FOREX EDUCATION: Everything You Need To Know About Forex Trading
History and Introduction
In the past, many different items have been used as money. One of the most important characteristics of money is scarcity, which is why people decided to use gold. Unfortunately, gold is so heavy that the amount a person could carry is very limited. As a solution, governments decided to print currency called bills or notes. The weight of a 10 dollar bill would be the same as the weight of a 1 dollar bill or a 100 dollar bill. This system didn't work because it couldn't prevent the government from printing lots and lots of money causing the currency to be worthless, thus the gold-exchange standard was born.
Golden-Exchange Standard prevailed from 1879 to 1934. Under this system, the values of the major currencies were fixed in terms of how much gold they could be exchanged for and thus, they were fixed in terms of every other currency. For example, a British pound was worth 24 grains of gold and a U.S. dollar was worth 12 grains of gold, then the British pound had twice the value of a U.S. dollar, fixing the exchange rate at 2 dollars for each pound. The only requirement for countries adhering to the gold standard was to maintain their money supply to a fixed quantity of gold, so the government could only issue more money if it had obtained more gold.
The Collapse of the Gold Standard
The problem with the gold standard was that a country would lose more and more gold as more goods were imported and less exported. Less gold would contract the country's money supply and in the end would hurt the economy. That is why in the 1930's, during the Great Depression, countries started abandoning the gold standard causing it to collapse.
Bretton Woods and the Adjustable-Peg System
In 1944, the leaders of the allied nations met at Bretton Woods, New Hampshire, to arrange a better system of fixed exchange rates. While all the other currencies were expressed in terms of dollars, the US Dollar was fixed at $35 per ounce of gold. This official fixed rate of exchange was known as the par value of currency or par of exchange or par exchange rate. However, they wanted to make sure that any macroeconomic adjustments were avoided to maintain the exchange rate.
Thus the creation of the Bretton Woods system was also known as the adjustable-peg system which only allows the exchange rate to be altered under specific circumstances. The International Monetary Fund (IMF) was created to affect this new system which required each country to value its currency in terms of United States dollar or gold. That helped to fix the exchange rate among all currencies. The Bretton Woods system began to weaken in the 1960’s when the reserves of gold fell, prompting the US to declare that they have enough gold to redeem all the dollars. Finally in 1971, President Nixon announced that U.S. dollars would no longer be convertible into gold, so the exchange rate was allowed to float causing the US to abandon this system. By 1973, floating exchange rates were established and are still in existence today.
Forex Fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate behavior of their currency. Fixing exchange rates reflects the real value of equilibrium in the forex market. Banks, dealers and online foreign exchange traders use fixing rates as a trend indicator.
The Managed Floating Exchange Rate
Managed floating exchange rate is a rate that mostly floats. Central banks can change a fating exchange rate by intervening directly into forex market. They typically buy or sell the currency that the country wants to influence, thus influencing supply and demand. Nowadays, Forex, or foreign exchange, is simply a process of buying of one currency in exchange for another. Although it is called foreign exchange, that is relevant to the person using the term because it may either be domestic or foreign. What is foreign to one person is domestic to another. The main reasons to exchange foreign currency for domestic one is to pay for goods and services in the foreign country, to invest in its financial assets, to hedge against unfavorable rates of exchange in the future, or to profit from those changes. Foreign currency holders need to convert it back to their domestic currency to take profits, so that businesses, governments, and other organizations can use the money at home.
Major Participants in the Forex Market:
The FX market, also called the foreign exchange market, is an over-the-counter (OTC) market. There are five major FX dealers: commercial banks, corporations and individuals, central banks, brokers and internet.
Banks and other financial institutions are the largest participants. They earn profits by buying and selling currencies among themselves. Two-thirds of all FX transactions involve banks dealing directly with each other.
Corporations and Individuals
Large companies need foreign currency in order to conduct business or make investments. If their requirements are large, some would even have their own trading desks. Individuals also need to buy foreign exchange so that when they travel abroad, they can make purchases in that foreign country.
Central banks who act on the behalf of their governments also participate in the FX market to influence the value of their currencies.
Brokers act as the mediators between banks. Dealers call them to find out where they can get the best price for currencies. Brokers earn profits by charging commission on transactions they arrange. Such arrangements are beneficial since they afford anonymity to the buyer/seller.
The Internet allows individuals to trade currencies using their home computers with the ultimate goal of making profit.
Characteristics of the Forex Market
The foreign exchange market, or the FX market, is where the buying and selling of different currencies takes place. The price of one currency in terms of another is called an exchange rate.
There are three main trading centers which handle the majority of all FX transactions. They are located in the United Kingdom, the United States, and Japan. Meanwhile, Singapore, Switzerland, Hong Kong, Germany, France and Australia account for most of the remaining transactions in the market. But nowadays, transactions can take place anywhere as long as telephone line and computer network is available.
The foreign exchange market is a 24/5 market. In the United States, trading begins Sunday evening and ends on Friday evening. Most banks are closed from Friday evening to Sunday evening and since banks are the main traders and dealers of currency, there is very little activity during weekends. Trading activity and liquidity in a particular currency is mostly determined by how many banks are open that trade in that currency.
At 8 a.m. during weekdays, the exchange market opens in London, while the trading day ends in Singapore and Hong Kong. At 1 p.m. in London, the New York market opens for business and later in the afternoon the traders in San Francisco follow suit. As the market closes in San Francisco, the Singapore and Hong Kong markets are just beginning.
The trading week starts when Monday morning first arrives in New Zealand and ends when it is late afternoon on Friday in San Francisco. Since New Zealand is just across the International Dateline, it is still Sunday in most of the world when it is Monday morning in New Zealand. So, for someone living on the east coast in the United States, the currency markets start opening about 5 p.m. Eastern Standard Time on Sunday.
The FX market is the largest financial market in the world. It is fast paced, very volatile and enormous. With more than $2 trillion trades every day, the activity of these participants is more than all of the world's stock and bond market combined.
Advantages of FX Trade
- Its huge trading volume, leading to high liquidity
- Its geographical dispersion
- Its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday
- The variety of factors that affect exchange rates
- The low margins of relative profit compared with other markets of fixed income
- The use of leverage to enhance profit margins with respect to account size
The $3.98 Trillion Break-down in Forex is as follows:
- $1.490 trillion in spot transactions
- $475 billion in outright forwards
- $1.765 trillion in foreign exchange swaps
- $43 billion currency swaps
- $207 billion in options and other products
Factors Influencing the FX Market
- Economic Policy - this is disseminated by government agencies and central banks.
- Government Fiscal Policy (budget/spending practices)
- Monetary Policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
- Economic Conditions - generally revealed through economic reports, and other economic indicators.
All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency.
- Internal Economic Conditions
- Regional Economic Conditions
- International Political Conditions and Events
This psychology and trader perceptions influence the foreign exchange market in a variety of ways.
- Flights to quality - unsettling international events can lead to a "flight to quality," a type of capital flight whereby investors move their assets to a perceived "safe haven." There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts.
- Long-term trends - currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.
- Buy the rumor, sell the fact - this market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought". To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.
- Economic numbers - while economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves.
- Technical trading considerations - as in other markets, the accumulated price movements in a currency pair can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.
Foreign exchange derivative is a financial derivative where the underlying is a particular currency and/or its exchange rate. These instruments are used either for currency speculation and arbitrage or for hedging foreign exchange risk. Is is also regarded as a financial agreement that has its value determined from the price of a certain asset, commodity, rate, index or the happening or significance of an event. The meaning of the word derivative itself comes from the way in which the value of these agreements are derived from the price of the item of significance. There are many known examples of derivatives such as futures, swaps, forwards, and options, all of which can be joined with traditional securities and loans thus creating structured securities, also commonly referred to as hybrid instruments.
Futures contracts are similar in many ways to forwards, with the exception that they are very standardized. The future contracts which are commonly traded on the majority of organized exchanges are so highly standardized that they are given the label of fungible - which means that they can be easily substitutable for one for another. Fungibility is advantageous in that it promotes trading and yields a larger trading volume in addition to greater market liquidity.
Forward deals are provide insurance against the possibility that exchange rates will fluctuate and ultimately differ from what they are between the present and the delivery date of the contract. A forward is also a simple common derivative because simply stated, it is a financial agreement with its price rooted in another asset. The delivery price is the price in a forward contract. This gives the investor the permission to fix the current exchange rate thus avoiding changes in the forex exchange rates.
Swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price.
The power of options lies in their versatility. They enable you to adapt or adjust your position according to any situation that arises. Options can be as speculative or as conservative as you want. This means you can do everything from protecting a position from a decline to outright betting on the movement of a market or index. This versatility, however, does not come without its costs. Options are complex securities and can be extremely risky.