I’ve heard a lot about Forex recently. I even overheard a couple of college – aged people talking about their experiences in forex trading. College-aged people? Really?
I had to find out more about this topic. Either it is the next investing fad (which has me concerned) or it might be a new alternative investment that I need to check out.
Here is what I found out………….
What is Forex?
According to babypips.com, Forex is an abbreviation for foreign exchange which is the buying and selling of one currency in exchange for another currency. Think going to Mexico from the U.S. on vacation and exchanging your U.S. dollars for its equivalent in pesos.
Same principle but different in how it is achieved. Forex is a truly global marketplace that allows people to trade currencies. Forex (aka FX) market is the world’s largest financial marketplace estimated to have over $6.6 Trillion traded daily.
Compare this to the world’s largest stock market exchange, the New York Stock Exchange (NYSE). The daily trading that goes on in the New York Stock Exchange is about $22 Billion daily. Yes, only $22B. In other words, the forex market is 300 times larger than the NYSE.
Unlike the NYSE, the FX market is a decentralized market. There is no central marketplace for exchanging currencies. Instead, currency trading is conducted electronically over the counter (OTC). This means that all transactions occur via computer networks between traders all around the world.
The market is open 24 hours a day, 5 days a week. Currencies are traded worldwide in the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Paris, Hong Kong, Singapore, and Sydney.
This means that the market is active virtually any time of the day. The market never truly closes and just shifts to a different financial center. The market starts each day in Sydney, moves to Tokyo / Hong Kong, and ends the day in New York. All the while people all over the world are constantly trading currencies.
How Does Forex Trading Work?
Like any other financial market, currency prices are set by the supply and demand of sellers and buyers. Other factors impacting the currency supply and demand are interest rates, economic growth, a country’s political environment, and the pace of economic growth.
There are also some basics a person needs to know before the 1st trade is made.
What Does Forex Trade?
Forex does not actually trade physical money. Buying a currency is like buying a share of a company. The price of a currency is a direct reflection of the market’s opinion on the current and future financial health of a country. In other words, buying a currency is like buying a share in a country.
For example, when you buy a Canadian dollar, you are basically buying a share in the Canadian economy. You are essentially betting that the Canadian economy will do better as time goes on. When the time to sell occurs, you hope you can sell at a profit.
Forex trades aren’t made for the purpose of exchanging physical currency (as when done when traveling internationally). Instead, traders speculate about future price movements much like would be done with stock day trading of options and derivatives. Forex traders are trying to buy currencies whose values they think will increase relative to other currencies or to sell currencies they think will decrease.
Currencies are always traded in pairs through a broker or dealer. Forex trading is the simultaneous buying on one currency and selling of another. Currencies are quoted in relation to another currency.
In every transaction, there is a base currency and a quote currency, whereby you sell one to purchase another. The price for a pair is how much of the quote currency it costs to buy the 1 unit of base currency.
In the example below, the British Pound is being compared to the U.S. Dollar. The first listed currency to the left of the slash is the base currency. The base currency is the reference element for the exchange rate of the currency pair. It always has a value of one.
The second currency listed to the right of the slash is the quote currency. When buying, the exchange rate tells you how much you must pay in units of the quote currency to buy one unit of the base currency.
In the example below, you must pay 1.21228 U.S. dollars to buy 1 British pound.
When selling, the exchange rate tells you how many units of the quote currency you get for selling 1 unit of the base currency. In the example below, you will receive 1.21228 U.S. dollars when you sell 1 British pound.
When U.S dollars are exchanged for euros, there are 2 currencies involved so the exchange always shows the value of one currency relative to another.
In this example, the USD / EUR means that that base currency is being bought and the quote currency is being sold. In simple terms, “buy USD, sell EUR”.
The pair is bought if it is believed that the base currency will appreciate (gain value) relative to the quote currency.
Also, the pair is sold if it is believed that the base currency will depreciate (lose value) relative to the quote currency.
The forex also uses symbols to designate specific currency pairs. Currency symbols always have 3 letters where the 1st 2 letters identify the name of the country and the 3rd letter identifies the name of the country’s currency (usually the 1st letter of the currency’s name).
Take the New Zealand dollar, the symbol is broken down as follows:
Where the 1st 2 letters designate the country (NZ) and the 3rd letter is the currency (dollar designated with D).
Three Ways to Trade Forex
The 3 basic ways to trade forex are as follows:
Spot Market
This is the primary forex market where currency pairs are swapped, and its exchange rates determined real-time based upon supply and demand. This is the largest forex market where the majority of trades are executed.
Forward Market
Forex traders can enter into a private, customizable, and binding contract with another trader that locks in an exchange rate for an agreed upon amount on a future date. Forward contracts are traded over the counter and is settled at the end of the agreement.
Futures Market
Forex traders can opt for a standardized contract to buy or sell a predetermined amount of a currency at a specific exchange rate at a date in the future. The difference from a forward market contract is that the futures contract is traded on an exchange instead of a private over the counter contract.
Both the forward and futures markets are primarily used by forex traders who want to hedge or speculate against future currency price changes. The exchange rates in these markets are based on what’s happening in the spot market.
How Leverage is Used in Forex Trading
From a profit generation standpoint, it does not make sense to trade just 1 U.S. dollar or 1 euro. The profit margins are too small. The best way to earn a significant profit in order to make the effort worthwhile is to trade in lots.
Lots come in various sizes. A micro lot is a lot of 1,000 units or currency. A mini lot is a lot of 10,000 units of currency. A standard lot that most full-time traders and hedge fund managers use is a lot of 100,000 units of currency.
The next basic question is, I don’t have enough money to buy 10,000 euros! No worries. A lot of people trade on margin.
What Is Margin Trading?
Before we discuss margin trading, let’s first define leverage. Leverage is the ratio of the transaction size to the actual cash used to buy currency.
When trading with leverage, the full amount is not needed upfront. Instead a small deposit is put down to make the transaction. This is known as margin.
Using margin trading, a large transaction can be purchased with a small amount of capital.
For example, a 50:1 leverage (also known as a 2% margin requirement) means that only $2,000 of margin (down payment) is required to open a $100,000 currency position.
Here’s an example:
You are seeing market signals indicating that a currency will go up against the U.S. dollar. A standard lot is opened (100,000 units) buying with the 2% margin requirement. The price of the currency is bought for 1.20000. This means that the 100,000 units of currency is worth 120,000 U.S. Dollars. Since the margin requirement was 2%, only $2,400 is needed in the account to create the trade. In other words, 100,000 units is controlled with only $2,400!
Next, sit back and wait for the exchange rate to climb. The predictions come true and the decision to sell is made. The position is closed at 1.20500. $500 in profit is earned on the deal. It only took investing $2,400 to earn a $500 profit. The rate of return on this deal is 21%. Not bad huh?
So, what’s the catch?
The Downside of Trading on Margin
The flipside is that a small margin deposit could just as easily lead to a big loss. Margin can work against you just as easily as it can for you. In the example above, the person could have lost the initial $2,400 payment PLUS additional money if the position moved .00500 in the opposite direction (1.19500)! That little movement could have cost you a lot of money.
Leverage sounds awesome… until it turns catastrophic.
If the broker has a margin call, you are expected to cover all losses at the close of business each day. A margin call may force you to sell all securities purchased to cover the losses experienced plus any trading fees charged.
How Forex Trading Could Fit Into a Portfolio
Now for the $10,000 question:
Can forex trading be used to enhance my portfolio?
Depends on your goals…….
If a person needs to find an inexpensive way to quickly build up a cash reserve, forex trading may have a place.
The good news about forex trading is that it is very liquid since literally trillions of dollars of transactions occur daily. It is not necessarily hard to find a buyer…… for the right deal. To avoid being “stuck” in a trade, the online trading platform can be set to automatically close your position once the desired profit level is achieved or close a trade if the trade is going against you.
Forex trading has a low barrier of entry. A person can get started for as little as $50 dollars. Using leverage can grow the potential profit margin significantly IF your analysis is correct. For example, a $50 deposit could create a $2500 transaction.
Lastly, there are low transaction costs and the market is open literally 24 hours a day, 5 days a week. You literally can go from one exchange to another all day long.
If worried about making a mistake, there are online platforms where a person can develop a strategy and practice it with a demo account before implementing. For finding the best app to get started, look here for more information.
What I’m Stuck On……..
Before you go out and sign up for forex trading, I do have some major concerns.
The first concern I have is that forex trading is a lot like stock day trading. To me, day trading is more like organized gambling than investing and forex seems to fit this bill.
Personally, I’m an investor. I do enjoy the research and analysis in finding a good deal, but my philosophy is long-term. Forex trading can occur in as little as 20 minutes and seems to me to be based on timing the market.
My experience with market timing is that it is extremely difficult to do and even harder to profit from.
Next, since the market is always open, I can see a person spending an inordinate amount of time currency trading. There is a time / performance tradeoff that needs to be considered.
I knew this engineer when I was a rookie straight out of college. He literally spent hours each day online day trading while he was supposed to be working. Others I know who are professional day traders that literally spend hours each day actively watching market conditions and looking for a deal.
My philosophy is to spend a lot of time doing research on a company, wait for a good deal, and act. Then sit back and monitor its progress. I flat out do not have the time others have to spend day trading.
Lastly, I am not a fan of buying on leverage. My philosophy is if I cannot afford the transaction, I do not partake in it. There are a lot of things that can happen when using leverage and most are bad.
While I like alternative investments, forex trading seems a lot like gambling to me not investing. Investing is buying in things I am knowledgeable in and can accurately predict with a measure of certainty. Quite frankly, to me, forex trading is gambling and I’m a horrible gambler. 😊
Tell Me What You Think………..
What do you think? Does anyone have experience in forex trading and want to share? Do you agree with my assessment or am I whacked? I’d love to hear from you. Send me your feedback here.
Until next time……
Live the Life You Love, Want, and Deserve! 😊