Forex – The 24 Hour Exchange
There is one additional bit of unfinished business, the Foreign Market Exchange.
The Forex market is the largest and most liquid market in the world. Many might ask what Forex is doing in a book on common stock trading? It is more an emotional issue than one of substance. We can’t connect to the web without being struck by intense marketing claims of quick and easy Forex fortunes to be made! We just can’t ignore the 2000 pound Gorilla in the room.
Forex (FX) is the Foreign Exchange Market where currencies are traded. What is traded? Simply money! This can be confusing since we aren’t buying anything physical. The principle behind a foreign exchange has always been evident whenever we travel outside the U.S. It occurs at the airport where we exchange our dollars for the local currency. There is a current exchange rate, which changes regularly. It is this change that prompts speculators to bet on where the rate will go.
The FX exists to allow multinational corporations to engage in cross-country commerce (payrolls, cost of goods bought and sold, etc.). However, this only accounts for about 20% of the FX market volume with the other 80% purely speculative in nature. It is this 80% that is the driver for the massive FX trade.
Currencies always trade in pairs, meaning we buy one currency and sell another simultaneously. The value of a currency is only valued by its comparison to another. Think of the airport experience. We sell our currency and buy theirs. There is the booth with the exchange rate posted where it is an easy exchange, our currency for theirs. We are always approached by hawkers near the booth who suggest a better deal as they flip through a stack of bills with a big smile. Caveat emptor!
The major currencies that make up most of the Forex trade are:
US Dollar (USD), British Pound (GBP), Swiss Franc (CHF), Canadian Dollar (CAD), Euro (EUR), Japanese Yen (JPY), Australian Dollar (AUD). Most common are EUR/USD, USD/JPY, and GPB/USD, accounting for over 95% of all speculative trading in Forex. Notice the USD is included in each pair. The US dollar is the king of currencies since it is the largest economy in the world and the world’s reserve currency. It has the largest and most liquid financial markets with a stable political system. Money we place into a Forex account is kept in US dollars.
While commercial and financial institutions are part of the Forex action, most trading volume is based on speculation, with traders buying and selling based on intraday price movements. This makes the Forex market extremely liquid, where huge trading volumes occur with relatively little effect on price.
A daily quote on the Forex would look something like this:
A Pip is an acronym for Price Interest Point. This is the smallest digit in the price quote of a currency pair. A move in the EUR/USD from 1.2449 to 1.2469 equals 20 pips. Since the currency pair is a ratio, it is quoted as a percent. One percent = 0.01; One Pip = 0.0001 or 1/100 of a percent.
With such a small unit of exchange and tight spreads, how can money be made in such a market? The answer is Leverage. Most Forex brokers allow a very high leverage ratio. Remember our discussion of trading on margin earlier in the book? A high leverage ratio means very low margin requirements. Stocks can double or triple in price, or fall to zero. A currency pair never does! That means the risk is much lower than it would be for stocks. Thus, the lower margin requirements.
Most brokers will allow a 100:1 leverage, or 1% margin. This means we can buy or sell $100,000 worth of currency with only $1,000 in our account. We can also make a profit on both the rise and fall of currency rates, going long or selling short. An added advantage unique to the Forex market is that it operates on a 24-hour basis (five days a week), with no intervals or stops, and does not cease operating in the event of extreme volatility, as is the case with stock exchanges and commodity markets. Sounds pretty good, eh? Just review the risk factors covered earlier in the discussion on Margin!
How do we determine profit or loss? Suppose we buy Euros and sell U.S. dollars with a current exchange rate 2.4300 / 2.4305 (the first number the “bid” price, the second the “ask”). Since we are buying Euros we’ll be working on the “ask” price of 2.4305 (the rate where traders are prepared to sell). We buy one standard lot at 2.4305, which then increases to 2.4331, or an increase of 26 pips, on 100,000 units;
(0.0001/2.4305) x 100,000 x 26 = 106.97 Euros profit
Retail clients (you and I) had been shut out of this market until the late 90’s when high-speed Internet access connected market makers to the end users. Today, we can trade with the biggest banks in the world, with similar pricing and execution. So what causes a currency pair rate to change? There are many possibilities, including changes in political leadership, natural disasters, economic booms and busts, etc. News events that can possibly affect the strength of a particular currency can cause dramatic and rapid swings in a currency trade. Think of the two parties in this pair – in a constant tug of war pulling the rope in opposite directions. The exchange rate fluctuates based on which currency is strongest at the moment.
With a Forex account we trade in a standard lot of 100,000 units. With 1% margin that requires only $1,000 cash in our account.
The FX market is unusual with no physical location or central exchange. The entire market is run electronically, within a network of banks, continuously 24 hours a day, five days a week, making it the most accessible market in the world. The market has no commissions, where brokers are really dealers who assume market risk as the counterpart to the investor’s trade. They make their money through the very tight bid-ask spread. In the FX, all members trade with each other based on credit agreements. This means the largest most liquid business in the world depends on nothing more than a symbolic handshake!
Your task in the FX market is to estimate (guess) the direction of the market and trade accordingly. The selected pair is constantly in a tug of war, with the exchange rate fluctuating based on which currency is the stronger.
Trading currency is very different from trading stocks. For example, if you bought $1000 worth of stocks and if the stock prices become $0 you will lose your $1000. In Forex, you can lose more than your investment, considering the margin feature, so apply the Money Management principles punched up in Provident Investing, Chapter 6 as a bare minimum! Use only a portion of your cash to invest and keep a cash reserve of at least 80% to cover the down-side. Trading in Forex can be risky, you can lose your hard earned cash! This is not the place to learn how to trade.