Level 1 Forex Intro - Currency Trading

The foreign exchange market (forex or FX for short) is one of the largest, most exciting, fastest-paced
markets in the world. It seems to be easier to understand, compared to the stock market. Chances
are you've already tried it when you've gone on a trip to another country and exchanged some
money.

Historically, only large financial institutions, corporations, central banks, hedge funds and extremely
wealthy individuals had the resources to participate in the forex market. However, now, with the
emergence and popularization of the internet and mainstream computing technology, it is possible
for average investors to buy and sell currencies with the click of a mouse from the comfort of their
own home.

If you follow the value of a currency, such as the American dollar (USD), you will know that daily
currency movements are usually very small. Most currency pairs, on average, move no more than 1
cent per day, which is less than a 1% change. Therefore, to make a respectable return, many
currency traders rely on the use of leverage (using margin) to increase their potential returns for
small moves in the exchange rate. In the retail forex market, leverage can be as high as 200:1 if
you're trading with less than $50,000 or as low as 50:1. For example, to trade $200,000 worth of
currency, if the broker is requiring 1% margin, you would only need $2,000 deposited to your
account – giving you leverage of 100:1. This is not as risky as it sounds, because currencies don't
fluctuate as much as stocks.

The availability of leverage, and massive size of the market and the ease of making fast transactions
has increased the popularity of the forex market. Positions can be opened and closed
instantaneously at the exact price shown to you, and typically with no commission or transaction
fees. Also, unlike the stock market, in which one large buyer or seller can adversely move the stock
price, currency prices are much harder to manipulate because the sheer size of the market prevents
any one player from significantly moving the currency price. Currency prices are largely based on
supply and demand.

Another reason why forex is so popular with traders is because the market is open 24 hrs, meaning
you can choose when you want to trade – regardless of whether you're an early bird or night owl.

The very popular forex market also provides plenty of opportunity for investors. However, in order
to trade profitably in this market, currency traders have to take the time to learn about forex trading
and dedicate enough time to practice what they've learned.

This forex tutorial will provide new investors and traders with the knowledge needed to trade in the
forex market. This tutorial will cover the basics of the forex market and will slowly progress to more
advanced topics, such as forex strategies. For now, let's take a look at "pairs" and "quotes" in the
next section, and learn how to read them correctly.

Currencies
The majority of trading in forex is concentrated in the world's major financial centres, such as
London, New York and Tokyo. Average daily volume in these markets is enormous, exceeding $3
trillion! Typically, a lot of the activity in the forex market is done by central banks, hedge
funds, institutional investors and large corporations. But success in this market doesn't depend on
how big you are - it depends on your dedication to learning the fundamentals, good judgment, hard
work and some common sense. This section will introduce you to the major currencies in the forex
market.
Each forex transaction involves two different trades: the purchase of one currency and the sale of
another. That is why forex quotes are quoted as a combination of two currencies, which is known as
a currency pair. While there are many possible currency pairs, the most heavily followed and traded
currencies are listed in the table below.

You may notice that the total market share adds to 200%, which is a result of currency pairs.

Market
Currency Share
USD 83.7%
EUR 60%
GBP 15.3%
JPY 13.4%
CHF 9.5%
SEK 2.2%
AUD 2.1%
CAD 1.6%
Figure 1: The most
heavily traded
currencies and their
market
Source: BIS Triennial
Survey, 2004

Not surprisingly, the U.S. dollar (USD) is the most followed and traded currency in the world, with
nearly 84% of the market share in 2004. Therefore, later on in this tutorial we examine the
relationships between the U.S. dollar and many of its major currency counterparts, such as
the euro and the yen.

In addition, although there are numerous currency pairs available, it can become extremely
confusing to try to follow and trade several currencies at one time. It is usually recommended to get
to know one major currency pair and practice trading that currency pair alone. But first, before you
can begin to analyse major currency pairs, you need to learn the basics of the market, such as
learning to read a Forex quote, which is discussed in the next section.

Reading a Quote
Most new investors in the forex market are usually confused with the way currency prices are
quoted. In this section, we'll take a look at currency quotations and see how they work in currency
pair trades.

When you look at a currency quote, you'll notice that all currencies are quoted in a pair – for
example, USD/CAD or USD/JPY. The reason that currencies are quoted as a pair is because when you
buy a currency you are selling a different one as well. A sample forex quote for the U.S. dollar (USD)
and Japanese yen (JPY) would look like this:

USD/JPY = 119.50
This is the standard format for a currency pair. In this example, the currency to the left of the slash
(USD) is referred to as the base currency, and the currency on the right (JPY) is called the quote or
counter currency. This is important to remember. The base currency (in this case, the U.S. dollar) is
always equal to one unit (in this case, US$1), and the quoted currency (in this case, the Japanese
yen) is what that one base unit (USD) is equivalent to in the other currency (JPY).

This sample quote shows that if you wanted to buy US$1, you would have to pay 119.50 yen. Or if
you wanted to sell US$1, you would receive 119.50 yen. If instead of USD/JPY, this quote
read USD/CAD = 1.20, you would read it the exact same way. If you want to buy US$1, it will cost you
C$1.20, and if you wanted to sell US$1, you would get C$1.20. These exchange rates simply tell you
how much you will pay/receive if you buy/sell the "base" currency.

When you are buying the base currency (because maybe you think the base currency's value will go
up) and selling the quote currency, you are entering into a long position. If you instead sell the base
currency and buy the quote currency, you are going into a short position. So again, looking at the
USD/JPY example, if you buy the USD, you're going long; if you sell the USD, you are going short.

Bid and Ask

Like buying a stock in the stock market, when trading currency pairs, the forex quote will have a bid
price and an ask price. The bid and ask prices are always quoted in relation to the base currency.

When selling the base currency, the bid price is the price the dealer is willing to pay to buy the base
currency from you. Simply put, it's the price you'll receive if you sell.

When buying the base currency, the ask price is the price at which the dealer is willing to sell you the
base currency in exchange for the quote currency. Simply, when you want to buy a base currency,
the ask price is the price you're going to pay.

A typical currency quote can be seen below. The number before the slash (1.2000) is the bid price,
and the two digits after the slash (05) represent the ask price (1.2005) - only the last two digits of the
full price are usually quoted. The bid price will always be lower than ask price. This is how the
dealers make their money; they buy low and sell for a little bit higher.

USD/CAD = 1.2000/05
Bid = 1.2000
Ask= 1.2005

If you wanted to buy the USD/CAD currency pair, you would be buying the base currency (U.S.
dollars) in exchange for the quote currency (Canadian dollars). You need to look at the ask price to
see how much (in Canadian dollars) the market is currently charging for U.S. dollars. According to
this quote, you will have to pay C$1.2005 to buy US$1.

To sell this USD/CAD currency pair, or sell the USD in other words, you need to look at the bid price
to see how much you are going to get. Looking at the bid price in this quote, it tells us you will
receive C$1.2000 if you sell US$1.

More on Quotes
Spreads and Pips
The difference between the bid price and the ask price in a forex quote is normally called the spread.
In the previous example: USD/CAD = 1.2000/05, the spread is 0.0005, or 5 pips. Pips, or points, is the
common name used to refer to incremental changes in a forex quote – a change from 1.2000 to
1.2001 would equal one pip. Although these currency movements may seem small, due to leverage
used in the forex market, small changes can result in large profits or losses.

With the major currency pairs such as the EUR/USD, USD/CAD, GBP/USD, one pip would be equal to
0.0001. However, if you take a look at a USD/JPY quote you'll notice the pair only goes to two
decimal places, so one pip would be 0.01. So, in general, a pip represents the last decimal place in
the quote.

Currency Quote Overview

USD/CAD = 1.2000/05
Base Currency Currency to the left (USD)
Quote/Counter
Currency to the right (CAD)
Currency
Price for which the market
maker will buy the base
Bid Price 1.2000
currency. Bid is always
smaller than ask.
Price for which the market
Ask Price 1.2005 maker will sell the base
currency.
One point move, in
The pip/point is the
USD/CAD it is .0001 and 1
Pip smallest movement a
point change would be from
price can make.
1.2000 to 1.2001
Spread in this case is 5
pips/points, or the
Spread
difference between bid and
ask price (1.2005-1.2000).

Lots
Similar to how most stocks trade in lots to facilitate trading, currencies are also traded in lots–
$100,000 is typically the standard lot. There are also smaller lots with a size of $10,000 called mini-
lots. These may seem like large amounts but because currencies only move in small increments, only
a few pips at a time, a larger amount of currency is needed to generate any sizable profits or losses.

Direct Currency Quote vs. Indirect Currency Quote

You can quote a currency pair in two ways, either directly or indirectly. A direct currency quote is
simply a foreign exchange quote where the foreign currency is the base currency; an indirect quote
is a currency pair in which the domestic currency is the base currency. For example, if you're in
Canada and the Canadian dollar is the domestic currency, a direct quotation would take the form of
a variable amount of the domestic currency for a fixed amount of the foreign currency. A Canadian
bank giving a quote of "C$1.20 per US$1" would be a direct quote. Conversely, an indirect quote
fixes the domestic currency and varies the foreign currency. In the same example, if the Canadian
bank gave a quote of "C$1=US$0.83" it would be an indirect quote.

Cross Currency
A currency quote given without the U.S. dollar as part of the currency pair is called a cross
currency quote. Common cross currency pairs include the EUR/CHF, EUR/GBP and EUR/JPY.
Although having cross currencies increases the amount of choice for the investor in the forex
market, cross currencies are not as popular as ones that have the U.S. dollar as a component of the
currency pair.

Now that you know more about reading and interpreting a forex quote, in the next section we'll look
briefly at the economics and fundamentals behind forex trades and what economic indicators a new
trader should become familiar with and be able to interpret.

Economics
Similar to the stock market, traders in forex markets rely on two forms of analysis: technical
analysis and fundamental analysis. Technical analysis is used similarly in stocks as in forex, by
analysing charts and indicators. Fundamental analysis is a bit different – while companies have
financial statements to analyse, countries have a swath of economic reports and indicators that
need to be analysed.

In order to analyse how much you think a country's currency is worth, you need to evaluate the
economic situation of the country in order to more effectively trade currencies. In this section, we'll
take a look at some of the major economic reports that help traders study the economic situation of
a country.

Economic Indicators
Economic indicators are reports that detail a country's economic performance in a specific area.
These reports are usually published periodically by governmental agencies or private organizations.
Although there are numerous policies and factors that can affect a country's performance, the
factors that are directly measurable are included in these economic reports.

These reports are published periodically, so changes in the economic indicators can be compared to
similar periods. Economic reports typically have the same effect on currencies that earnings reports
or quarterly reports have on companies. In forex, like in most markets, if the report deviates from
what was expected by economists or analysts to happen, then it can cause large movements in the
price of the currency.

Below are some of the major economic reports and indicators used for fundamental analysis in the
forex market. You've probably heard of some of these indicators, such as the GDP, because many of
these also have a substantial effect on equity markets.

The Gross Domestic Product (GDP)

The GDP is considered by many to be the broadest measure of a country's economic performance. It
represents the total market value of all finished goods and services produced in a country in a given
year. Most traders don't actually focus on the final GDP report, but rather on the two reports issued
a few months before the final GDP: the advance GDP report and the preliminary report. This is
because the final GDP figure is frequently considered a lagging indicator, meaning it can confirm a
trend but it can't predict a trend, which is not very useful for traders looking to identify a trend. In
comparison to the stock market, the GDP report is somewhat similar to the income statement a
public company reports at year end. Both give investors and traders an indication of the growth that
occurred during the period.

Retail Sales
The retail sales is a very closely watched report that measures the total receipts, or dollar value, of
all merchandise sold in retail stores in a given country. The report estimates the total merchandise
sold by taking sample data from retailers across the country. Because consumers represent more
than two-thirds of the economy, this report is very useful to traders to gauge the direction of the
economy. Also, because the report's data is based on the previous month sales, it is a timely
indicator, unlike the GDP report which is a lagging indicator. The content in the retail sales report
can cause above normal volatility in the market, and information in the report can also be used to
gauge inflationary pressures that affect Fed rates.

Industrial Production
The industrial production report, released monthly by the Federal Reserve, reports on the changes in
the production of factories, mines and utilities in the U.S. One of the closely watched measures
included in this report is the capacity utilization ratio which estimates the level of production activity
in the economy. It is preferable for a country to see increasing values of production and capacity
utilization at high levels. Typically, capacity utilization in the range of 82-85% is considered "tight"
and can increase the likelihood of price increases or supply shortages in the near term. Levels below
80% are usually interpreted as showing "slack" in the economy which might increase the likelihood
of a recession.

Consumer Price Index (CPI)

The CPI is an economic indicator that measures the level of price changes in the economy, and is the
benchmark for measuring inflation. Using a basket of goods that is representative of the goods and
services in the economy, the CPI compares the price changes on this basket year after year. This
report is one of the more important economic indicators available, and its release can increase
volatility in equity, fixed income, and forex markets. The implications of inflation can be a critical
catalyst for movements in the forex market.

Conclusion
This is just a brief overview of some of the major reports you should be aware of as a new forex
trader. There are numerous other reports and factors that can affect a currency's value, but here are
some tips to keep in mind that will help you keep on top of your game.

Know when economic reports are due to be released. Keep a calendar of release dates on hand to
make sure you don't fall behind. Quite often, the markets will also be volatile before the release of a
major report based on expectations.