If you think education is expensive — try ignorance
Derek Bok, president of Harvard University
Maybe this is your first step into the exciting world of Forex, or perhaps you’re an advanced trader wanting to brush up on some skills. Either way, this course has been designed with you in mind.
This is the introductory lesson, a comprehensive (but painless) coverage of some of the important basics of the foreign exchange markets.
By the time you have completed this section, you should be able to cut through the Forex jargon with ease, clearly understand how currencies are priced relative to each other and appreciate market behaviours such as supply and demand.
Furthermore, you will recognise who the market players are and whom you will be trading against. You’ll understand the effects of trading during various times of the day, learn how to calculate the value of a pip, discover the various methods for executing trades and even be introduced to Forex analysis.
What is Forex?
‘Forex’ simply stands for FOReign EXchange; in the same way that FX is taken to represent Foreign EXchange. Forex and FX can be used interchangeably.
Forex is the largest financial market in the world, but it is not a physical market, and therefore has no central point. There is no big Forex building in London or New York, or anywhere else for that matter. If you buy one currency using another, whether in your local bank, on an online exchange or at the airport, you are participating in the Forex market. This market covers everything from you buying your foreign currency for your holiday abroad through to large international companies hedging their exposure to the different countries they operate in, and, of course, everything in between.
Compared to the £5 billion a day volume of the London Stock Exchange, the foreign exchange market is far larger – measuring close to a whopping £3 trillion a day in traded volumes. That’s 600 times the size!
Speculators in the market readily make up £1 trillion of that daily volume. This leaves a whole lot of liquidity for traders to play with (more on liquidity later).
What is Trading?
Trading is simply the process of buying and then selling something with the goal of generating a profit. In Forex trading, we buy one currency using another. This can also be thought of as buying one currency and selling another. If someone buys yen and uses dollars to pay for them, they are buying yen and at the same time selling dollars.
As with all markets, the current price of a currency is based on what the market is prepared to pay for it. In Forex, this is called the ‘exchange rate’ between currencies, often simply referred to as ‘the rate’. The exchange rate is simply a measure of what the market thinks one unit of one currency is worth in a unit of another currency.
It goes without saying that everybody understands the processes involved in buying something. The buyer starts out with money, finds something they want to purchase, and buys that item with the money. It’s a process so simple, people rarely pause to think about it. A trade could be anything from a chocolate bar to a super-yacht or stock. It’s only when you break down the processes of a seemingly obvious transaction that you can clarify exactly what is happening.
A buyer starts with an asset that somebody else might want, for example money. The buyer then finds something else they want, for example a pizza. Right now, because the buyer is hungry, they feel the pizza has more value to them than the money. So they swap their money with the current owner of the pizza and walk away with their lunch.
Of course, the same can also happen in reverse. If a person needs money, and feels they are able to exchange an item that they own for an amount of money they feel has more value than the item, they may swap it for the money. To do this, they will need to find someone who feels that the value of the item is higher than the price they want to sell it at. They can then swap the item for the buyer’s money. All simple so far, and everybody walks away feeling like a winner.
In this exchange, what is actually happening is that the buyer is effectively selling their money at the same time as buying the product, because they feel that the product’s ‘money’ value is higher than the equivalent in cash. If you are selling the product, you are effectively buying the money because you feel that the product’s value to you is lower than that of the money that you exchange it for. In both examples, you are always buying and selling simultaneously. Clear as mud? Think of this way: before money was invented, people relied on a system of barter, exchanging sticks for stones and in effect buying stones and at the same selling sticks.
Okay, back to the market. When you have a product to sell, but are unable to find anybody that will buy the product, it becomes necessary to lower the price you are willing to sell the item for, because there is no demand for the product at the its current price. Similarly, if you want to buy a product at a particular price but cannot find anybody selling, you will need to increase the amount that you are willing to pay in order to find a seller, because there is a lack of supply at the price that you want to pay.
Supply And Demand
Products and markets rely on these principles of supply and demand. When an item is popular, it has high demand and the price typically rises until more people are willing to sell their items. Thus, available supply rises. Then, as the market becomes flooded with the items, demand for them at the higher prices falls away and the market price inevitably drops.
The currency markets behave in exactly the same way and this is a crucial concept for new traders to really grasp. The market is, after all, just a series of orders by buyers and sellers.
If everybody wants currency A and purchases it with B, the supply of currency A falls. This makes each remaining unit of currency A on the market worth more, causing its value to go up relative to currency B. Although in reality the amount of currency A doesn’t dry up, the orders do.
Not unlike Newtonian physics (although thankfully much easier!), an equal and opposite reaction has also taken place. While the value of currency A has gone up, the value of currency B has gone down. This is because currency B has now become more abundant due to everybody selling it.
These examples depend on there being a finite supply of a currency. Don’t worry too much about this at this stage, but if, for example, the Central Bank for currency A prints more of currency A and makes it available to the market, then its value will go down due to the increase in availability of currency A. This doesn’t happen often, but the recent financial crises did result in Central Banks doing this on a temporary basis.
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