Introduction
This is a very basic explanation of the Forex market. I remember when I first heard the term "Forex" I had no idea what the term meant or why I should be interested. So I did some Internet searching, as you may have done to find this information, and learned a little about the Forex. Since then I have gone on to make a nice chunk of change in the Forex markets.
I am going to begin with the very basics, which may be too basic for some and I will get into some deeper information later on.
I. What is Forex???
Forex is a shortening of "Foreign Exchange" and is the market where foreign currencies are bought and sold. Allow me to give a very simple example. My wife and I spent almost a week in Rome. In Rome we cannot use American Dollars we have to use Euro. At the airport, I handed the clerk 100 American dollars and recieved in return about 68.50 Euro. You could say the exchange rate was .685. While in Rome I used ATM machines to get more money and my US bank and the Italian bank whose ATM I had used did a similar transaction for me.
A week later when I was back at the airport to go home (after having a GREAT time!) I turned in my leftover Euro for American dollars since I will not need Euro again for a while. I had 65 Euro left and received 100 American dollars. The exchange rate was not .65 because the dollar had "weakened". Each dollar was now worth fewer Euros.
To give that a concrete example, if I were to go to 7-11 in Las Vegas to buy a $1.00 can of Coke, I would have paid 68 Euro cents the day I left but only 65 Euro cents the day I came back. My Euro cents were worth more. On the other end, if I went into a Roman café to buy a 1 Euro cup of cappuccino, I would have had to pay $1.47. On the last day of my trip I would have paid $1.53 for the same cup of cappuccino.
A simpler way of saying all this is that my dollars had lost value.
As an investor, if I would have sold $1000 the day I left and bought Euro and made the reverse exchange when I came back, I would have had a profit of $40 or a 4% return in one week.
Not bad!
II. So who would bother buying and selling currencies? And when did all this start? Let's be serious, I don't go to Rome that often. As a matter of fact, my wife and I have vacationed in Europe a total of one time! Why would so many dollars and Euros be exchanged?
Aside from all the many travelers who do go back and forth, the bulk of the foreign currencies that are exchanged are done so for large corporations. As an example, Ford Motor Company sells many, many cars in Europe. Let's say that Ford expects to ship 50 cars to Europe one month from today and each will sell for $20,000 for a total of $1 million which today is worth 650,000 Euros. Ford will start building those cars today and does not want to have to worry about how much the dollar and the Euro might move between now and then. They could simply buy 650,000 Euro today that will sell back the day they get their payment one month from now. That way they know today that they have $1 million dollars in hand, no matter what happens to the exchange rate.
All this trading has happened for years and years. Think back to Marco Polo visiting China from Italy. He probably had some Italian gold coins with which he bought silk in China. There was no standard then and Old Marco did the best he could for his gold coins.
In the late 1800's there was a gold standard, which set the value of each country's currency. The gold standard was replaced in 1944 as World War Two was coming to its finish by the Bretton-Woods Agreement, which set the price of currencies against the US dollar. This era ended in 1971 when the dollar no longer had a set value compared to gold. Since 1973, most major currencies have been freely traded with prices fluctuating daily.
Some currencies still did not fluctuate for a long time. The biggest example is the Chinese Yuan, which the government of China kept at a set rate of about 8.28 Yuan per dollar for many years. Some would say it still does not float freely but there certainly is more fluctuation.
The Euro came into existence on January 1, 2001 and started being used in many European countries on January 1, 2002.
III. Where is the Forex and how did it start?
You have probably heard about the New York Stock Exchange and seen pictures of the traders screaming frantically trying to buy or sell stocks. You also may have watched some famous person ring the bell at 9:30AM to open the trading. Well, you already know that the Forex does not have an opening bell because it is always being traded! But if it did have an opening bell, where would it be?
Well actually, the Forex does have a start and end time. The Forex "closes" at 4:30 PM on Friday, New York time and opens again at 5PM on Sunday, New York time. But there is no opening bell! There is not one place where the Forex is traded because it is all electronic. Having said that, London does the largest share of trading followed by New York, Tokyo and Singapore.
I am sure you have heard that we now have a global economy and thanks to that global economy, American Dollars and Euros and Great British Pounds and Japanese Yen and Canadian Dollars, etc, etc are being exchanged back and forth all day every day. Since all these currencies are used in all the different time zones around the world, the Forex is truly a market that doesn't sleep. You could buy some Euro before you leave for work in the morning at 7AM, sell it when you get home from work at 6PM, buy it back before you leave for a movie at 7:30PM, sell it again when you get home at 11PM and even buy again at 2 in the morning when you get you get up to change the baby's diaper.
Assuming you live on the East Coast of the US, when you are going to work at 7AM, a trader in London is about to go to lunch at noon. When you get home at 6PM, a trader in Los Angeles is about to go for his 3PM coffee break. When you leave for the movie at 7:30 PM, a trader in Anchorage, Alaska is thinking about lunch at 11:30 AM. When you come back from the movie at 11PM, a trader in Tokyo Japan just came back from lunch at 1 PM. And while you are changing the baby's diaper at 2AM, a trader in Rome is dropping off the baby at day care at 8AM. So whenever you are ready to trade, so is someone else in some other place in the world.
IV. Currency Pairs and Interest
Whenever you are trading the Forex, you are always trading a currency pair. The currency pair most traded in the world is the United States Dollar and the Euro. In large part because of liquidity - there are always dollars and Euro flowing back and forth and you can easily buy and sell.
When trading the Forex, three letters are used to identify the currency pair and the order is standardized. When you start trading the Forex, you will most probably begin trading the EUR/USD, which is the Euro, US Dollar pair. You might also trade the GBP/USD, which is the Great British Pound, US Dollar pair. I also trade the USD/CHF or the US Dollar, Swiss Franc pair.
You don't have to trade dollars. You can also trade the EUR/CHF or the CHF/GBP. There is also the Canadian Dollar, the Australian Dollar, and the New Zealand Dollar.
One of the ways that people make money trading the Forex is by taking advantage of the different interest rates set by central banks. It is hard to not hear news about the US Federal Reserve Bank interest rate meetings. Former Chairman Alan Greenspan was often in the news saying (or not saying) of the rates would go up or down. The same thing happens at the central bank of any country that has a currency.
As I write this, the interest rate in the US is 4.25%, the interest rate set by the central bank in Europe is 4.00%. What I could do is borrow 1 Euro from the bank and owe 1.04 Euro one year from today. If I invest that Euro in a US bank, I will receive 4.25% interest or ¼ percent more. So when I pay back that Euro at the end of the year, I could keep .25 Euro cents. I know that that is not a lot, but what about the difference between the US Dollar and the Swiss Franc, where the interest rate is 2.75%. If I borrow 1 Swiss Franc and invest it the US for one year and then return the money, I would get to keep 1.5 Swiss Franc cents. That is 1.5% on money that was not even mine! I borrowed it!
Of course these are ideal figures that don't completely reflect reality, but there is money to be made in this way. Especially if you consider the difference between the interest rate in New Zealand - 8.25% and Japan, .5%. And you will son find out how to multiply these numbers by 100,000!
V Leverage
Leverage is a simple. In physics the concept of leverage tells us how to multiply a force. I cannot pick up a car by myself to change the tire. But if I use leverage by employing the car jack, I can lift the car and change the tire.
In finance, leverage is similar. When my wife and I bought our first home, we did not have $200,000 in the bank with which to purchase the home. But we were able to take the money we did have, say $20,000 and leverage it by taking a mortgage. The same way I can multiply my strength by 500 times to lift the car here I multiplied my money by 10 times to purchase a home.
One of the really great things about leverage in investments comes when you make money.
My wife and I did really well on the purchase of our home. As I said we bought it for $200,000 and sold it about 10 years later for $600,000. Now you may think we had a 300% profit by figuring 200,000 times 300% equals 600,000. But I would disagree. I would say we had a 3000% profit. The math that I would do is 20,000 (the amount that came out of my bank account) times 3,000% equals 600,000. (With the example of a house there is more information to take into account like interest and principal, others would argue that I would have been paying rent anyway.)
In the Forex market, leverage is very important because your broker will lend you money to invest. It is easy for them because they know how much you have in your account and can sell your positions if they feel that the value will go to less than zero - this is called a margin call. Don't worry, you will never have to put up more money, but, yes, you can loose the money you invested if you choose really poorly.
Many brokerages will multiply - or leverage - every dollar you put in by allowing you to purchase $100,000 worth of currency. So is the EUR/USD is at $1.45, your $1.45 investment will buy 100,000 Euro.
Remember when I told you about interest I wrote that you could make .25 Euro cents per year. That just became 250 Euro, which is quite significant. In fact you will probably only use a 10% margin of your account, which brings that down, but leverage still makes you Forex account bring in significant amounts of interest.
Conclusion
The Forex market is a rather straightforward investment vehicle. Is it a surefire method of investing? No. No investment is surefire, not even US Treasury bills. Treasury bills have a lot less risk and you know exactly what to expect, 5%, barely above inflation. But using the correct strategies, Forex can be a lucrative part of your overall investment strategy.
by Shaya Kass
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