Forex trading for dummies, part I
Reading time: 12 minutes
In this article you will learn the Forex market's basics - including its size, scope, structure and the route mechanics of currency trading.
We will also identify and explain the key terms associated with Forex.
Part II will explore the different types of market analysis and trading styles, before exploring how they can be tested on a Forex dummy account.
You can also check out our Forex trading for beginners guide - which goes more in-depth explaining forex trading, strategies, psychology, money management, fundamental and technical analysis etc.
Knowing why we do the things we do, helps us prioritise and provides motivation.
So as a preface to this article, let's start by answering why anyone would start financial trading in the first place?
Consider this quote from the Boston Federal Reserve:"When you or I write a cheque, there must be sufficient funds in our accounts to cover the cheque. But when the Federal Reserve writes a cheque, there is no bank deposit on which that cheque is drawn. When the Federal Reserve writes a cheque, it is creating money."
More specifically, it is creating debt.
Unlike the Federal Reserve, the European Central Bank and most other national banks can only inflate their home economies in a more modest way.
However, because economies are wired together like networks, rather than simple circuits, the debt travels across borders and through generations.
For many, the only way to repay it is by creating more debt, thus leading the global economy closer to the next inevitable meltdown.
Which conveniently brings us to the next point.
Why start financial trading at all?
Because everything else can be classed as economic suicide.
Very slow, yet very definite.
Every financial institution in the world knows this.
That is why they train professional financial traders and hire them.
Think about it.
When you bring your hard-earned money to a bank, you are not actually just leaving it there for safekeeping.
It is not the Wild West.
You are actually lending your money and the bank can do whatever they want with it.
What they often do is either speculate on financial markets, or loan up to 90% to others.
As money is re-deposited and re-lent, a currency can grow exponentially.
This is neither good, nor bad.
This is how the contemporary global economy functions - and it has been like this for quite a while now.
The Internet age has made financial markets widely accessible.
And that's a good thing, because you can now be your own bank so to speak.
However, the next time the bubble bursts, your national bank won't buy out your debt - just your bank's debt.
This pretty much covers the initial question.
Highly volatile markets like Forex attract private investors and traders.
These traders often have no background in financial trading and only bits of knowledge on the subject.
As a rule, Forex newcomers have a few things in common, including that they:
- are eager to improve their economic situation
- expect to earn ever so much from investing ever so little
- hope, without a plan, to achieve this in a very short time
- approach Forex with unrealistic expectations, which helps them justify quitting at the first trading failure.
This article was written with the aforementioned approach in mind.
It's set out to create general awareness regarding financial trading, with a particular focus on Forex trading.
Most importantly, this guide is set to cool down appetites:
...to convince you that trading works best when comprised of analysis and patience...
...and works worst when hectic and hasty.
In this manner, we hope to change the mindset of aspiring traders and prevent them from leaving empty handed before they have even truly started.
The Foreign exchange market - often called Forex or the FX market - is the most traded financial market in the world.
It is the financial hub through which the world's economic, investment and speculative flows move.
However, unlike most other financial markets, Foreign exchange is the trader's market.
It is open around the clock, so traders can react to world events in real time.
It is the market where million-dollar trades take split seconds to execute, tipping the balance in supply and demand only slightly.
Average daily currency trading volumes exceed $2 trillion, which is least 10 times the volume traded at all the world's stock markets combined.
Above 90% of that volume comes from speculative trading, which puts Forex market liquidity far above any other market.
Liquidity is a good thing for a trader.
The higher the liquidity, the deeper the market.
This means it's easier for traders looking to buy or sell to find each other
A market open around the clock
Forex is a decentralised marketplace.
It is not bound to one physical location that is open during business hours.
Rather, it exists as an electronic trading network, available 24 hours a day, five days a week.
A Forex trading day consists of three overlapping trading sessions that last roughly eight hours each:
- Asian-Pacific - 00:00 to 08:00 GMT
- London or European - 08:00 to 16:00 GMT
- North American - 16:00 to 24:00 GMT.
This way, Forex is traded around world and around the clock from early Monday morning to late Friday night.
Trading sessions vary in total trading volumes, as well as relative trading volumes per instrument.
For example, the London/European session accounts for approximately 50% of total daily Forex trading volume.
This is followed by North American and Asian-Pacific trading sessions, which share the remaining volume more or less equally.
The most actively traded currencies per session are usually the ones native to the region.
Thus, during the Asia-Pacific session, the most traded pairs are:
- USD/JPY (18% total daily volume in 2013)
- USD/AUD (7%)
- EUR/JPY (3%).
This is also due to market news being released at these hours by local financial institutions.
Market interest and liquidity peak during the London/European session, with European currencies trading against the US dollar including:
- EUR/USD (27%)
- USD/GBP (9%)
- USD/CHF (3%).
The North American trading session overlaps with the European and Asian-Pacific sessions - adding USD/CAD (3%) to its trading menu.
By the way, the US dollar is the most traded world currency - taking 87% of all Forex trades.
What else is there to trade on the financial markets?
Currency exchange, as you probably know, is not the only financial market in the world.
Other examples are the precious metals market (i.e. gold, silver, platinum), energy futures (crude oil, natural gas), stocks, indices, the grain market, bonds and other instruments.
Markets vary in almost every feature imaginable, but the underlying principle of supply and demand forming price remains the same.
Despite the variety of financial instruments available to Forex traders (depending on their broker's offering), this guide will concentrate on currencies.
As a side note, a certain amount of speculation exists regarding the interrelationship of markets.
Markets do not exist in a vacuum, so from time to time their movements coincide.
However, correlation does not always equal causation.
The mechanics of trading currency for dummies
In the Forex market, financial instruments are presented in the form of currency pairs, since currencies are valued against one another.
Every exchange operation involves both buying and selling.
For example, placing a buying order (known as going long) on the EUR/USD pair would involve buying euros in exchange for US dollars at the order's opening.
Traders would then wait for the euro currency to appreciate against the dollar, before selling it back and yielding more dollars than there were before the transaction took place.
This is called the round trip and constitutes a single complete trade.
A sell order (or going short) on the EUR/USD pair would require the reverse sequence, since the trader expects the euro (the base currency) to depreciate against the dollar (the counter currency).
There are three things to note here.
First, this mechanism applies to all currency pairs.
Second, traders can sell currencies they do not actually own.
Third, both buying and selling takes place in every transaction.
Any two currencies can be combined to make a Forex pair, but not all make much sense to actually trade.
What attracts Forex traders is liquidity and volatility.
With this in mind, all currency pairs are divided into four groups - majors, minors, cross pairs and exotic pairs.
Majors and minors all include the US dollar on the one side:
- majors are EUR/USD, USD/JPY, GBP/USD and USD/CHF
- minors are USD/CAD, AUD/USD and NZD/USD.
Combinations of currencies from these pairs that do not involve the US dollar are called cross pairs.
They are EUR/JPY, GBP/CHF, AUD/CAD and so on.
All the other pairs - the so called exotic pairs - account for less than 10% of total daily volume.
They are less liquid, but they can be as volatile.
Profit and loss
Profit and loss (P&L) is how traders measure success and failure.
However, unlike the previous material in this article, P&L calculations might not be easy for a dummy in Forex to understand.
Having a clear understanding of P&L is important.
Especially when you consider that changes in your P&L will directly affect the balance on your margin trading account.
It is true that modern trading platforms calculate P&L automatically, so why bother?
Because platforms only do it after you have opened an order, which is already too late for calculating risk.
It is all about leverage and margin.
Financial leverage is a feature offered by Forex brokers to help traders control larger amounts of assets, despite having relatively small accounts.
Let's say you have an account with a leverage ratio of 100:1.
This means that $1 of margin in your account can control a $100 position size.
Margin is the amount of money that participates in a trade.
Let's say EUR/USD is at 1.1234/1.1240.
This means you can buy one euro at the ask price of 1.1240 US dollars, because that is how much is being asked for it.
Alternatively, you can sell one euro at the bid price of 1.1234 US dollars, because that is how much is being bid for it.
Imagine you want to go long and buy 100,000 Euros.
Using the currency pair quote from above, you would need 112,400 US dollars to do that.
But since you have 100:1 leverage, the required margin to make such a transaction is only 1,124 US dollars.
The remaining sum is provided by your broker.
However, you must have the required margin on your trading account (meaning your margin level is above 100%) to keep these positions open.
As soon as your margin starts falling below 100% (and fall it might as the floating P&L from active trades affects your balance directly), your broker may close your order automatically.
This is called a margin call and it is performed when a debtor (traders) can no longer meet their obligations to their creditor (the broker) for the leverage provided.
This is the dual nature of financial leverage - potentially profitable and as potentially devastating.
Margin calls can come at 100%, 50% or 30% margin levels, depending on the broker.
For these reason, a trader must not only evaluate his margin requirements prior to entering trades, but also be aware of the broker's conditions on margin calls.
P&L is calculated in pips, sometimes called points or ticks.
A pip is the fifth digit in a currency price quote.
For example, when the EUR/USD ask price changes from 1.1240 to 1.1245, it has moved five pips up.
When the USD/JPY bid price changes from 112.45 to 112.37, it has moved eight pips down.
Pip value is a fixed amount and is measured in the currency of your account.
For example, assuming your account balance is in US dollars - buying one lot of EUR/USD will yield one pip of $10.
But if your account is in Euros, one pip will equal around eight euros.
You may find it convenient to use a trader's calculator, many of which are available online
Knowing how many pips in a P&L drawdown that your account can bare before it's on a margin call - is as important as knowing how much margin is required to open a trade in the first place.
Swaps and interest rates
A swap - sometimes called a 'rollover' - is a unique type of a transaction that occurs every time an order stays open from one date to another.
Swaps are almost unique to Forex market and they exist because of interest rates.
Interest rates are the biggest drivers of money supply.
This is important to realise for dummies when trading Forex, as interest rates are the primary tool that central banks use to control inflation.
When interest rates are increased, it becomes more expensive for banks to borrow currency from the central bank.
This causes a shortage in currency supply and pushes the currency price up.
Ergo, inflation decreases.
...when interest rates are cut, money is borrowed at a lower cost and in higher volumes...
...which stimulates inflation.
Either can be useful at times, which is why national banks periodically raise and lower interest rates.
What does this have to do with a trader?
Well, in effect you are your own bank now remember?
Interest rates apply to you as well.
For example, when trading a pair in which the base currency has a higher interest rate than the counter currency (like NZD/JPY at 3.6% to 0.1% respectively) - it's cheaper to buy and hold NZD than JPY.
The difference between interest rates within one Forex pair is called the interest differential.
In cases where the interest differential is a positive number (as it is with NZD/JPY at 3.5%), you will earn interest simply for being in a long trade.
Similarly, for being in a short trade, you will be due to pay interest.
The information on swap rates is always available in a currency pair's description - either directly on your trading terminal, or on your broker's page.
At 00.00 GMT, your broker will credit or debit your account based on active trades, along with the volumes of those trades.
To be continued
This rounds up part I.
This is also where you will find calculations and answers for the self-test assignment.