forex for dummies

Forex Participants

There are various entities in the forex market arena. Each trades for its own financial objective. The following are the main Forex participants

Central Banks
Within the foreign exchange market national central banks play a very important role. Ultimately, the objective of central banks is to keep inflation low and steady by controlling money supply. One of the most important responsibilities of a central bank is the restoration of an orderly market in times of excessive currency rate volatility. Many times, the mere speculation of central bank intervention is enough to stabilize a currency. However, in the event of aggressive intervention the actual impact on the short term supply/demand balance can lead to the desired moves in exchange rates.

Banks
The inter-bank market provides for both the greater part of commercial turnover as well as huge amounts of speculative trading on a daily basis. The type or trading that banks do can be divided into two. First, trading on behalf of the banks customers. Here instructions are given to the bank by the individual customer to buy or sell a specific amount of currency. The second type of trading is proprietary trading. Proprietary trading simply put is when the bank's dealers trade the bank's capital to make the bank a profit. A very large part of interbank trading takes places on electronic broking systems.

Interbank Brokers
Until not long ago, the foreign exchange brokers were doing large amounts of business, facilitating interbank trading and matching anonymous counterparts for relatively small fees. The increased use of the Internet has forced a lot of this business to move onto more efficient electronic systems that are functioning as a closed circuit for banks only. The traditional broker box providing the opportunity to listen in on the ongoing interbank trading is still seen in most trading rooms, but turnover is noticeably smaller than just a few years ago.

Customer Brokers
These type of brokers are the ones that handle the trades you will make in the forex market. These brokers are a direct result of the increased use of the internet. Their numbers are growing fast and the service they provide is becoming better and better as days go by. Forex trading has become such a lucrative business for these brokers that they literally will do everything to acquire customers. The function of these brokers is to provide foreign exchange dealing services, analysis and strategic advice to customers. The services of such customer brokers are more similar in nature to stock, futures and mutual fund brokers and typically provide a service orientated approach to their clients.

Commercial Companies
Companies engaged in international trade conduct a lot of their business in foreign currencies. These companies use the currency market as a means of protecting themselves from unfavorable moves in the market. A US company operating in England would receive payments for its goods or services in Great British Pounds (GBP). The company decides at one point to change the GBP for USD. This trade, from GBP to USD, is where the company's transaction forms part of the daily liquidity of the forex market.

Investors and Speculators
It is estimated that the largest portion of the daily volume in the forex market derives from investors and speculators. Simply put, this group of market participants trade with one objective in mind, maximizing their profit, while attempting to limit losses. These type of traders are attracted to the forex market due to the incredible leverage it provides and high liquidity. Please be mindful, however, that without due risk management, leverage may magnify losses instead of gains. Ten years ago this group consisted mainly on big well funded traders. Since the internet has become more used and more efficient in terms of connection speed big traders and investors are not the only ones who can take advantage of currency speculation. The field has leveled and today's small speculator has the same tools big investors and speculators had 10 years ago.

Hedge Funds
Simply put, a hedge fund is a managed investment where the fund manager is authorized to use derivatives and borrowing with the aim of providing a higher return. The fund manager is allowed to use aggressive strategies that are unavailable to mutual funds, including selling short, leverage, program trading, swaps, and arbitrage. Hedge funds have increasingly been known for aggressive currency speculation in recent years. The main reason for this is due to the high leverage, volatility and liquidity the currency market provides.

How A Currency Trade Works

1. Reading A Currency Quote

Currencies are quoted in pairs, e.g. GBP/USD, USD/CHF etc. The first listed currency is called the "base" currency. The base currency is the basis for the buy or sell transaction. The second listed currency is called the "cross" currency. As an example, if you place a buy GBP/USD order with your broker what you have effectively done is sell US dollars and bought Great British pounds (GBP). By definition, the first currency is the stronger between the two.

Let's look at another example: USD/CAD If you believe that the Canadian government is going to weaken its currency (Canadian dollar) in order to help its export industry you would BUY USD/CAD (in trading terms: GO LONG). Why? Because you want to own US dollars while they appreciate against the Canadian dollar. On the other hand, if you believe that due to instability in the US economy the US dollar will lose value you would execute a SELL USD/CAD (in trading terms: GO SHORT). By doing so you have sold US dollars with the expectation that they will depreciate against the Canadian dollar.

There are many currency pairs in existence. However, the ones we consider important are those with the best market liquidity, i.e. the most heavily trade. They possess all the quality a good market has for trading purposes. The following is a list of these currency pairs:

• EUR/USD: Euro and United States dollar
• USD/JPY: United States dollar and Japanese yen
• USD/CHF: United States dollar and Swiss franc
• GBP/USD: Great British pound and United States dollar
• AUD/USD: Australian dollar and United States dollar
• USD/CAD: United States dollar and Canadian dollar

2. Understanding Pips

Every currency pair has a corresponding value and hence a quote. For example, a GBP/USD quote could be 1.5776. This means that the exchange rate for every GBP is USD 1.5776. In other words, it would cost the trader USD 1.5776 to buy a single GBP.

A pip is the smallest price change that a given exchange rate can make. In our example a move from 1.5776 to 1.5777 would indicate a 1 pip increase. Since most major currency pairs (but not all, example of an important exception is the USD/JPY pair) are priced to four decimal places (.0000), the smallest change is obviously that of the last decimal point, or one basis point.

3. Calculating Pip Value

The value of a pip depends on the amount that is being bought or sold of that specific currency.
Let's use a 10,000 unit purchase for our example. Formula: (one pip with proper decimal placement/currency exchange rate) X (amount being purchased) = pip value

Example: GBP/USD Rate is 1.5776

0.0001/1.5776 X GBP 10,000 = 0.6339 GBP. Since we want the value in USD we multiply the GBP pip value by the exchange rate: 0.6339 X 1.5776 = USD 1.00. In other words, in a USD 10,000 purchase of GBP's the pip value is one dollar.

We can see that when the USD is the weaker currency between the two, a pip value will be one USD. However, this is not the case if the USD is the stronger currency. Let's look at some examples:

Example: USD/JPY Rate is 113.20
.01/113.20 X USD 10,000 = USD 0.8834. Since the USD is the base currency we do not have to go on and multiply the pip value by the exchange rate (like in the above example).

Don't worry! We just wanted you to know the correct way to calculate pip value but in reality most trading platforms will tell you automatically the correct pip value of the currency pair you are about to trade.

4. Trading On Margin

There are several unique features in the forex market that attract traders and investors, trading on margin is one of them. Buying or selling on margin simply means that the trader is borrowing money from his broker in order to be able to buy more currency than it would possible with only the traders own money, i.e. buying and selling assets that represent more value than the capital in the traders account. Leverage, in our case, is simply the use of margin to increase the potential return of the currency investment/trade. You have to be able to understand how all this translates into numbers so we will look at an example:

A trader has USD 10,000 in his brokers account. However, he wants to be able to trade USD 100,000, which is 10 times more than his account value, i.e. money he does not have. His broker lends him the full amount which now means the trader is controlling USD 100,000 with only USD 10,000. In terms of margin, a 10% margin is used, and in terms of leverage a 10:1 ratio is used.

Why 10:1?
10 times 10,000 equals 100,000, or the borrowed amount of money.

Why 10%? USD 10,000 (the amount of money the trader has in his account, money the trader OWNS) is 10% of the total amount of money being used to trade, USD 100,000.

Bottom line, these two numbers bring you to the same outcome, i.e. knowing how much money you can borrow or are borrowing from your broker to execute a trade. When you start searching for a forex broker to work with, you will always see that the broker displays the maximum leverage allowed. Most brokers will allow you a 100:1 leverage, but some will go as high as 200:1! Buying or selling with borrowed money can be very risky because both gains and losses are amplified. That is, while the potential for greater profit exists, this comes at a hefty price - the potential for greater losses. This issue is important and will be dealt with in the money management section with more detail.

5. The Trade

Placing a trade in the forex market is basically the same as placing a trade in any other market. Some people get confused because they feel they are not buying or selling anything like in the stock market, were you buy or sell part of a company. We will dissect a trade from beginning to end in order to understand what is being done in the process.

* Step 1: The trader has USD 10,000 in his forex broker account.

* Step 2: In the morning the GBP/USD quote is 1.7478. This means that every GBP (Great British Pound) is worth 1.7478 dollars (i.e. 1:1.7478). Based on his analysis, the trader thinks that within the next 24 hours the GBP will gain strength against the US Dollar (i.e. a single GBP will exchange for more dollars). The trader wants to profit from the speculated move.

* Step 3: The trader places a BUY GBP 100,000 (remember, although the trader does not have that amount of money in the account, trading on margin will allow this transaction) order with his broker either through the phone or through the broker's on-line trading platform. At this moment the trader has purchased GBP 100,000 at a cost of 1.7478 USD per GBP. In effect, what has also happened is that the trader sold USD 174,780.

* Step 4: About 12 hours after placing the trade, things turned out as the trader has speculated and the GBP has appreciated in value against the USD and the quote is 1.7578, a difference of 0.0100 (or 100 pips) from the quote 12 hours ago. The trader decides to liquidate the position with the current profit.

* Step 5: In order to close the position the trader has to now SELL the GBP's he bought earlier and buy back USD. An order to sell GBP 100,000 is placed. Outcome: The market moved into the direction the trader speculated and a 100 pip profit was achieved. The profit is calculated in the following manner:

• Trade Open (rate 1.7478) GBP +100,000
• Trade Close (rate 1.7578) GBP -100,000
• Profit: USD +1,000
• USD -174,780
• USD +175,780
• Past results are not necessarily indicative of future results

Important!
Here we saw a trade from beginning to end with a final outcome of a USD 1,000 profit or a return of 10% on the trader's equity. By now you obviously understood why it was possible to make a 10% profit in less than one day, we traded on margin. Remember how we mentioned above that using leverage can bring you incredible profits (like in our example)? Well, what if instead of the price going up 100 pips it would have gone down 100 pips to 1.7378? That would have been a loss of 10% of the trader's total equity. Bottom line, and as already mentioned above, leverage can bring you big profits but it can also bring you big losses if not used properly.