Lessons from the Pros

Featured Article

What is the Forex Market?

Hello traders! This week I’d like to explore the background of the spot foreign currency exchange market and explain why it is my favorite market to trade.  I’ll explain what foreign currency exchange actually is and some of the positives and negatives of this market.

First of all, what is foreign currency exchange, also known as Forex or FX? If you’ve ever traveled to a foreign country you have probably had to trade your home currency for the currency of the country you are visiting. A week later when you left that country you probably traded your leftovers of that country’s currency for your own home country’s currency. Congratulations, you are a Forex trader! Now, this is slightly different than what professional Forex traders do. Very often we plan on being in trades for a few minutes to a few hours, instead of a vacation week or two.  Plus, we don’t place our trades at little blue kiosks in airports! Most of our trading is done very similarly to any type of stock, futures, or options trades you’ve done in the past through your own computer.

So how did this market come to be? Towards the end of World War II, the “Bretton Woods System” was enacted to help stabilize the world financial markets by setting up an exchange rate for all currencies vs. gold. Over time, the rules enacted were deemed to be too stifling and obsolete, so in 1971 the Agreement was abolished, which allowed currencies to more freely float against each other. Until the late 1990’s, this foreign currency market wasn’t readily available to the average United States retail investor. In fact many traders in the US had never even heard of Forex until 1999!

As more and more brokerage firms in the US started offering Forex, and more and more traders started trading this market, the volume in this marketplace has increased dramatically. According to a survey coordinated by the Bank for International Settlements, Forex market turnover has increased from ~$500 billion/day in 1988 to ~$1.5 trillion/day in 1998 to over $4 trillion/day now! By comparison, volume on the New York Stock Exchange (NYSE) is approximately $74 billion/day. Not even close! Along with this increase in volume comes a few benefits. Tighter spreads (the difference between the bid and ask price) has certainly helped decrease our costs. When I first started trading Forex in 2002, the spread on the most popular/liquid currency pair, the EUR/USD, was 3-5 pips. Today the spread has been cut by more than 50%, now commonly .9-1.5 pips. What is a pip you ask? It used to be the smallest tradable unit in the Forex market. Much like US stocks very often trade in .01 (one cent) increments, the Forex market used to trade in .0001 (one one-hundredth of a cent) increments. These days this market now trades in fractions of a pip (.00001). Sounds a bit confusing, but all it really means is our cost of trading measured by the spread has dropped considerably, which is a great thing!

The above numbers are referencing currency pairs where the US dollar is the quote currency, meaning it is the second of the two currencies in the pair. The first currency is called the base. When talking about the British pound vs. the US dollar currency pair, the trading symbol is GBP/USD (sometimes GBPUSD) where the pound is the base (first) currency and the dollar is the quote (second) currency. So when you look at the trading price of the GBPUSD of 1.5900, the price you see is actually how many US dollars and cents it takes to buy one British pound. The odd thing about the Forex market is that you are actually exchanging one currency for another-essentially buying the first while selling the second, and vice versa. When the GBPUSD moves from the 1.5900 to 1.5905, that is a move of 5 pips. That move doesn’t look like much when we are used to seeing prices move in many pennies or dollars at a time when we trade stocks-with the large leverage in this market that few little pips/fraction of a penny move can help us make a nice living!

Let’s talk about the leverage available in this market. Leverage basically means you invest a little bit of money to control a lot of money/stocks/real estate/or whatever else you are investing in. In the US stock market your broker will very often offer you 2:1 leverage, meaning if you deposit $10,000 in your trading account they may allow you to buy $20,000 of stock. Sounds great doesn’t it? It is when your trade makes money, not so good when your trade loses money. Over-leveraging your account-trading too big of size for your experience and account size-is one of the primary reasons people blow up their trading accounts. In the US, leverage of 20 or even 50 times your money is available at most brokers! In the stock market, you are trading things called shares, in futures you are trading things called contracts, and here you are trading things called lots. One standard lot costs you ~$2,000 to place the trade, and you control $100,000 of currencies with a 50:1 leverage. That should sound a bit scary because it is. Here is an example of over-leveraging:

Say you have a $5000 trading account and do a trade for two standard lots (each lot in this example costs $2000) where you control a total of $200,000 of currencies. If you bought the GBPUSD at 1.5950 each pip would be worth $20 in this trade. This also means that a move of 250 pips against you would wipe out your entire account. That 250 pips is only two and a half cents!

If you look at the Average True Range (a measurement of volatility) of the GBPUSD, you will see that it currently moves approximately 120 pips per day. In the above example you could have blown up your account in about two trading days! Again, this is an example meant to scare you. When used properly and with discipline, leverage may help to increase the profits in your trading account!

Another terrific benefit of this marketplace is the fact that it is open 24 hours a day straight, from Sunday afternoon to Friday afternoon. That means you can trade at 2am, 12 noon, or 8pm at night! You get to customize your trading plan and style to fit the rest of your life instead of the other way around. Have you ever had the urge to place a trade at 12 midnight EST? I have! If you only trade stocks, all you can do is place a limit order and wait for the market to open the next trading day. In the spot Forex market you can place trades and perhaps make money at midnight!

So there you have it. A brief history of the foreign currency market, and a couple of the reasons this is my favorite market to trade-leverage and 24 hour trading. To find out much more about this terrific marketplace, come to one of our Online Trading Academy classes-hope to see you soon!

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

Join over 170,000 Lessons from the Pros readers. Get new articles delivered to your inbox weekly.