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  What is Forex

  Forex (meaning FOREign EXchange) is the acronym used for the international market where currencies are traded against each other. The Forex market, unlike a stock exchange, does not have a physical location but is considered to include all transactions involving the exchange of currencies. The decentralized nature of the Forex market explains both its volume and liquidity - transactions can take place around the world, 24 hours a day. The Forex market in its current form arose as a result of the breakdown of the gold standard in the early 1970s. Gold had long been an important unit of exchange and in the 19th century was increasingly used to back currency payments following the surge in international trade as a result of the Industrial Revolution. Major currencies were pegged to gold which ensured the value of the money received. This arrangement, however, was not destined to last. By the 1930s the system was under a great deal of pressure due to its inflexibility -- since currencies were tied to the price of gold, when a country acquired more currency, it had to acquire the corresponding amount of gold to maintain the correlation. The gold standard was reformed after World War II resulting in the famous Bretton Woods agreement which pegged the US dollar to gold at 35$ per ounce and every other currency to the US dollar. The IMF was also created. Within a few decades, however, the Bretton Woods system began to break down as foreign countries accumulated large reserves of US dollars, and the ability of the US government to redeem those dollars came increasingly under question. In 1973, US President Nixon announced that the US dollar would no longer be backed by gold. As a result, most major currencies, including the US dollar, began to be valued and traded relative to each other, with the exchange rate changing in response to market forces.

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  Currency Exchange Rate

  A currency exchange rate is one unit of one currency expressed in terms of another. For example, when the EUR/USD exchange rate is 1.2505, it means that you can buy one Euro for 1.2505 US Dollars. When two currencies are juxtaposed as in our example here (EUR/USD), it means that we are buying the currency in the first position (EUR) and selling the currency in the second position (USD).

  The exchange rate of any currency is usually shown with two figures: the Bid price (left) and the Ask price (right).

  The Bid Price represents how much of the quote currency (US Dollar in our example) will be obtained when selling one unit of the base currency (Euro in our example).

  The Ask Price represents how much of the quote currency (US Dollar in our example) has to be paid to obtain one unit of the base currency (Euro in our example).

  The Spread is the difference between the Bid and the Ask price.

  Every currency traded on the Forex market is assigned a three letter abbreviation which is generally used in all transactions and quotes. The US dollar, for example is abbreviated 'USD', the euro has the abbreviation 'EUR', etc.

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  How to Buy/Sell a Currency Pair/ Leverage

  The concept of leverage in currency trading describes an arrangement between a broker and a client whereby the broker provides the client with the means to trade with much larger sums than the client has available.   For any given transaction, the client supplies a certain fraction of the total amount of the trade as a 'security deposit' which serves to protect the broker (who has fronted the money for the trade) from taking a loss if the trade turns out to be losing. The broker reserves the right to close one or more of the client's positions at the point where the client's deposit can still cover the losses. This procedure is called a "stop out." If, on the other hand, the client makes a profit, the broker is simply returned the funds that were lent and the client keeps all the profits.

  The idea behind using leverage is to increase the magnitude of one's trading. The use of leverage gives traders the chance to make much larger profits than they would have otherwise had, but also increases the risk of taking heavier losses. The higher the leverage, the more money can be alotted to a trade, which means greater opportunity for profit and greater risk of loss. Leverage is usually displayed with the number "1" and a colon followed by a second number. For example: 1:50. In this case, the number "50" means that a trader can trade with 50 times the amount of money he or she has in their account.  While a higher leverage does increase the risk of loss, proper money management technique can greatly reduce the risk of incurring substantial losses.

  So having forecasted that EUR/USD is moving higher, you buy 10,000 EUR and sell 12,509 USD.

  Let's take a look at an example of a transaction:

  Let’s assume that the EUR/USD exchange rate is 1.2505/1.2509. Let's say you've done your analysis and you think the euro is going to rise in value against the dollar. You decide to buy 10,000 EUR (0.1 lots) at 1.2509 (the ask price).

  This means that you bought 10,000 EUR and paid 12,509 USD (this is derived from the exchange rate). Keep in mind that you don't actually have to have 12,509 USD available in your account to make this trade because the broker will lend you the necessary amount to make the trade. You only need to have in your account a certain percentage of that, which serves as a security deposit. Let's suppose the leverage in this instance is 1:100. This means that you only need to provide 1/100 or $125.09 to make this trade.

  Let's say your analysis turns out to be accurate and the euro does indeed rise against the dollar. You decide to sell at 125.99/06. So we are now selling our Euros (i.e. doing the reverse of the original transaction). We sell at the lower of the two prices, 125.99 (remember, the difference is the spread).

  So now we are buying back the 10,000 dollars that we started with. But now we are selling at a higher price (125.99). We end up with $12,599. Once the broker takes the $12,509 that was originally lent to us, we end up with a profit of $90. Keep in mind we only started with $125, so we ended up doing quite well.

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  Rollover (Swap)

  If you leave a position open overnight, you will encounter what are called swap or rollover charges (for the 'rolling over' of a position overnight). These are derived from the difference in the interest rates of the two currencies involved in the trade. When the interest rate for the currency sold is greater than the rate for the currency bought, you will have to pay the difference. However, when you buy a currency with a higher interest rate than the rate for the currency you sold, you will receive the difference (actually slightly less than the difference because your broker charges a small commission for handling the rollover)

  Here's an example: let's assume the interest rate for the euro is 4.25% and 3.5% for the dollar and that you have a 1 lot short position open on EUR/USD. This means you sold 100,000 EUR (and buying USD), borrowing the EUR at 4.25% per annum. Because the interest rate for USD is only 3.5%, the difference in exchange rates is 1.25 or 937.5 USD per year (2.57 USD per day).

  So as a result, $2.57 per lot will be debited from your account every day that you have the position open. If you had a long position (buy position) on EUR/USD, you would be credited the swap charge (minus a small commission).

  Note: Swap charges rolling over of a position opened on a Wednesday and held overnight are three times higher than for other days. This is because the value date (the date on which the value of a financial instrument is established) of a trade held overnight on Wednesday would normally be Saturday and is therefore moved to Monday, hence the extra two days.

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Why Forex?

Thanks in part to the rise of web-based brokerage services, currency trading has experienced a sharp rise in popularity in recent years. The Forex market, once the exclusive domain of central banks and major corporations, is now available to anyone willing to learn the ropes of this fast-paced, often highly lucrative market. While Forex is by far and away the world's largest and most liquid market -- and a potentially very lucractive one for traders of all types -- it has acquired a not entirely undeserved reputation as a risky form of investment (as with any leverage-based trading). But the risks of Forex can be greatly mitigated by maintaing disciplined approach to money management and avoiding overexposure (the all eggs in one basket effect). Furthermore, Forex does not suffer market-wide downturns as many other markets do. Because currencies are traded against each other, a downturn in one currency necessarily means an upturn in another. Considering that price fluctuations are virtually nonstop, the Forex trader always has an opportunity to profit, regardless of the state of the economy at large.

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  Why is Forex so popular?

  The following can be considered the main reasons why Forex is so popular among investors and financial speculators today:

  • 1. Liquidity. Forex is the largest financial market in the world, with over $3-4 trillion changing hands daily, whereas the volume traded on stock markets amounts to only $500 billion.
  • 2. Flexibility. Since Forex has a 24-hour trading schedule, you do not have to wait to react to significant events. On other markets, you simply have to wait until morning to respond and the price will already be affected by the event and greatly differ from the desired level.
  • 3. Lower transaction costs. Traditionally there are no commissions on the Forex, except for the spread (the difference between the ask and bid prices).
  • 4. Price stability. Forex's high liquidity helps ensure price stability, allowing practically unlimited contract sizes to be executed at fair prices. Instability usually happens in the stock market and other exchange-traded markets because of lower trade volumes, where only a limited number of contracts can be executed at a certain price.
  • 5. Margin. Margin size (leverage) for trading on Forex is determined through an agreement between the client and the bank or broker that gives the client access to the market, and usually is around 1:100. Thus, if a trader provides a collateral of 1,000 USD, he can make a transaction equivalent to 100,000 USD. The combination of high leverage and rapid rate fluctuation make Forex very profitable but also extremely risky.
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  Forex Market Classification.

  FOREX can be classified by the following characteristics:

  • 1. Transaction type. For example, there is an international conversion market (conversion transactions such as US Dollar / Japanese Yen or US Dollar / Canadian Dollar etc.).
  • 2. Geographic location. Unlike other financial markets the Forex market has no physical location, in contrast with, for example, a stock exchange. It operates through an electronic network of banks, computer terminals or simply by phone. The lack of physical exchange enables the Forex market to operate on a 24-hour basis, spanning across all time zones and major financial centres (Sydney, Tokyo, Hong Kong, Frankfurt, London, New York, etc.), allowing dealers to buy and sell currencies 24 hours a day throughout the entire working week. Trading begins in the Far East, in New Zealand (Wellington), then Sydney, Tokyo, Hong Kong, Singapore, Moscow, Frankfurt-on-Maine, London and finally ends in New York and Los Angeles. The approximate trading hours for regional markets are shown below:
    
    

    Session	City	GMT	EET
    Asian	Tokyo	00:00 - 08:00	02:00 - 10:00
    European	Frankfurt London	06:00 - 14:00 07:00 - 15:00	08:00 - 16:00 09:00 - 17:00
    American	New York Chicago	13:00 - 21:00 14:00 - 22:00	15:00 - 23:00 16:00 - 00:00
    Pacific	Wellington Sydney	21:00 - 05:00 22:00 - 06:00	23:00 - 07:00 00:00 - 08:00

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  Commercial Banks

  Commercial banks are responsible for the main volume of currency operations. Other market participants hold accounts in these banks and carry out necessary conversion, deposit and credit transactions through them. Banks accumulate (through client operations) market demand/market requirements in currency conversions and the attraction/investment of funds and refer with them to other banks. Aside from filling client requests, banks also trade on their own account.

  Ultimately, Forex is a market of interbank transactions, and subsequently, when discussing currency and interest rate fluctuations we need to bear in mind the interbank foreign exchange market.

  Large international banks whose daily operation volumes can reach 1 billion dollars, such as Deutsche Bank, Barclays Bank, Union Bank of Switzerland, Citibank, Chase Manhattan Bank, and Standard Chartered Bank, have the largest impact on world exchange markets. These banks are distinct in that their large transaction volumes can cause significant changes in quotations or currency price. The large market players are usually divided into two groups: bulls and bears. Bulls are those market participants who want the currency price to increase; bears are those who want the price to decrease. The market is usually in balance between bulls and bears, and currency quotes usually fluctuate within a narrow range. However, when bulls or bears gain power in the market over one another, currency rates begin to fluctuate sharply and significantly.

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  Companies Involved in International Trade

  Companies that take part in international trading either have a strong demand for a foreign currency (importers) or supply a foreign currency (exporters), and also deposit and draw in currency surpluses. As a rule, these organizations do not have direct access to the Forex market and make conversion and deposit transactions through commercial banks.

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  Companies Depositing Foreign Assets (Investment Funds, Money Market Funds, International Corporations)

  These companies represent various types of international investment funds, who diversify asset portfolios by depositing funds in government bonds and securities of assorted national corporations. In dealer slang, these companies are simply called "funds". The most popular funds are George Soros's "Quantum" fund and "Dean Witter".

  This type of market participant can also refer to large international corporations making foreign industrial investments in branches, joint enterprises, etc. This describes companies such as Xerox, Nestle, General Motors, British Petroleum, and others.

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  Central Banks

  The main concern of central banks is currency regulation on the foreign market, particularly to prevent sharp bounces in national currency, thus avoiding economic crises, supporting a balance between exports and imports, etc. Central banks have a significant influence on the Forex market: both direct (currency intervention) and indirect (money supply and interest rate regulation). Central banks cannot be referred to as bulls or bears, as they may play on a rise or fall depending on their current concrete objectives. Central banks may act alone on the market to influence a national currency, or they may act in conjunction with other central banks to realize a collective currency policy on the international market or for collective interventions.

  The following banks have the largest influence on the world currency market: the US central bank — US Federal Reserve (FED), the German central bank — Deutsche Bundesbank and the British central bank — The Bank of England (Old Lady).

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  Foreign Exchanges

  Foreign exchanges operate side-by-side with emerging economies, carrying out currency exchange for legal entities and forming market exchange rates. The government usually actively regulates the exchange rate, making use of the density of currency exchange.

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  Currency Brokerage Firms

  The function of currency brokers is to bring together a buyer and a seller of a certain foreign currency. Brokers charge a commission for their services which is usually a percentage of the total transaction amount .

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  Individuals

  Individuals make a large amount of non-commercial transactions related to traveling abroad, salary conversions, pensions, earned income transfer, and buying or selling money on the foreign exchange market. The introduction of margin trading in 1986 gave individuals the opportunity to invest and make a profit on Forex.

  The main volume (90-95%) of transactions on Forex is completed by large global commercial banks both in their clients’ interests and on their own account. Advances in computer technology have allowed more and more brokerage firms and banks to provide access to Forex through the Internet.

There are special currency abbreviations accepted in banking practice: for example, the exchange rate for the dollar against the yen is referred to as USD/JPY, the British pound against the US Dollar is GBP/USD. The first currency is called the base currency and the second is the quote currency:

This abbreviation specifies how much of the quote currency you have to pay to obtain one unit of the base currency (in this example, 120.25 Japanese Yen for 1 US Dollar). The minimum rate fluctuation is called a pip.

For USD/JPY, EUR/JPY and GBP/JPY currency pairs, one pip is 0.01. For all other currency pairs (without JPY in the abbreviation), one pip is 0.0001.

Currency pairs on Forex are quoted as the bid and ask (or offer) prices:

Bid is the rate at which you can sell the base currency (in our example USD), and buy the quote currency (JPY).

Ask (or offer) is the rate at which you can buy the base currency (in our example USD), and sell the quote currency (JPY).

Spread is the difference between the bid and the ask price..

Margin trading trading on Forex using a guaranteed collateral based on the clients' funds and the leverage provided by the dealer.

This means that a client makes a minimum deposit as collateral, which is much smaller than the minimum contract, but can operate with the larger amounts necessary to enter the real market. These extra funds are provided to the client by brokers along with their informational services and make it possible for a trader to work with positions larger than their account balance. This collateral is typically referred to as margin.

Leverage is the ratio between the collateral and borrowed funds: 1:20, 1:40, 1:50, 1:100. A leverage of 1:100 means that you need to have a deposit 100 times less than the contract size to make a transaction.

Currency Rate is the value of one currency expressed in terms of another. The fluctuation depends on the supply and demand on the market and/or open market operations by a government or central bank.

Lot is a fixed standard amount of a currency for trading provided on the collateral — margin. It is sometimes called the contract size. The 1.0 lot contract size for each currency pair is listed in the Contract Specification.

Storage is the charge to rollover a position overnight. It can be either positive (credited to your account balance!) or negative (debited from you account balance) depending on the difference between the interest rates of the countries whose currencies you trade.