Forex markets explained

Forex Overview

What is Forex?

Foreign exchange, forex and FX are all terms that refer to the transfer of money between different currencies. Every day there is a need for businesses and people alike to transfer their Dollars to Euros, Euros to Yen and so on. The amount of money that converts from one currency to another on a daily basis is in the Trillions. Over the last ten years more and more individuals have started trading in the currency markets in an attempt to earn profits. Not long ago this was the exclusive domain of the major banking desks but now almost anyone can open an account with a very small initial deposit and establish leveraged positions on almost any currency pair imaginable.

Forex is very different than most markets in the fact that there is no central exchange. We are all familiar with the New York Stock Exchange and the NASDAQ, these are the two largest stock exchanges in the United States. The SEC and NASD are the regulatory bodies that oversee the stock market. The futures markets mostly trade through the Chicago Mercantile Group (CME and CBOT) with the NFA and CFTC being their governing bodies. In both cases the US Government has stepped in and regulated these markets, requiring proper auditing, oversight, and centralization that regulations imply. The forex markets have no governing body and no central exchange. Because of the international nature of foreign exchange and the fact that FX only recently become popular with individual investors the ability of any one governing body to step in and control Chinese Yuan converting to Yen and Kiwis to Dollars is way too difficult. It would take an international treaty with every major country in the world.

In the last few years the NFA has taken several actions to try and police the domestic markets. A recent increase in the reserve capital requirements from $1million to $5million was a significant move that forced many smaller dealers out of the game. They have also been able to make sure that their members (commodities futures brokers) are held to the same marketing and advertising standards with forex as they are when marketing commodity investments.

Needless to say, there are many sound ways for an investor to approach these markets. By working directly with an NFA or NASD registered brokerage firm or major bank you’ll have the additional piece of mind in knowing that the bulk of the firms business is heavily regulated. Small firms that just meet the $5million capital requirement and have no diversification in their balance sheet should be considered less sound. If they are subject to NO regulatory requirements and simply make markets for their clients while being domiciled in a foreign country you should use extreme caution. Some firms will ‘make markets’ for their clients which means that their taking the opposite side of your trades. They do this knowing that most of their clients lose money and so they just take the other side of your trade while feeding you bad advice all along. This is what’s known as a bucket shop. Most of the firms operating in the US are reputable and ultimately cover most of their risk at one of the major banks trading desks.

Having said all that, there are many good places to open an account and sleep sound at night knowing you’re in safe hands. Just look for names you know and you’ll be fine. There are many established brokerage firms that offer forex investments and you should feel as confident domiciling your forex account with them as you would holding a futures or equity account. Once you’ve selected a sound brokerage firm to domicile your account you need to understand the markets.

We all know that currencies fluctuate against each other. As I write this the Pound is at $2.10 and the Canadian Dollar is at 1.09. Yet the spread between the Canadian Dollar and the Pound is about 2:1, about where it’s always been. The world of foreign currency pairs is quite dynamic and interesting. You have the ability to trade any currency pair you’d like, CD/US, JY/BP, NZ/AU, are just a few examples to illustrate the possibilities.

First you need to decide how much you want to trade with, how much leverage you’ll use and how large of a contract size you’ll trade. These are all related and important decisions that will effect how well you manage your money.

If you were to open an account with an initial deposit of $10,000 you would be able to trade up to 400x that amount depending on your brokerage firm’s policy. This is a very aggressive level of gearing that will almost certainly lead to disaster if used. A prudent investor should limit his exposure to a reasonable amount. The day of my writing the British Pound was up 160 points. A forex trader can choose how much each tick is worth to him by the size of the contract. Each tick can be worth as little as $1 to .10 cents or as large as you budget, you decide the size of the contract. There is a lot of leverage easily available in the forex markets so you need to use extreme caution in making sure you control your losses and not get in trouble.

Another important consideration is the spread your firm will charge you. Instead of charging a commission per trade, FX firms will charge a spread. Much like the currency exchange at the airport won’t let you buy and sell at the same rate, FX firms will have a spread between the bid and ask. When you see FX quotes it will represent two prices, one to buy and one to sell. This is how FX firms make their money. Be cautious of any FX broker who claims no commissions, there is a cost to trade forex no matter what you’re told.

Forex trades are unlike futures contracts in the fact that they pay or charge interest to hold them. When you enter a forex pair you are in essence selling one currency short on leverage and buying another. When you are short a foreign currency, you’re charged interest on the position and when you’re long you are paid. This adds an additional element to the equation as some pairs have larger carrying costs while other pairs can actually pay you to hold them.

The foreign exchange markets are the largest and most liquid markets in the world. The amount of money that changes hands in this sector on a daily basis is staggering and so are the opportunities. Forex can also be a dangerous and risky sector that should be researched extensively before any investment is made. I hope this information will provide a building block for your understanding of this incredible market.

There is a substantial risk of loss in futures and forex trading. You should only trade with risk capital that you can afford to lose without impacting your lifestyle or retirement plans.

Futures-Fx markets explained

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Forex Overview

What is Forex?