An Introduction To Forex

Foreign exchange market (a.k.a. Forex market) is the most liquid financial market in the world. Every day, over five trillion dollars change hands in this vast market.

As such, it represents a haven for speculators. Ever since personal computers and Internet appeared in our lives, retail Forex traders had the opportunity to participate in the most dynamic market of them all.

Improved technologies made the access to the interbank market easier. Have you ever wondered what is Forex market? Here’s your answer: the interbank market.

The problem was (to some extent it still exists today) that it was costly for retail traders to access it. That is until new technologies became available.

Nowadays, Forex brokers simply represent a link between the end user (trader) and the interbank market. For this, they charge a commission and offer the possibility to leverage a trading account.

What is Forex?

The financial system as we know it gravitates around the world’s reserve currency: the U.S. dollar. Everything (almost everything today) ends being denominated in dollars.

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Have you thought what happens with a Chinese national’s money when buying a property in Canada? His/her bank will change the Yuan into U.S. dollars first. Next, with those dollars, the bank will pay for the Canadian property.

The bank’s client doesn’t see these transactions. All he/she knows is that his money paid for it.

Behind the scenes, the commercial bank has a treasury department. People in charge with exchanging the money and investing the excess reserves in various other currencies in the world.

When doing that, they tap the interbank market (a.k.a. Forex market). Now, imagine all the participants in this vast “game”:

Commercial and central banks
Forex brokers and liquidity providers
Hedge funds and high-frequency trading entities
Retail traders

All transactions around the world, like the example above, happen on the Forex market. So, a complete definition of what is Forex market sounds like this: the sum of all monetary transactions involving all currencies around the world.

How Does Forex Work?

For the retail trader (the average Joe that wants to profit from the currencies swings), Forex seems simple enough to make a living of it. That’s not entirely accurate.

Forex brokers present it like this. Forex is more than that. Traders end up comparing different economies around the world; adjusting their positions when economic news comes out; placing pending orders to sell/buy from a technical level, etc.

But the way the Forex market is presented to traders is, indeed, simplistic. There’s a Forex dashboard, made of the total number of currency pairs the broker offers. In plain English, traders pick one of the currency pairs from that list and trade it.

One cannot just buy or sell a currency. Instead, the Forex dashboard shows different currency pairs.

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A currency is paired with a different one, and, based on their comparison, a value results. Or, a quote. That’s what traders buy and sell: the contrast between two different currencies.

Examples of currency pairs are EURUSD (the Euro and the U.S. Dollar), USDJPY (the U.S. Dollar and the Japanese Yen), and so on. Typically, a Forex broker offers tens of various currency pairs, plus some other products like CFD’s (Contracts for Difference).

Say you pick the EURUSD pair, that now trades at 1.18082. In other words, one Euro is worth 1.18082 American dollars.

If you think the Euro rises in value in the future, and the Dollar will depreciate or stay at the same level, you might want to buy the EURUSD pair. Now, let’s say the pair moves to 1.18554.

The difference between the entry level and the current one represents the profit. If on the other hand, the EURUSD moved lower, it would have been a loss.

What is Forex Trading?

The ability to speculate on a currency pair’s movement represents the bread and butter of Forex trading. But, the art of speculation is difficult to master.

This market is the wildest beasts of all financial markets combined. To make it in this business, one needs both fundamental and technical knowledge, mixed with a bit of luck and psychological traits of a gambler and money manager at the same time.

However, there’s order in all this relative chaos. For example, the currency pairs that make the Forex dashboard depend on the U.S. Dollar.

As such, all currency pairs that have the Dollar in their componence, are called major pairs. The rest of them are cross pairs.

Here are the most representative major pairs:

EURUSD – the most liquid currency pair, and the most popular among retail traders
USDJPY
GBPUSD – also called “Cable”
USDCAD – also called the “Loonie” pair
AUDUSD – also called the “Aussie” pair
NZDUSD – also known as the “Kiwi” pair

And, some of the most representative crosses:

EURGBP
GBPCAD
EURAUD
CADJPY

For a currency pair to rise or fall, it must weaken or strengthen against the other. Therefore, some traders directly compare different economies using the same parameters (unemployment rate, GDP – Gross Domestic Product, inflation, etc.) and decide which one performs better. As a result, they’ll buy or sell a currency pair.

The beauty of Forex trading is that one can simply sell a pair, without “owning” it. One can go SHORT the EURUSD (a.k.a. selling the pair), and if the pair moves to the downside, a profit is made.

The profit or loss, however, depends much on the position size. Namely, how much to sell or buy? For this, let’s have a closer look to different lot sizes.

Understanding Forex Lot Sizes

Not all trades are the same. Some traders have a more significant risk appetite than others. As such, they pursue aggressive trading strategies, risking more for more reward.

Others are conservative traders. They don’t like entering a trade unless there’s certainty.

In earnest, when trading financial markets, there’s no such thing as one hundred percent sure trade. What exists, is money management.

The cornerstone of any money management plan is the lot size. Or, how much to buy or sell when opening a trade?

It depends very much on the account size, and the underlying trading strategy. The volume of a trade is illustrated in lots.

As a rough estimation, one lot on the EURUSD pair will result in $10 profit or loss per pip. That is, if the EURUSD pair moves from 1.18085 to 1.18185, the ten pips difference will worth $100 if the volume traded was one lot.

Now, that’s too much for regular retail traders. Forex brokers know that and came to the rescue: they offer micro-accounts, where traders can trade fractions of a lot.

Namely, one can use 0.1 lots or even 0.01 lots in a transaction. As such, micro-accounts appeared, and retail traders could use their small size accounts on the biggest market in the world.

What is a Pip?

Today, most of the trading accounts show a five-digit quotation. 1.18085 on the EURUSD pair, shows five digits, signaling an exact quote for the pair.

Yet, what is a pip? Is it the last digit? No. It is the fourth one.

There’s a history to this. Bank in time, when the current execution technologies didn’t exist, Forex brokers couldn’t offer five-digit accounts. Four-digit ones were the norm.

Therefore, it was a big difference the bid and ask prices of a currency pair. For example, the EURUSD pair had a three-pip difference.

What it meant was that if you wanted to sell the pair, you could do it only from the bid price. But, if you closed it ten pips later, the actual profit would just be seven pips, as the difference (spread) was almost 30% of the trade.

Nowadays, new technologies narrowed the spreads to incredible levels. Here’s a current USDCHF bid/ask price:

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How to read a Forex quote like this one? Easy: the spread on the USDCHF pair is 0.4 pips, as the fourth digit, the one that defines the pip, is the same.

Conclusion

Buying or selling on the Forex market couldn’t be easier. Because there’s a stiff competition among Forex brokers, conditions will improve even further.

Some years ago, to think of a 0.4 pip spread on a currency pair was a wild dream. Yet, today is the norm on the retail Forex market.

What matters the most when trading Forex is how one approaches the trading game. There’s no holy grail in trading. There’s only hard work, discipline, and the willingness to understand that growing an account isn’t the sum of only winning trades.

When Forex traders understand that, they’ll know what is Forex and how to profit from the opportunities it provides.