Introduction to Forex

CHAPTER OBJECTIVES

In this chapter you will learn the following:

• What it means when people say they trade Forex

• The basics of Forex Leverage

• The basics of the Forex Pair

• The best times to trade Forex

• The history of Forex Trading

When people say they trade Forex, which means buying and selling money in the worldwide Foreign Exchange market, what they are saying is that they trade money. It is as simple as that: Forex traders buy and sell different types of money. After all of the strategizing, technical analytics, and fundamental analysis, the basic Forex trade is betting that one country's currency will be worth more than another country's currency at some point in the future. You as a Forex trader might use a mathematically based diversification theory to minimize the risk of your Forex trading account. You might wait until a technical indicator such as a 200 day/50 day moving average cross signals you to "go long" the Euro and short the U.S. dollar. You might study the Bank of England's website http://www.bankofengland.co.uk/ and discover that the UK's economy is shaky, leading you to "short" the Great British pound against the Swiss franc.

Either way, you are placing an educated bet that one currency will be worth more of another currency at the end of the holding period. How is this done? Currencies are traded in pairs. In the case of the Euro/U.S. dollar pair, a Forex trader has the choice to bet that the U.S. dollar will get stronger in relation to the Euro, or that the Euro will get stronger in relationship to the U.S. dollar. If you were the Forex trader and you thought that the Euro was going to get stronger against the U.S. dollar, you would "go long" or "buy" the Euro/U.S. dollar pair. What this means is that you are simultaneously betting that the Euro will go up, at the same time betting that the U.S. dollar will go down. Extending this out further, a long Euro/U.S. dollar trade is in reality a long Euro/short U.S. dollar trade.

How Is Money Made on a Forex Trade?

In order to see how money is made on a currency trade you first have to understand what is going on behind the scenes in a trade. If you thought the Euro was going to get stronger against the U.S. dollar, we have seen that you would go long the Euro and short the U.S. dollar. In reality, what happens is that by shorting the U.S. dollar, you are in effect "borrowing" U.S. dollars and using the money to "buy" Euros. When this is done, you then have an IOU to your Forex broker for the amount you shorted. This IOU is denominated in U.S. dollars. When the Euro gets stronger than the U.S. dollar, you would then close out the trade, take the Euros, and use the money to settle out the IOU from when you "borrowed" U.S. dollars. Since the Euro got stronger, you would be able to use less Euros to satisfy the U.S. dollar IOU and pocket the difference as a profit. This works due to the exchange rates of the two currencies having changed (see Figure 1-1). At the beginning of the trade, you would have one exchange rate, and at the end of the trade you would have another.

In this book, Forex Demystified, you will be lead along the sometimes twisting, turning path of Forex trading, or trading the different currencies of different countries. You will learn all of the key ideas behind what makes Forex trading one of the most exciting financial products to trade. You will also learn one of the key elements in any type of trading or investing: how to spot trades that have a good chance of becoming profitable. In order to do this, you will be shown where to look for long-term signals to a good trade, such as how to read between the lines of central bank websites. You will also be shown how to use basic charting techniques—also known as technical analysis—to help you determine the best price level to enter into and exit out of a trade.

In addition to learning how to seek out and spot good trading ideas, you will be shown the fundamentals of how to actually handle the software that comes with your own Forex trading account. You will learn the advantages and risks of the huge amounts of leverage (sometimes called gearing by Forex traders) that Forex trading is known for, and what creates the potential to squeeze out profits from the smallest moves in the market.

You will also learn how to match your trading activities with your risk appetite, available time, established portfolio, and lastly, your long- or short-term investment objectives. You will learn how to build a grouping of Forex positions that are designed to last six months to two years, and have Forex effectively act as an alternative asset class that has returns that are uncorrelated to your traditional assets such as stocks, bonds, and mutual funds. You can also use your Forex trading skills to earn quick profits; using your Forex trading endeavors as a form of second job—a hobby that produces income.

What It Means to Trade Currencies

Trading Forex, or the concept of trading currency pairs, can best be described as making money from the difference of the money of two different countries. Other ways that Forex trading can be described are: (1) using very high amounts of leverage to benefit from the price differentials of one currency as it moves in value against another, or (2) a method of placing bets where the trades are made in currency pairs in a 24-hour market of overlapping trading time zones.

Trading currencies is like trading stocks, ETFs (Exchange Traded Funds) or mutual funds. A trade is made on a trading software platform with the hopes that it will create a capital gain. Forex traders make capital gains when they can accurately predict the direction of the movement of one currency against another. Forex trading is simple: one currency gets strong, the other gets weak.

When trading equities, stocks move either up or down, with most market participants taking a bullish stance (meaning they set their trades to make money when the stock gains in value). When you are trading currencies, you not only have to decide what currency will go up, but you will have to decide what currency that currency will get stronger against. In other words, not only will one currency go either up or down in price, it will do so at different rates against different currencies (called the counter currencies). While this may seem to make the process of deciding which Forex trades to place a difficult one, any complexity is greatly outweighed by the simplicity of the relatively small number of currency pairs to trade: Equity traders have thousands of stocks to trade, Forex traders only have somewhere between 20 and 50 currency combinations to worry about. This makes the process of...