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Before we wade into the waters of Forex, it is best to take a moment to describe the landscape of not just foreign exchanges, but all investment markets.
In our ongoing entry guides to different investing methods, and to the different types of securities you can trade, we like to start by defining the terrain. One thing you will notice in all forms of investing is that we love acronyms – acronyms show up all over the place.
It is a way for investors to try and reduce the complexity of markets. Still, it can also lead to confusion for new investors. And different media outlets, online stock brokers, and financial services companies may refer to the same thing with different verbiage.
So, whether it is Foreign Exchange, Forex, FX – all those words are referring to the same thing, the same marketplace. We will use Forex the rest of the way through as our standard convention.
What is the Forex Market?
Forex is a vast market where currencies and only currencies are exchanged. But this goes far beyond, “I’m flying home from Paris and converting my leftover Euros to Dollars”.
Yes, structurally, the same types of transactions are happening. Still, in forex trading, it is happening on a much larger scale.
This introduction will cover why forex markets exist, who uses them, and the critical differences between what small investors and large institutions do inside forex markets.
Forex Trading: What is a Pair?
The forex markets trade all currencies in pairs. Every individual trade is, therefore, two actions happening at once – the buying of one currency and the selling of another currency.
And this makes intuitive sense; you show up to a window with one currency and leave with a different currency.
Each nation’s currency has its own country code, such as:
- USD – U.S. Dollar
- CHY – Chinese Renminbi
- JPY – Japanese Yen
- EUR – Euro Zone
The most popular 7-8 currency pairs make up most of the daily trading on forex markets, comprising over 80% of daily activity. Those pairs include:
- EUR/USD (Euro/Dollar)
- USD/JPY (Dollar/Yen)
- GPB/USD (British Pound/Dollar)
- USD/CHF (Dollar/Swiss Franc)
- USD/CAD (Dollar/Canadian Dollar)
- AUS/USD (Australian Dollar/U.S. Dollar).
You’ll notice a common theme here, the prevalence of the U.S. dollar. The USD is the king of currencies, a longstanding title based on the economic dominance of the U.S. and its historical safety, liquidity, and strength.
But there are plenty of other global currencies out there, and they form dozens of available pairs to trade.
These are often grouped into categories like “major pairs” (the four listed above), minor pairs, exotic pairs, and regional pairs. Minor Pairs are typically those not involving the U.S. Dollar, such as:
- and EUR/JPY
Exotic pairs are generally a major developed nation’s currency against an emerging nation’s currency.
And regional pairs are those focused on countries in close geographic proximity, such as AUD/NZD (Australian Dollar/New Zealand Dollar).
How to Read a Forex Quote
When reviewing currency pairs, there are some naming conventions to learn so that you are reading and referencing the right thing. The most important is simply how to read a currency pair. Let us use the example:
- EUR/USD – The most heavily traded Forex Pair on the planet.
The first currency listed in any pair is called the base currency. The second currency listed is the quote currency. So, in our example, EUR, the Eurozone currency, is the base currency, and the U.S. Dollar is the quote currency.
The base currency is the one you are buying in this two-way transaction; the quote currency is the one you are selling.
Each currency pair has a real-time price – a single conversion figure that floats throughout the day. If the EUR/USD is currently trading for 1.30, then the proper way to read this currency pair is to say, “One Euro is worth 1.3 Dollars”.
If the Euro were to rise against the U.S. Dollar, then a single euro (notice the base currency is always in units of one) would become worth more U.S. dollars. So, if the EUR/USD rose to 1.45, then one Euro would now be worth 1.45 dollars, or $1.45.
Major FOREX Markets
Forex markets are decentralized, meaning there isn’t one single market that all trades must go through. There are Four Major Forex Markets around the world – New York, London, Tokyo, and Sydney – ensuring that forex markets are open 24 hours a day (though only 6 days a week, not 7).
This is a significant feature of Forex for global central banks and multinational firms, as they don’t have to wait for someone else’s market to be open to make a trade.
Despite the decentralized nature of Forex, almost all major currencies have forex trades cleared through the Bank for International Settlements (BIS), located in Switzerland. (This is why the Swiss franc shows up in a lot of currency pairs, despite being a rather small nation economically.)
Forex is the Biggest Financial Market
In terms of the amount of money that works its way through them every day, foreign exchange markets are by far the largest financial markets on the planet.
It dwarfs the amount of money flowing through the stock market daily and even outpaces the massive bond markets. So why don’t you hear more about Forex and the $5 trillion transacted there every day?
Why isn’t Forex leading in the business headlines every day?
It’s a good question, and the process of answering it will point you toward figuring out if forex trading is something you want to get involved with.
You see, the vast majority of forex market trading is done by large banks, companies, and asset managers looking to protect, insure, and do regular business. It is, for lack of a better description, “boring”. About as dull as exchanging your euros for dollars at the airport.
The largest banks and companies – known as “multinationals” because they do business all around the world – need to manage multiple currencies. If you are a U.S. company setting up a factory in Europe, Japan, China, or Sweden, you have to pay your expenses in the local currency.
You have to pay taxes in places you operate, and you have to do it in their currency. And as sales are made in foreign lands, foreign currencies come in.
Forex is where Euros and Yen and Chinese Yuan can be converted into U.S. dollars, or vice versa.
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Why Do Companies Trade Forex?
So, the vast majority of that $5 trillion a day in forex transactions are done as a matter of daily housekeeping, by companies, by central banks, and other large players.
They trade Forex to bring foreign currencies into home currencies, and to hedge against adverse outcomes. A hedge can best be thought of as an insurance policy.
For instance, you buy auto insurance because you want to hedge against the negative outcome of totaling your car. If you total your car, it could cost over $20,000 to replace it.
But you choose to pay a small fee instead (the insurance premium), knowing that in most cases that premium is never coming back to you. Still, if the worst case happens, you’ll be made whole on a huge bill.
Hedging in the financial world works the same way. Airlines hedge against the price of fuel going higher, Starbucks hedges against the price of coffee going higher, and large banks hedge against the value of their home nation’s currency moving sharply higher or lower versus other countries they routinely do business with.
Forex Speculation – A Different Animal
In sharp contrast to hedging is speculation. Speculation says, “I’m here to try and make a profit”. When investors buy stocks, it is usually done as speculation. And when individual investors trade Forex, it is often done as speculation.
Forex trades can be short-term, lasting for only a few hours (even minutes for some!), or it could be a trade that lasts for a few days or weeks.
But in each case, the trader goes in with an expectation of making a profit, and then selling out, or “closing out” the trade.
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Forex Trading: The Stakes are High
With Forex, the stakes of speculation are higher than for most types of stock trading.
And the reason why is because of some important investing terms we are about to introduce to the discussion – specifically “leverage” and “margin”.
Leverage and margin are the habanero chili peppers of the trading world – they spice things up, but they are also not for everybody’s palate.
Almost all forex trading is done with leverage. Leverage means you put up a small amount of money to control a larger amount of money – and your profits or losses are based on the larger amount of money.
The small amount of money you put up is your margin. In Forex, leverage can be between 10 times your margin deposit, all the way up to 50x.
Part of why leverage is so typical in Forex is because actual currency moves are small, mild, and boring. So, if you had $1,000 invested in a currency pair, that pair might only move a few pennies over a few days.
Not a way to make much money. But what if you only had to put down $1,000 to control $50,000 worth of capital? Now that same move in the underlying pair of “just a few pennies” can really add up.
But as you are probably already sensing, therein also lies the increased risk. In Forex, it is possible to lose more money than you put in.
That is not the case when buying anything with straight cash; the most you can lose is everything you put in. But opening oneself up to losses more than the initial investment is why leverage is such a risky trading style.
How to Trade Forex
Most major currencies are allowed to “float” freely, meaning that the value of the currency can rise or fall based on market conditions, like the perceived strength of the home country, that country’s rate of inflation, and many other factors.
And while they are rarer, some currencies are “pegged” by a nation’s government, such as the Chinese Yuan (CNY).
By allowing their currency’s value to float based on market conditions, a nation opens itself up to more global trade.
Investors who trade Forex may have “fundamental” reasons for purchasing a pair like the EUR/USD – they may think the Eurozone is a safer place to park cash, or that inflation in the U.S. is going to rise, which may devalue the Dollar.
They could buy the EUR/USD pair and profit if their belief turns out to be correct.
In this context – and it is also true for stocks, real estate, and other investments – “fundamental” reasons are based on significant macroeconomic factors, doing investment research, thinking through scenarios and making predictions.
At the other end of the investing spectrum is “technical” analysis and trading.
In technical analysis, there is no reasoning, thought, or high-level research going into anything. You are just trading price.
Forex Trading Technical Analysis
Technical analysis is often called “charting”, as proponents of this method use historical price charts and patterns to tell them when to buy and sell. It is pictures and lines, and that’s about it.
Here is an example of a EUR/GBP price chart, a technical tool investor will use to pick specific price entry points and targets in the hopes of making short-term profits.
We will talk more about both methods, fundamental and technical trading, in our deeper dives into stocks, bonds, Forex, and derivatives. Each has an extensive literature and educational resources available.
While some investors find themselves employing both styles, most tend to focus on one or the other as they gain experience in the markets.
And with just some mild training, any investor can learn to construct trades that employ leverage but also hedge against adverse outcomes (like losing more than you put in!).
These types of mitigation strategies will be discussed in greater detail in future guides.
In a stock transaction, or a home, a car, a piece of art, there could be profits, and there could be losses, but they’re usually isn’t the potential to lose more than you put in. Suffering a full loss is (dragging, on, don’t need to take this much time with it).