What is Forex?

The foreign exchange market is where currency trading takes place. Forex market is the largest market in the world and it is also the most liquid, differentiating it from the other markets. There is no central market place for the exchange of currency, but instead the trading is conducted over-the-counter.

Fx transactions typically involve one party purchasing a quantity of one currency in exchange of paying a quantity of another. The Foreign Exchange Market that we see today started evolving during the 1970s when world over countries gradually switched to floating exchange rate from their erst while exchange rate regime, which remained fixed as per the Breton Woods system till 1971.

Today FX market is one of the largest and the most liquid financial markets in the world, and includes trading between large banks, central banks, currency speculators, corporations, governments, and other institutions. Traditional daily turnover was reported to be over US$ 3.2 trillion in April 2007 by the Bank for International Settlements. Since then, the market has continued to grow.

The purpose of FX market is to facilitate trade and investment. The need for a foreign exchange market arises because of the presence of multifarious international currencies such as US Dollar, Euro, Pound Sterling, Yen, etc., and the need for trading in such currencies.

Forex Trading

Facts related to Forex Trading

Forex refers to Foreign Exchange, which is basically exchange of currency of one country with that of the other.

Exchange value of a particular currency is not universal and absolute, but relative to the other currency based on the economic principle of demand and supply.

Currency trading takes place between a pair, where one currency is bought and the other is sold, which is unlike stocks or bonds or indices where ‘short’ is ‘short’ and ‘long’ is ‘long’.

For example, say, in case of the currency pair, EUR/USD, when EURO is bought, at the same time USD is sold, or in other words, a ‘long’ position is considered to be opened in EURO and at the same time, a ‘short’ position is considered to be opened in USD.

Forex Trading is one of the financial trading operations, which continues around the globe, non-stop round the clock without stoppage, as all global business transactions, i.e., imports, exports, trades, services, tourism etc. end up with settling in foreign exchange.

The trading operations undertaken by forex brokers start from Sunday 17:00 EST through Friday 17:00 EST non -stop 24 hours a day.

What is the Foreign Exchange Market and Who are the Participants?

The foreign exchange market is the market for buying and selling different currencies. It is primarily an over-the-counter market with trades between large commercial banks accounting for most foreign currency transactions. The main participants are:

Inter-Bank Market

Inter bank Market is at the top, which is made up of the largest investment banking firms. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle.

Banks

The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account.

Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems.

Federal / Central banks

Central banks play an important role in the foreign exchange markets. All Central and federal banks have the monetary tools to maintain economic stability to maintain inflation target and price stability. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Usually, Central/Federal banks do not interfere with the market directly but can intervene to maintain its economic objectives. The mere expectation or rumor of central bank intervention might be enough to stabilize a currency.

Other participants in the foreign exchange market include:

Commercial Companies

Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. A big Chunk of market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants

Hedge Funds

Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor. 70% to 90% of the forex market transactions are speculative. i.e., the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds participates aggressively in FX market.

Forex Brokers

These Brokers basically focus on individual traders and retail brokers, who match buyers and sellers in the market. They offer the opportunity for speculative trading. Retail traders, i.e., individuals are a small fraction of this market and may only participate indirectly through brokers or banks. These forex Brokers are largely controlled and regulated by the CFTC and NFA. At present, the NFA and CFTC are imposing stricter requirements, particularly in relation to the amount of Net capitalization required of its members. This activity is moving toward NDD (No Dealing Desk) and STP (Straight Through Processing) to improve the security in the forex market.

Other : Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as Foreign Exchange Brokers but are distinct from Forex Brokers as they do not offer speculative trading but currency exchange with payments, i.e., there is usually a physical delivery of currency to a bank account.

Forex Trading - How does it work?

In Simple words, Forex Trading is buying and selling of international currencies. The US dollar is almost always the base currency against which other currencies are bought and sold in real Forex Trading. Local currency can also be used as a base currency. In such a case it will be called a CROSS TRADE. Cross trading is then an exchange of two currencies where US dollar is not involved.

How Currency Trading Works

Say, if you decide through you analysis that the CAD might appreciate in value against US dollar in near future. The current exchange rate of CAD is 1.30 to a US dollar. You go to the bank and exchange US$ 10,000 for CAD 13,000.

US$ 1.00 = CAD 1.3000

US$ 10,000.00 = (1.3000 *10,000)

You will get: CAD 13,000

Profit

Later on, as expected, the CAD appreciates by five cents to CAD 1.2500 to a US dollar. You then take your CAD back to the bank and exchange them into US dollars. You will get US$ 10,434.78. This extra US$ 434.78 will then be your profit on top of your initial investment of US$ 10,000.

CAD 1.2500 = US$ 1.00

CAD 13,000 = (1/125)*13,000 = US$ 10,400

Initial Investment was: = US$ 10,000.00

Your PROFIT: = US$ 400.00

Loss
On the other hand, instead of appreciating, the CAD further weakens. After all, it was only an expectation that the CAD will appreciate and was not a guarantee.

Say, it weakens by five Cents to CAD 1.3500 to a US dollar. Now there are two choices, to either hold on to your CAD until it appreciates or exchange them back into US dollars. Suppose, you want to exchange them back into U.S.dollars for fears of further CAD weakness. You then exchange CAD to US dollars. You will get US$ 9,600.00. Your loss is US$ 400.00. Now your initial investment of US$ 10,000 is reduced to US$ 9,600.

CAD 1.3500 = US$ 1.00

CAD 13000 = (1/125)*13,000 = US$ 9,629.62

Initial Investment was: = US$ 10,000.00

Your LOSS: = (-US$ 370.37)

Forex Trading is neither gambling nor should it be perceived as such. In gambling, once you place a bet you cannot withdraw from a losing situation. You either win or lose. On the other hand, with Forex trading, you decide how much you are prepared to lose or wait until you are in profit depending upon your risk to reward ratio. Forex trading strategies provide several means to accomplish just that. Therefore, one can trade Forex euphorically which could amount to speculation or in an organized manner, whereby tools and techniques are there to help you learn how to trade currency, it's up to you to use them for your best interest.

CURRENCY PAIRS

All currencies are assigned an International Standards Organization (ISO) code abbreviation. In currency trading, these codes are often used to express which specific currencies make up a currency pair. For example, USD/CHF refers to two currencies: the US Dollar and the Swiss Franc.

EXCHANGE RATE

An exchange rate is the ratio of one currency valued against another. The first currency is referred to as the base currency and the second as the counter or quote currency. If buying, an exchange rate specifies how much you have to pay in the counter or quote currency to obtain one unit of the base currency. If selling, the exchange rate specifies how much you get in the counter or quote currency when selling one unit of the base currency.

USD/CHF

Base currency/quote currency

SPOT FOREX

Spot foreign exchange is always traded as one currency in relation to another. So a trader who believes that the dollar will rise in relation to the Euro, would sell EUR/USD. That is, sell Euros and buy US dollars.

The following is guide for quoting conventions :

Currency Pairs - Exchange rate relationship between two currencies, where one currency is expressed in terms of the other. For example, USD/CAD (US dollar against Canadian Dollar) is a currency pair.

Base Currency - The base currency is first currency in any conventionally quoted currency pair. Thus in EUR-USD, Euro is the underlying currency ; in USD/JPY it is the US Dollar ; while in EUR/JPY, it is again Euro

Buying and Selling Currency Pairs - How to Trade Forex

All Forex trades result in the buying of one currency and the selling of another (currency trading), simultaneously.

Buying ("going long") the currency pair implies buying the first, base currency and selling an equivalent amount of the second, quote currency (to pay for the base currency). It is not necessary to own the quote currency prior to selling, as it is sold short. A trader buys a currency pair if he/she believes the base currency will go up relative to the quote currency, or equivalently that the corresponding exchange rate will go up.

Selling ("going short") the currency pair implies selling the first, base currency, and buying the second, quote currency. A trader sells a currency pair if he/she believes the base currency will go down relative to the quote currency, or equivalently, that the quote currency will go up relative to the base currency.

An open trade or position is one in which a trader has either bought or sold one currency pair and has not sold or bought back an adequate amount of that currency pair to effectively close the trade. When a trader has an open trade or position, he/she stands to profit or lose from fluctuations in the price of that currency pair.

GTC Order
Order that is active until it is cancelled by the trader.

Limit-Entry Order
Entry orders are executed the moment the market reaches the order's specified price. Different Entry Order types include, Entry Limit Buy, Entry Limit Sell, Entry Stop Buy, Entry Stop Sell.

Limit Order
The limit order is usually a profit order, or in the event of no existing trade, the limit order represents a buy or sell order below or above the current market price. A limit order is placed when a trade has been put on.

Market Order
A market order is executed immediately at the currently quoted market price. The available market order types includes : Buy and Sell.

OCO Order
A One Cancels Other (OCO) order is two separate entry orders "linked" together that are requested (and managed) as a single order. When either of the two orders is executed, the other order is cancelled.

If/Then Order
An If/Then order is two separate entry orders "linked" together that are requested (and managed) as a single order. When the "If" order is executed, the "Then" order becomes an active entry order.

If/The OCO Order
An If/Then OCO order is three separate entry orders "linked" together that are requested (and managed) as a single order. When the "If" order is executed, the "Then" OCO order becomes an active OCO order.

Day Order
Day order, remains active until the end of the trading day.

Stop-Loss Order
The stop-loss order is a protection order when a position has been taken. It is the maximum possible loss. After a stop-loss order is executed for the same position amount, the position is liquidated and the loss has been taken.

Open Order
An order to buy or sell when a market moves to its designated price.

Open Position
Any deal which has not been settled by physical payment or reversed by an equal and opposite deal for the same value date.

Long Position
A position where the trader has bought a currency he/she does not already own. Normally expressed in base currency terms, e.g. long US dollars (short Japanese Yen).

Short Position
A position where the trader has sold a currency he/she does not already own. Normally expressed in base currency terms, e.g. short US dollars (long Japanese Yen).

Hedging
A hedging transaction is one, which protects an asset or liability against an adverse move in the foreign exchange rate.

Structural Hedging
The process of reducing or eliminating currency exposure by matching receivables and payables in each currency or currency bloc to minimize the net exposure.

Leverage
Facility whereby a small margin deposit can control a much larger total contract value, a mechanism, which determines the ability to make extraordinary, profits at the same time as keeping the risk capital to a minimum.

Round Trip
Buying and selling a specified amount of currency in order to open and close a position.

High/Low
Usually the highest traded price and the lowest traded price for the underlying instrument for the current trading day.

Pip
This is the smallest incremental move an exchange rate can make.

Lot
This is the unit to measure the quantity of the deal. Mini accounts normally use this term. Each lot is 10,000, but the 100k platform refers to a 100,000 trade size.

Spread
The difference between the bid and offer prices; Narrow spreads usually indicate high liquidity.

Margin
A margin is the amount of money used for putting on a trade.

Margin Call
A margin calls happens when the market has moved adversely, i.e. the broker requests to add funds to the margin in order to maintain the trade that is in a trading loss.

Liquidity
The ability of a market to accept large transaction with minimal to no impact on price.

Liquid Assets
Assets that can be easily converted into cash. Examples: money market fund shares, US Treasury Bills, bank deposits, etc.

Hard Currency
A currency whose value is expected to remain stable or increase relative to other currencies.

Cash Market
The cash market is the actual financial market on which a futures or option contracts are traded. There is a physical exchange of funds: therefore the term CASH.

Bull Market
A market distinguished by a prolonged period of rising prices (opposite of bear market).

Bear Market
A market distinguished by a prolonged period of declining prices accompanied with widespread pessimism.

Let us understand the term “Trading”.

Trading can be defined as buying and selling of commodities with the intention on making surplus.Trading activity, i.e. ,buying and selling, is usually for a shorter span. If the commodity is held for a longer period , the activity would be considered as Investment.Period cannot be defined in absolute terms, as it varies from commodities to commodities.

Ratio of successful Forex traders is low. There are no definite statistics, but approximately various surveys show that 95% of forex traders are unsuccessful.Why is Forex trading so difficult? What does it take to be in the 5% slot of successful Forex traders?

Forex trading is buying or selling of currency with the intention of making surplus and usually is for a very short period of time. It could be a few minutes to a few weeks, depending upon the trader. One of the main characteristics in Forex trading is that the leverage available for margin money is highest amongst all industries. That’s what makes Forex trading risky.In almost all trading activities, there is a thin line between trading and speculation. When trader takes up the position by applying systematic, logistical or scientific techniques like technical analysis or fundamental analysis or statistical methods, either-or combination of these techniques, where result can be explained, is Trading Activity.

In speculation, usually traders take a guess, based on gut feelings and results cannot be justified or explained. When trader takes a decision based only on gut feelings and ignoring any logical model or scientific techniques, the trader’s activity becomes speculative.There are certain qualities that the trader needs to develop in order to be a SUCCESSFUL Trader.

* Trading is a skill which needs to be cultivated and has to be systematically developed.
* Trading requires adequate knowledge about the commodity. In case of Forex, trader needs to
understand fundaments of currency and its movements.
* Trader needs to evaluate various techniques and use the one which suits their nature the best.
* Trader needs to be emotionally stable and should be able to withstand pressure and strain, as any emotional decision against the logic of his own technique could make the trading activity speculative.
* Trader must take calculative risk only and should never trade more than their capacity to take losses, i.e., the trader must stick to Risk-Reward ratio.
* Trading is a combination of skill, knowledge and to a certain extent art.
* Trading requires patience, tolerance and time.Conclusion: Trading is a profession and to be a successful trader, it requires combination of skill, knowledge and art. One of the main quality which a trader must have is DISCIPLINE and the second main quality being, Guts.

Trader should be able follow his developed model, any emotional interference will make trading a speculative activity. Trading is a full time activity and requires patience, tolerance and time. What if you are interested in trading and do not have all the requirements?

Forex Trading Volatility

Nature of Forex Trading

Forex trading between any currency pair relates to trade or business related to goods, services, investments, tourism and many more activities between the two countries, which in turn ends up settling in currency exchange.

The volume of foreign exchange is large, usually in billions of dollars per day.

This factor contributes in making currency trading, highly volatile in nature.

The term “highly volatile in nature” can be interpreted in two ways :

a. Increase in the volume of currency trading could be due to increase in the demand of that particular currency or it could be due to the increase in the supply of that particular currency. This could be due to any fundamental change in the economic or financial policy of the government or any such major global economic, political or environmental factor affecting a country’s trade and business.

This may lead to frequent fluctuation in price that makes currency trading highly risky and volatile.

b. Fluctuation in exchange rates could be either high or low, or it could be both high and low. Usually currency rates move in bands. On an average day, it does not fluctuate more than one percent, and on unusual days, fluctuation may be up to three percent.

What makes currency trading highly risky is not the percentage change in a day, but the volume of trade.

Conclusion : Currency trade carries one of the highest levels of risk and is highly volatile in nature.

Is Forex Trading Risky?

Forex trading activity is highly risky in nature. Therefore, the Forex traders and investors are advised to attain a certain level of knowledge and follow professional advice on Forex trading or investing.

Let us study the factors that make Forex Trading a high risk activity;

* Volatility : Unlike stocks or bonds, Forex deals are done globally, 24/7, round the clock.

* Import and Export influence the prices : Let us have a closer look at Forex trading. Forex rates are not quoted for the purpose of trading only, unlike securities, but they are determined by actual buying and selling of currencies from international trades, for example oil. When a country exports oil, the currency needs to be converted from importer ( buying country - importer) currency to exporter currency (selling country - exporter).

* Investment Pattern :
If interest rate is going higher of any particular economy, investments inflows in to that particular country increases, as the yield on securities increases, which in turn makes the currency rate of that economy more volatile.

* Service Industries : such as tourism, airlines, fund transfer, banks etc. add to the volume of trading currencies. All these combined factors lead to high volumes and make currency volatile.

Currency trading has an approximate volume of 1.9 trillion dollars a day, which makes it an efficient and liquiid instrument of trade.

Leverage :
Rate Fluctuation. Currency is always traded in pairs and usually, at the most, the fluctuation is only 15% a year in a volatile pair. The question would be that, With an average 15% p.a. volatility in a currency pair, why is Forex Trading more riskier than securities?The reason would be, the currency is an efficient instrument and it has liquidity in itself. The result is that, the leverage available for trade in currency is 1:100 approximately, whereas that of securities is hardly 50% to 70%. This factor of less margin due to high leverage encourages humongous volume. Due to high volume, fluctuation of one cent on one lot ($100,000) leads to profit/loss of $1000, approximately. This could happen in seconds!

Result : Even though currencies are supported by the government , the risk is the highest in almost all trading activities globally.

Conclusion : The essential factor to limit risk from the losses which may incur due to volatility in trading is, to keep a Stop Loss Order.

Stop Loss Order (or Stop) : An order to buy or sell when a particular price is reached, either above or below the price that prevailed when the order was given.

What Does Risk/Reward Ratio Mean?

A ratio used by many investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns. This ratio is calculated mathematically by dividing the amount of profit the trader expects to have made when the position is closed (I.e. the reward) by the amount he or she stands to lose if price moves in the unexpected direction (i.e. the risk).

Explains Risk/Reward Ratio

Let's say a trader purchases 100 shares of XYZ Company at $20 and places a stop-loss order at $15 to ensure that her losses will not exceed $500.

Let's also assume that this trader believes that the price of XYZ will reach $30 in the next few months. In this case, the trader is willing to risk $5 per share to make an expected return of $10 per share after closing her position.
Since the trader stands to make double the amount that she has risked, she would be said to have a 2:1 risk/reward ratio on that particular trade.

The optimal risk/reward ratio differs widely among trading strategies. Some trial and error is usually required to determine which ratio is best for a given trading strategy.

The simplest form of calculation involves nothing more than the following
Entry Price
Stop Loss Target
Stop Profit Target
The resulting Risk/Reward Ratio

There are two options available to deal with foreign exchange.

* Investment

* Trading

Let’s explore these options.

Investment

When an investor buys a currency in physical form and holds it for a long period of time with the anticipation of that currency appreciating against the other currency, it’s called Investing in currency.

Normally, investors park their funds in daily interest or short term treasury bills to earn interest income. It is normally for a long period of time. The disadvantage of physical form of investing is that, it costs more, as commissions have to be paid for buying & selling currency.

Trading

Trading is a kind of activity where the dealer does not deal in physical transfer of currency. Trader buys and sells currency through a registered Foreign Exchange Broker. The trader does not have access to physical form of currency as the activities are carried out through brokers.

Trader usually trades in one or more currency pairs on a margin. In trading, there is no physical transfer of money and hence, the margin money is substantially low. On an average, traders get a margin ratio of 1:100 approximately, depending upon broker’s policy.

There is no commission in Forex Trading. The forex brokers make their money on spreads.

Trading is usually done in high volumes as the margin required is low. With marginal fluctuation in rates, the profits / losses are substantial due to the high volume. This factor makes currency trading highly risky.

Forex trading is permitted only in globally convertible currencies. This means, the value of the currency is determined by market forces.

In the developing countries, currency trading is not permitted as their currencies are non-convertible and the economies of those countries have Foreign Exchange Control.

Forex trading is a high risk business as explained in Part-I.
Unfortunately, more than 90% individual traders lose capital in Forex Trading.
This is surprising, but true. Let’s examine.

What exactly is Forex Trading ?

Trading, by definition, is buying or/and selling securities or commodities with the intention of making surplus/gain or to limit loss.
Forex trading is buying or/and selling currency with the intention of making surplus or gain or to limit loss. Trading includes factor of educated guess, based on logical reasoning, for taking a decision. This logical reasoning could be based on fundamental analysis, technical analysis, statistical techniques or any other logical belief predicting an event. This decision to trade could be successful or unsuccessful, but the result could always be logically explained.

Let’s study Speculation :

Speculation is assumption of unusual business risk (Trading Decision) in hopes of obtaining commensurate gain. Deciding a trade without logical reasoning or initiate trading action against logical reasoning or decision based on emotions, make trading a speculative activity.

Generally, trader works in a fast paced environment with high volume, high volatility, ever changing external factors affecting the economy. Under this pressure, traders usually tend to compromise their very own strategy and compromise on trading principles. This makes the trading activity highly speculative. There is a thin line between trading and gambling. As soon as the trader compromises his/her logical and knowledge based decision for emotional one, his/her decision is, speculative. These factors contribute to loss of capital of most of the traders.

What are the few essential factors required to do successful Forex Trading ?

* Adequate capital : Maximum capital draw down employed per trade should be less than 10% approx.
* Maximum 10% of portfolio should be invested in Forex.
* Discipline in trading.
* Define strategy based on fundamental or technical analysis.
* Constant research on fundamentals of the currency.
* Utilization of techniques like hedging, averaging and stop loss, if necessary, to preserve capital.
* Leverage on margin requirement should never be utilized more than 25%.