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Forex Trading Basics

What is FOREX?

Foreign exchange, or FOREX, is what is usually called currency conversion. It is the amount of money needed in one currency to purchase a set amount of another currency. FOREX also refers to the trade in foreign currency, where the money used around the world is itself treated as a commodity, akin to grain, gold, and oil.

The basics of FOREX and why the value of money fluctuates are to be found in the way money itself works. With the widespread abandonment of the gold standard, currencies today are based either entirely or in part on what is called the fiat standard. The word “fiat” is used because the money has value only because the government issuing it says it does, but how much value that money has is only indirectly and partly controlled by the issuing government.

The three basics factors in controlling the value of currency are 1) a government’s fiscal policies, 2) the general health of that country’s economy, and 3) what people and particularly traders believe the value should be for the currency. In the first instance, consistently running a deficit means a government is either regularly borrowing abroad or using the inflationary practice of “resorting to the printing press,” which drives down the value of the money issued by the government. The opposite is also true: reducing deficits and controlling inflation inspires confidence and drives currency values up. In the second instance, solid economic performance boosts confidence and the value of the currency. The third instance covers market forces and overlaps with the former two instances, as traders look at news and signals, form strategies, and make investment bets for or against selected currencies. As with any trading market, when a lot of capital chases a particular currency, the price soars. When few want a currency and many are eager to sell, the price drops.

Examples

If a government should be running a large and systemic deficit; suffers from a weak economy; and is bedeviled by financial scandals, its currency will suffer a crisis of confidence and the value falls. National banks, private banks, speculators, and corporations will all start to sell holdings of that currency in favor of what are perceived as more stable or valuable currencies and speculators. This is precisely what took place when the US dollar set a record by going into a downward spiral against the Japanese yen, Euro, and British pound sterling in 2007 to 2008.

Another classic example is the early value of the Euro. Introduced on January 1, 1999, the Euro was a new concept in unified currency, and many pundits were dubious about its long-term prospects. The strength of American finances and economic performance at the time, coupled with irrational doubts about the Euro’s future, led a long period of poor performance vis-à-vis the dollar. The low point was reached on June 7, 2001 when 85 US cents bought 1 Euro.

Investing in FOREX

FOREX trades money as if it was a commodity, and like all other commodities trading, it is speculative in nature. FOREX investment strategy calls for identifying a trend early and getting out in front of it, to follow the classic maxim of buying for a little and selling for a lot. The major trading currencies are the US dollar, the British pound sterling, the Euro, the Swiss franc and the Japanese yen.

As with other commodities markets, FOREX trading can be done on a margin. This means that assets can be bought and sold at a level much greater than the money available in a trader’s account. For example, if the margin is 1% and the trader has $100,000 in their account, they can operate as if they had $100,000,000. This allows for substantial speculation, but also carried substantially increased risk.

All the other terminology and trading forms familiar to commodities traders are available to the FOREX trader, such as Futures, Forwards, Swaps, and Options.

Trading Basics

FOREX business is conducted through an over-the-counter “interbank” market, with trading involving the simultaneous purchase of one currency and sale of another (thus an exchange). The most important market for FOREX is the spot market, so called because all exchanges are settled on the spot (i.e. immediately).

Even for veteran traders, venturing into FOREX can be a new and unsettling experience. FOREX activity is always going on somewhere around the world, so trading can be done 24 hours a day. Therefore, until one gets the hang of how the market signals and one’s trading strategies correspond to actual market activity, it is best to operate and account on a manual footing and leave working with an automated system for later.

Automated Trading

FOREX automated trading software, which are sometimes called FOREX “robots,” offer some advantages over manual trading. Using algorithms to trade within set parameters, they offer a good time management tool that will take advantage of market developments on their own, freeing a trader to spend their time and attention elsewhere. They can also take full advantage of the 24 hour trading market, conducting trades while their owner is asleep. However, they also pose the same potential problems of any automated system in that they can only do what they are told. In this case, their instructions come from their program and the parameters set by the trader, and the actions of the FOREX “robot” will only be as good as that. Mistakes can become costly, as the FOREX “robot” repeats them over and over until caught.

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