What is forex?
Generally, the foreign exchange market (currency, forex, or FX in short) trades currencies. It lets banks and other institutions easily buy and sell currencies. The objective of the foreign exchange market is to help international trade and investment. A foreign exchange market helps businesses convert one currency to another.
For instance, it permits a U.S. business to import European goods and pay in Euros, even though the business's income is in U.S. Dollars.
In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The foreign exchange market is known to be the largest market in the world, with trades amounting to more than USD 3 trillion every day, far more than the world's stock and bond markets combined. Most forex trading is speculative, with only a low percentage of market activity representing governments' and companies' fundamental currency conversion needs.
Unlike trading on the stock market, the Forex market is not conducted by a central exchange, but on the “interbank” market, which is thought of as an OTC (over the counter) market. Trading takes place directly between the two counterparts necessary to make a trade, whether over the telephone or on electronic networks all over the world. The main centres for trading are Sydney, Tokyo, London, Frankfurt and New York. This worldwide distribution of trading centres means that the Forex market is a 24-hour market.
How it all started?
Initially, the value of goods was expressed in terms of other goods, that is an economy based on barter between individual market participants. The obvious limitations of such a system encouraged establishing more generally accepted means of exchange at a fairly early stage in history, to set a common benchmark of value. In different economies, everything from teeth to feathers to pretty stones has served this purpose, but soon metals, in particular gold and silver, established themselves as an accepted means of payment as well as a reliable storage of value.
Before World War I, most central banks supported their currencies with convertibility to gold. Although paper money could always be exchanged for gold, in reality this did not occur often, fostering the sometimes disastrous notion that there was not necessarily a need for full cover in the central reserves of the government.
At times, the ballooning supply of paper money without gold cover led to devastating inflation and resulting political instability. To protect local national interests, foreign exchange controls were increasingly introduced to prevent market forces from punishing monetary irresponsibility.
In the latter stages of World War II, the Bretton Woods agreement was reached on the initiative of the USA in July 1944. The Bretton Woods Conference rejected John Maynard Keynes suggestion for a new world reserve currency in favour of a system built on the US dollar. Other international institutions such as the IMF, the World Bank and GATT (General Agreement on Tariffs and Trade) were created in the same period as the emerging victors of WW2 searched for a way to avoid the destabilising monetary crises which led to the war. The Bretton Woods agreement resulted in a system of fixed exchange rates that partly reinstated the gold standard, fixing the US dollar at USD35/oz and fixing the other main currencies to the dollar - and was intended to be permanent.
The Bretton Woods system came under increasing pressure as national economies moved in different directions during the sixties. A number of realignments kept the system alive for a long time, but eventually Bretton Woods collapsed in the early seventies following President Nixon's suspension of the gold convertibility in August 1971. The dollar was no longer suitable as the sole international currency at a time when it was under severe pressure from increasing US budget and trade deficits.
The following decades have seen foreign exchange trading develop into the largest global market by far. Restrictions on capital flows have been removed in most countries, leaving the market forces free to adjust foreign exchange rates according to their perceived values.
But the idea of fixed exchange rates has by no means died. The EEC (European Economic Community) introduced a new system of fixed exchange rates in 1979, the European Monetary System. This attempt to fix exchange rates met with near extinction in 1992-93, when pent-up economic pressures forced devaluations of a number of weak European currencies. Nevertheless, the quest for currency stability has continued in Europe with the renewed attempt to not only fix currencies but actually replace many of them with the Euro in 2001.
The lack of sustainability in fixed foreign exchange rates gained new relevance with the events in South East Asia in the latter part of 1997, where currency after currency was devalued against the US dollar, leaving other fixed exchange rates, in particular in South America, looking very vulnerable.
But while commercial companies have had to face a much more volatile currency environment in recent years, investors and financial institutions have found a new playground. The size of foreign exchange markets now dwarfs any other investment market by a large factor.
Why trade forex?
The foreign exchange market is unique because of:
- its trading volumes
- the extreme liquidity of the market
- its geographical dispersion
- its long trading hours: 24 hours a day except on weekends
- the variety of factors that affect exchange rates
- the low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)
- the use of leverage
How to get started?
Well, to get started, you have to understand a couple of forex terms.
Spread
The spread is the difference between the price that you can sell currency at (Bid) and the price you can buy currency at (Ask). For instance, the customer will buy from the market-maker at the higher "ask" price, and will sell at the lower "bid" price, thus giving up the "spread" as the cost of completing the trade. The spread on majors is usually 3 pips under normal market conditions.
Pips
A pip is the smallest unit by which a cross price quote changes. When trading Forex you will often hear that there is a 3-pip spread when you trade the majors. This spread is revealed when you compare the bid and the ask price, for example EURUSD is quoted at a bid price of 0.9875 and an ask price of 0.9878. The difference is USD 0.0003, which is equal to 3 “pips”. On a contract or position, the value of a pip can easily be calculated. You know that the EURUSD is quoted with four decimals, so all you have to do is cancel out the four zeros on the amount you trade and you will have the value of one pip. Thus, on a EURUSD 100,000 contract, one pip is USD 10. On a USDJPY 100,000 contract, one pip is equal to 1000 yen, because USDJPY is quoted with only two decimals.
Trading Scenarios Encountered
Trading Rising Prices
If you believe that the pound will strengthen against the yen you'll want to buy pound now and sell it back later at a higher price.
You open a trade and buy pound: GBPJPY is quoted at Bid 145.60 and Ask 145.68, which meant you can sell 1 pound for 145.60 yen or buy 1 pound for 145.68 yen. You buy pound at the Ask price which is 145.68.
The market moves in your favour: Pound strengthened and GBPJPY is quoted at Bid 146.50 and Ask 146.58.
You close the trade which sells pound: You sold pound at the Bid price which is 146.50.
Profit in pips: (145.68-146.50) X 100 = 82
Trading Falling Prices
On the other hand, if you believe that the pound will weaken against the yen, you'll want to sell GBPJPY.
You open a trade and sell pound: GBPJPY is quoted at Bid 145.60 and Ask 145.68 and you sold pound at the Bid price which is 145.60.
The market moves in your favour: Pound weakened and GBPJPY is quoted at Bid 144.50 and Ask 144.58.
You close the trade which in turn buys pound: You bought pound at the Ask price which is 144.58.
Profit in pips: (145.60-144.58) X 100 = 102
Note: Your size of trade is the one that determine your profit in USD.
Footnote: Most of the contents were quoted and taken from wikipedia.com and forextrading.com.
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