Forex is one of the best ways to make money but when people look at charts and read technical articles full of buzzwords they get put off what is potentially a huge money maker online. In this article and many others on this site you will read about the basics of forex.
An Introduction to Forex
Forex is the nickname for the Foreign Exchange Market. In the United States, there are several branches of the stock market, each with their own name. For instance, some stocks trade on the Dow Jones, others on Nasdaq. Of course, all stock market transactions in the United States take place on the New York Stock Exchange (NYSE). In other countries the same is true. There may be one or more distinct markets.
However, international trade takes place on the market termed the Foreign Exchange Market, or Forex. Several countries across the world in almost every time zone participate in trade on Forex, with multiple currencies being utilized and stocks and commodities from all participating countries being offered for trade.
Because there are so many nations and time zones involved, Forex does not function as a “business day” entity like most domestic stock markets. It remains open for trade 24 hours a day, 5 days a week.
Of course, these additional hours increase the risk factor intensely for those of us who are human and obviously cannot monitor our investments 24 hours a day. This means that the value of your holdings could potentially plummet overnight, while you sleep, because other countries are still trading while you are in a dream world.
Again, it is like a car – there are many moving pieces under the hood, and just because you cannot see them does not mean they are not functioning.
This is one reason for several safety options, like limit orders, which we will discuss later. This is also why it is strongly recommended that your first attempts to make money on the stock market are not transactions that take place within the Foreign Exchange Market but on a standard nine-to-five domestic trading market.
In our car analogy, this would be comparable to having asked someone who has never driven or even changed the oil in a car to rebuild the engine.
While the functionality of Forex is the same as a domestic stock exchange, the commodities and prices are more volatile, and there are additional factors to take into considerations besides the typical risks associated with a domestic market.
You will have to contend with not only the value of your stocks and your currency, but also the foreign currencies involved in any trades or exchanges on Forex, as well as the inconsistencies of values of particular goods and services across international borders. It is like driving a car with a standard transmission as opposed to an automatic.
On the domestic front, the work is mostly done for you, and all you have to do is navigate, much like an automatic transmission. However, shifting gears is quite similar to having to constantly take part in the currency conversion. It can be distracting, and it certainly complicates the act of driving.
Because the financial situation of many countries is not as secure as that of the United States, this can pose a formidable problem in determining where to invest your money and what to expect next in the international market. Knowing what countries and currencies are involved in Forex can assist you by allowing you to more closely monitor the financial situation in the nations with which you will be interacting.
The History Of Forex
When foreign trade began, it was not an international trade market. It was borne out of the Bretton Woods agreement in 1944, which set forth that foreign currencies would be fixed against the dollar, which was valued at $35 per ounce of gold.
This precedent was first put into practice in 1967, when a bank in Chicago refused to fund a loan to a professor in sterling pound. Of course, his intention was to sell the currency, which he felt was priced too high against the dollar, then buy it back later when the value had declined, turning a quick profit.
After 1971, when the dollar was no longer convertible to gold and the domestic market was stronger, the Bretton Woods agreement was abandoned, and the currency conversion process became more variable. This allowed for a stronger backing in the foreign markets, and the United States and Europe began a strong trade relationship. In the 1980s, the market hours and usage was extended through the use of computers and technology to include the Asian time zones as well.
At this time, foreign exchange equaled about $70 billion a day. Today, about twenty years later, the trade level has skyrocketed, with trade equaling close to $1.5 trillion daily.
Originally, trading across international lines was more difficult, with several different currencies involved across Europe. Though the major players in the European market were deeply involved in and veterans of international trade by the time other markets joined in, there were more currencies to keep track of – the franc, the pound, the lira, and many more – than was reasonable.
With the birth of the European Union in 1992, the wheels were set in motion to create a single currency that would be used across most of Europe, and the Euro was finally established and put into circulation in 1999.
While some countries have still not accepted the currency as their own (such as Britain, who still uses the sterling pound), the process of currency conversion has been simplified without the large number of various currencies that were previously dealt with. Instead of dozens of currencies, the main countries trade in five – U.S. dollars, Australian dollars, British pounds sterling, the Euro, and the Japanese Yen.
Today, the Foreign Exchange Market is international and worldwide. The market is open 24 hours a day, 5 days a week, to accommodate all of the time zones for all of the major players. These now include most of Europe, the United States, and Asian markets, especially Japan.
Even Australia has joined the international trading markets, and since such nations are halfway around the world from some of the other top players, time zones obviously must be taken into consideration.
Another completely separate but perhaps more important concern with trading in Forex is understanding how trade works in multiple currencies. How can you compare the value of a stock across international lines if the values are expressed in two separate, non-equivalent currencies? And how do you measure gains and losses when conversion rate is constantly changing?
Understanding Currency Conversion
When you begin trading on Forex, you have to learn how to convert currencies and note the difference in values, as well as how currencies are exchanged between international lines. This means studying not only domestic market trends and currency values, but also those of foreign markets.
Working With Multiple Currencies
Since Forex is the Foreign Exchange Market, you obviously cannot expect everyone within the market to trade in U.S. dollars (and why not, you might ask? – but remember that not everyone covets the U.S. dollar).
With so many variables and volatile currencies being exchanged, how can you know a good buy or sell when you see one without complete awareness of the value of foreign currency?
The first step is to find a source that will give you a basic idea of the current exchange rate between your domestic currency and the foreign currency in question. You should do this as a base listing for any currency that with which you might become involved.
Of course, this will not be consistent down to the cent or fraction of a particular currency throughout an entire business day, but at least you will have your starting point from which to begin, almost like North on a compass. Such sources can be found all over the Internet, as well as through many brokers, both on line and in person.
It is also good to understand the means be which the currency conversion is expressed. The comparison is usually made in a ratio known as the cross-rate. In this configuration, the two currencies are listed in an XXX/YYY ratio, with the XXX position referred to as the base currency.
The base currency is usually expressed as a whole number, while the YYY position is expressed as the decimal that most closely matches the based currency rate.
It is sort of like making reference to miles per gallon or rotations per minute on a car – a direct comparison of one to the other in the form of a ratio.
The smallest fraction, or decimal, in which a currency can be traded, is called a pip and this is usually the degree to which a cross-rate is expressed.
For example, if the British pound sterling can be traded in thousandths, the currency will be expressed to the third decimal place. The U.S. dollar is often expressed to the hundredth of a cent (the fourth decimal place).
In one cross-rate expression example, one U.S. dollar may be equivalent to 117.456 Japanese yen. This ratio would be expressed as 1.000/117.456.
The base currency is almost always expressed as a single unit (as in one dollar as opposed to ten dollars), and frequently that unit of measurement is the U.S. dollar.
Since the whole number value (or big figure, as it is referred to) of the secondary currency, or the currency in the YYY position in terms of conversion changes so infrequently, often only the decimal portion of the number is mentioned in the Foreign Exchange Market.
Therefore, in the ratio above, you may hear that the yen is trading at .456, with no mention at all of the 117 whole yen that is shown in the ratio. This is because the exchange rate may vary from 117.456 to 117.423, but not to 119.024.
Experiencing a change in the big figure – the whole number ahead of the decimal – unless it was only because the number was already within a few thousandths, would represent much too large a shift in value for a single trading period and would be a rare occurrence that could cause the entire market to make a drastic swing in one direction or the other.
The most common currencies found in Forex are the U.S. dollar, the British pound sterling, the Euro, the Japanese yen, and the Australian dollar. In the past, there would have been many more currencies to keep track of (such as the franc, the lira, or the Deutschmark).
However, with the consolidation of most of the European market trading on Forex to the Euro, many currencies have been eliminated, making trade on Forex for other lands less complicated.
If you purchase a commodity in a particular currency, and that currency’s value falls against the U.S. dollar, you can actually make money by selling that same commodity in dollars.
The same is true in reverse should the value of a foreign currency increase against a U.S. dollar. Of course, you can only take advantage of such a situation should the commodity be traded in both currencies and both markets in question.
We will discuss this process, as well as other ways to take advantage of the Foreign Exchange Market (like arbitrage) in more depth in future chapters.
Once you are able to discern a base value of each particular currency and its conversion rate against others traded on Forex, you will be able to more closely monitor the change in currency conversion, including its inconsistency and volatility.
Such ideas will not seem so “foreign”, and you will be caught up and knowledgeable right along with the pros. Then, you will need to learn how to read, understand, and ultimately interpret additional market trends.
Following charts, listening to the advice of market analysts and chartists, and learning to make educated predictions yourself will help you keep track of various marketing trends.
Will it be a clear, calm day with little activity, or is there a storm brewing with winds of change and uncertainty? How can you tell what will happen with your holdings the following day or even further into the future?
Simply learning to read market trends can remove a lot of natural apprehension and uncertainty for beginning traders.
In fact, sometimes the best first step to entering the market is to watch shows about it or read the financial sections of the newspaper that detail the trends and expected outcomes.
The following chapter will explain more about how to interpret the statistics and basic trends.
You have now become somewhat familiar with how the stock market works, and you understand to a point what is involved in trading on the Foreign Exchange Market.
Now, you would like to know how to gauge market trends in order to profit from your business ventures on the open market. We are no longer discussing penny stocks and playground games. You want the real goods.
The name of the game is statistics, and the first rule is that you must be aware there is no such thing as a sure thing on the stock market.
While you can never be 100% sure at any given time of the next move that will be made on the market as a whole, being able to read statistics and interpret them will place you ahead of the pack in regards to “guessing” what will happen next.
Investing is a lot like gambling. If you can keep track of the cards that have already been played, you are more informed, statistically, regarding what is likely to be dealt next, meaning you can place abet with greater insight than someone who has no clue what has already been played.
With the open market, if you have information as to what has already occurred over the past few days, months, or even years, you are again placed in a better position to more logically conclude what will happen next.
You simply learn the pattern and follow it to the end, reaping the financial rewards.
Charts And Chartists
Wait, did you think you were going to have to research and map out the market’s past all by yourself? Of course not! There are people who get paid to do that sort of work.
They monitor the market hourly, daily, weekly, monthly, and yearly so that they can provide big-time traders with the same knowledge mentioned before.
The more an investment company knows about the market, the more money they can make. The same is true for stockbrokers. They make money when you make money, and they want to do the best they can to make sure that you make intelligent decisions.
The best part of this is that you have access to the same information as these VIP clients. Chartists, who are essentially market analysts that publish their findings in easy to read charts, produce what is referred to as a candlestick chart.
These charts are basically a combination of a line graph and a bar graph that show the trend of various stocks, indexes, or other interests over a specified period of time.
Therefore, you can easily determine if the commodity is on an uptrend or if it is taking a downturn, when the last major change occurred, and how long it is predicted that the stock or bond will continue on the current path.
You can actually find information on most commodities and their market trends for years in the past, and some even all the way back to their introduction to the open market.
Using this information can help you decide whether it is a good idea to buy or sell the stocks or securities in which you have interest, or if it is better to hold off for a peak in the market trend.
Understanding Market Trends
Understandably, as economies vary, the value of various commodities can change. This is because, when an economy is strong and flourishing, a nation is wealthier and has more purchasing power. Along with that power comes a higher value for the items purchased.
In other words, if people have more money to spend and are spending a greater amount of that money at Walmart stores, the value of stock at Walmart is going to multiply at a considerable rate.
Therefore, stockholders become wealthier in terms of assets, simply because the shoppers are driving the market with their purchasing power.
When stockholders are wealthy, and the value of their holdings is on the rise, they continue to purchase stock, which again, pumps the economy. A strong upward trend in the stock market is an excellent sign for any economy.
However, there are also things that affect the market in a negative fashion, causing stock values to plummet. For example, warfare rarely has a positive effect on the stock market.
On September 11, 2001, when terrorists attacked the World Trade Center in New York City, the economy of the United States took a huge dive, and the nation was threatened with a depression. Some analysts were sure that it would never properly recover.
The same thing typically happens any time there is an attack or act of war within a nation. However, the critics proved to be wrong, and the United States proceeded to rebound, or recover from a bad downtrend, in a strong manner.
This quick recovery occurred mostly because the people of the United States continued to push and spend, forcing money and wealth back into the economy. In watching the reaction of the stock market, you can learn to read trends based on world events.
Oil prices commonly affect the stock market, as well. Especially on the Foreign Exchange Market, you will find trends vary depending on many current events. You will also note that, over time, the principle value (or face value) of a currency may purposely be revised by a nation in terms of currency conversion.
This is referred to as devaluation.
Forex Volatility and Market Expectation
Volatility, or the tendency for fluctuation that can affect your earnings within the stock market, is typical within a domestic market but even more evident and much stronger on the Foreign Exchange Market. What factors affect the value of currency on Forex, and is there any way to control this?
Devaluation And Revaluation
As mentioned in the previous chapter, devaluation refers to the purposeful decline in value of a currency in relation to other currencies as charged by a government entity.
For example, if the U. S. dollar is worth ten units of a foreign currency that is then devalued by ten percent, the U. S. dollar is now equivalent to only nine units of the foreign currency.
This makes any items purchased in the foreign currency more expensive for those trading in U. S. dollars, as the exchange rate is lowered. It also makes items in the foreign country less expensive to trade in U. S. dollars.
An opposite change in value can also occur, raising the value of the foreign currency. This is referred to as revaluation. While it may seem that purposely adjusting the value of a nation’s currency is “cheating”, or taking an unfair advantage by making foreign products cheaper to purchase and increasing the value of exports, there are regulations in place to prevent the manipulation of exchange rates for such purposes.
The charter of the IMF (International Monetary Fund) assists in prohibiting such occurrences and enforcing the policy.
There are ways in which you can take advantage of devaluation and revaluation, which will be discussed later on.
However, what happens when the value of a foreign currency changes due to market fluctuation rather than purposeful reductions or increases by a federal government or federal bank?
What effect do appreciation and depreciation have on the stock market?
Appreciation And Depreciation
Depreciation can be easily related to the life of a car. As soon as you drive a new car off the lot, the value is almost cut in half. This is extreme depreciation. However, over the next few years, the car continues to lose value at a more gradual pace. This is considered to be depreciation as well.
Currency appreciation and depreciation are changes in the value of the currency that are driven by market forces rather than by government mandate.
For example, in an attempt to repay certain loans, in 1998 the Central Bank of Russia announced the coming devaluation of the ruble. The exchange rate, which was currently six rubles per U.S. dollar, would over a period of time change to 9.5 rubles per dollar, effectively a depreciation of 34%.
However, prior to the change, there was a widespread panic within the former Communist nation, and the value of the ruble dropped due to many people in Russia opting to trade in their securities prior to maturity. In a single day, following the announcement, the Russian ruble was depreciated by an amazing 25%.
The same sort of crisis occurred in the 1920’s with the crash of the U.S. stock market. In that time, a nationwide panic set in, and people rushed to the banks to withdraw cash that was not available or to trade in securities and stock options that were not matured. In running to the bank, people actually caused the crash rather than escaped it.
On the flip side of the coin, too fast of an appreciation sets up a country for inflation, or an increase in the retail value of products sold to the public based on currency valuation. While inflation is bound to occur, it can be minimally tempered through the use of the currency valuation.
Appreciation can be related to a vehicle as well. Often, men enjoy taking old cars and restoring them to their original beauty. In doing so; they drastically increase the value of the vehicle or appreciate it.
The ever changing rates of currency conversion and volatility of the market create an inherent market risk, or a day to day potential to experience loss due to fluctuation in securities prices. There is no way to diversify this type of risk, as it is always going to affect investment to a certain degree.
However, some risk can be offset by particular types of investments or ways of investing that are more secure or protected.
We will take a look at long and short positions, short selling, stop orders, and other ways to protect your investments from drastic loss in additional chapters. These options include the ability to preset your purchase or sell price for a specific commodity, as well as using various predetermine order levels to place orders and complete transactions.
Of course, do not delude yourself into thinking that you can rid yourself of all possible risk factors on the market. There is always a cloud hanging over your head waiting to burst, and all it takes is one little pinprick. You must always exercise caution, though the idea of playing the stock market entails danger and excitement inherently.
Aspects Of The Trade
You are now versed in the functionality of the stock market and have decided that you are willing to accept the risk factors involved. However, you want to know everything you can about balancing that risk with intelligent investment options. How can you be sure that the risks you take are more likely to be rewarding in the long run than destructive?
Long and Short
One of the most important parts of making money on the stock market is to determine your position. The long position is basically the purchasing position – you are about to take on a long-term commitment for ownership of some stock, security, or other traded commodity. The short position, by contrast, is the selling position – you are shortly going to dispose of the same sort of ownership and any responsibility toward it.
The best time to take up the long position is when stock prices are low. This will get you into the market at a reasonable price and increase your chances for profitability as new offerings go up in price and older investment options recover or rebound.
In fact, as others take the long position and purchase at the same time you do, this will actually drive the value of securities up through the standard rule of supply and demand, causing the beginning of what could be a bull market.
You may equate this with the end of the month at a car dealership. The prices tend to drop on any cars left on the lot for sale, and the dealer is more often willing to bargain because he or she wants less inventory on the lot.
Likewise, when stock prices are low, some will panic and dump all of their holdings at these low prices, thinking that their shares will never recover the value. This can only be of assistance to you.
When prices are high, it is likely time to turn around and sell your shares to bring in a profit, not losing anything on unrealized gain (profit that cannot be counted in liquid assets or cash because it is still invested in a volatile stock option).
You should never sell for a price that is below your cost, as this brings negative equity and loss of funds. You should always sell for the greatest amount of profit that you feel is safe.
In other words, if you buy a security at fifteen dollars per share, and it quickly rises to twenty-five dollars per share, you may very well feel that it could hit thirty dollars per share within a week.
However, you must determine if you are willing to risk losing your already secured earnings of ten dollars per share to wait that long, should the price actually fall, so you may decide to sell at the current high price.
Market-Makers And Selling Short
What if the stock values are up incredibly high, but you did not get in on that particular commodity and own no shares? Your first step should be to visit a market-maker or to make a deal with a broker for a short sell.
A market-maker is literally a stockbroker who purchases keeps a certain amount of shares of several securities or stocks on hand, which are purchased during a time when the market rates are low.
The firm will then turn around and sell those shares to an individual at that low price, regardless of the market rate, in effect making its own market (thus the name). The individual who purchases from the firm can immediately sell the commodities on the open market at market rate (which is higher), making an incredible amount of profit in a short period of time.
A short sell is another option for a quick profit. In this scenario, you will borrow a particular number of shares from a stockbroker to sell when the market value is high. Your job is to then wait for the stock price to go down, purchase the same quantity of stock, and return the holdings to the broker, keeping the profit from the sale, minus the broker fees.
The way that a car dealer works with trade-ins is very similar. They will purchase the car from you at a very low price, then turn around and sell it on the lot for a high profit margin.
One of the most positive aspects of a short sell is that you never actually take possession of the stock, meaning that you are never in a position to lose money. Because you have sold shares for a high price, you have already profited, and in the worst-case scenario, the particular stocks will not drop in price.
Rather than return the stocks to the broker from whom they were borrowed, you can simply pay back the amount for which they were originally purchased, along with the premium.
How can you be sure that you will not overshoot the best price options or miss a good rate because you are unavailable to place a buy order or sell order with your broker? Is there a way to set limits on your trades? Next, we will discuss ways to protect your investments and limit your risk factors.