in the FOREX market is a $100,000 contract. In other words, when trading one lot in a standard account, a trader is essentially placing a $100,000 trade in the market. Without leverage, most investors would not be able to afford such a transaction. Leverage of (100–1) would allow a trader to place the same one lot ($100,000) trade with the post of $1,000 in margin. $100,000 divided by 100 equals $1,000, thus (100–1) leverage means that $1,000 of margin is able to control a $100,000 position.

Many retail FOREX traders today begin their trading in a Mini account. Because standard contracts in the FOREX market are rather large, even with (100–1) leverage, $1,000 of margin per contract traded is still expensive for some investors. For this reason most retail brokers offer the option of a Mini account.