Introduction to FOREX Investing
Foreign exchange has been a hot topic lately with the weakness of the US Dollar and has always been an area rife with scams and rip-off artists (even the SEC warns about it on their website for forex transactions). Trading in foreign currencies works off the same principles are trading anything else, you want to buy low and sell high. Scammers would like you to believe FOREX is magic, that there are sure-fire trading systems that work 100% of the time, but Forex isn’t magic and there are no sure-fire trading systems… it’s just another way to invest.
So for years, the Foreign exchange market has been a secret and somewhat of a mystery to many traders, including myself. If you thought about investing, you mostly looked to the stock market or to bonds as places to invest. If you were like me, you knew about people trading in currency on the foreign exchange market but you never knew much more about it.
While I’m not advocating anyone jump into Forex investing today, I think there’s value in understanding how it works, even if you never plan on investing in it. To help demystify the Forex market, I thought I’d write a Foundation article about the basics of FOREX.
What is FOREX?
Forex is the shorthand name for the foreign exchange or currency market. The Forex market is the largest capital market in the world with an estimated 2-3 trillion dollars changing hands every single day.
So where is the Forex market? It’s kind of everywhere people exchange currency and there is no central clearinghouse, unlike stocks and options. Stocks that trade on the New York Stock Exchange are bought and sold in New York. Many futures and options are traded on the Chicago Board of Ttade in Chicago. With forex, it’s everywhere.
Another interesting distinction is that forex is traded twenty four hours a day from 20:15 UTC on Sunday until 22:00 UTC on Friday. The NYSE trading hours are only from 9:30 AM ET until 4 PM ET, with some pre-market and after-hours trading.
Also, unlike other markets where everyone is presumably on the same footing, there are different levels of access in the forex market. At the very top are commercial banks and securities dealers in the “inter-bank market,” which accounts for about 53% of all transactions. That’s where bid and ask prices vary by only a pip or two (more on that later). Below that level are the smaller banks, then multi-national corporations, hedge funds, and then retail investor/speculators. As you move down the hierarchy, the bid and ask spreads on transactions widens (which is where market makers earn a profit).
How does a trade work?
First, currencies are quoted in pairs. The majority of currencies are traded against the US Dollar. The Eur.Usd (Euro/US Dollar), Gbp.Usd (Pound/US Dollar), Usd.Chf (US Dollar/Swiss Franc) and the Usd.Jpy (US Dolar/Japanese Yen) are considered the “majors” and are the most actively traded currencies. Trading in the majors equates to approximately 80% of all volume transacted in the Forex market.
Let’s take the Eur.Usd pair as our example. We are buying the first currency using the second, so we’re buying Euros with Dollars. We do this if we believe that the Euro will increase in value versus the US Dollar. In other words, we are taking a long position in Euros at the current market price and expecting to close our position at a higher price at a later time in the future.
Also, there are no restrictions in short selling because. If you think that a currency will lose value, you can take a short position and sell that currency immediately. Regardless of which direction the market is moving you will be able to make the appropriate decision that fits your trading plan.
Forex Commissions & Fees
The interesting thing about the Forex market is that brokers are compensated through the difference in bid and ask prices. When you go to sell a currency pair, you sell it at the bid price. If you go to buy a currency pair, you buy it at the ask price. The more liquid the pair, the lower the spread and the lower the commission.
You don’t pay a per transaction commission in the traditional sense, the commission is built right into the bid/ask spread. The transaction fee can be very high for the small time investor because spreads can be very wide on some of the more illiquid pairs. Whereas TradeKing always charges you a flat $4.95 a trade, you have to pay careful attention to spreads when making forex trades because the price, percentage-wise, can vary greatly.
In addition to the transaction fees, there are all the other fees common associated with any broker. Review to see what the minimum balance requirements are, if there are inactivity fees, fund transfer fees and the like.
So Why Forex?
If it sounds like forex is mostly for speculators, you’re not far off. Forex isn’t for the buy and hold investor because every site I read touted features of the forex market that appealed to speculators. The 24 hour nature of the market, the massive liquidity, speed of trade executions, and the number one reason forex is so popular – leverage.
Many brokers enable their clients to trade over 200-1 leverage. This allows you to increase your position size exponentially. You can increase your over all return while tying up less capital. This is like trading stocks on margin and increases your risk exponentially.
If you are utilizing 200-1 leverage, starting with $2000 in margin would allow you to control upwards of $400,000 in currency! With stocks, you’re usually only talking leverage around 2-1, not 200-1.
For all the scams and rip-off artists claiming you can become very very rich in a short period of time, you can also become very very poor just as quickly. With leverage, gains are magnified… but so are losses.
Picking a FOREX Broker
If this sounds like the game for you, because it’s a game for speculators, you will want to find a reputable broker.
Most brokers offer paper accounts, letting you paper or demo trade for a month or so. This lets you familiarize yourself with their software package, how the market works, and let’s you lose fake money without real penalty. 🙂 You can take a test drive of their charting packages and analysis services, just to get a feel for it.
Here’s something important though, you have to figure out how they execute trades. Brokers will do one of two things when they take your currency transaction:
- they will either use a dealing desk,
- or no-dealing desk model of execution.
A dealing desk firm will offset your transactions internally
In other words, when you place an order, your broker will be the direct counter party for your trade. You will buy or sell directly to your broker, which means you probably aren’t getting the best price.
When executing your trades, a dealing desk is taking an open market position which immediately creates a conflict of interest against you.
A no-dealing desk broker will pass your order through directly to an interbank counter party
This means that your orders are anonymous and your broker does not take an active interest against your positions. When deciding on a broker, be sure to ask these types of questions.
Good brokers will be happy to explain their dealing methods and inform you of any other restrictions they may have.
I can see why forex trading can be very exciting and why there are so many “get rich quick” schemes. When you can leverage 200-1, you can earn a lot of money very quickly (and lose it just as quickly).
With 24 hour trading, it’s a lot like gambling in the casino… the lights are always on and the clocks are always off. I’m fairly certain forex trading isn’t for me but it was fun reading about it.
Do you have any experience in Forex trading? Words of warning or advice?