Beginner’s Guide to Foreign Exchange

Everyone who’s ever left home for a vacation abroad has had to exchange their home currency for the currency of the country they were visiting. If this has happened to you, hopefully you were aware of the need to make this currency exchange before attempting to pay for a cab ride from the airport in Tokyo to your hotel in the Ginza with dollars. Regardless, however, of where you may have exchanged your money, at the moment you did you participated in a so-called “spot” transaction in the largest financial market in the world: the foreign exchange (or foreign currency) market, through which roughly three trillion dollars flow each day.

Beginner's Guide to Foreign ExchangeThe foreign exchange market exists so that currencies can be converted from one to another. While many of the transactions that take place daily are of the type entered into by our Tokyo traveler, the vast majority of transactions occurring in the foreign exchange market are entered into by sovereign governments, through their respective central banks (such as the US Federal Reserve, the UK’s Bank of England or Germany’s Bundesbank), by multinational banks seeking to fund their global operations in the most advantageous manner or by businesses engaging in international trade. In the case of the former, central banks may engage in the purchase or sale of their home currency in order to either decrease the money supply (for the purpose of supporting the value of their national currency), to increase the money supply (in order to stimulate the domestic economy) or to settle debts between nations; businesses, in turn, engage in foreign exchange transactions either to pay for imported goods or to pay for costs and expenses associated with their overseas operations, such as salaries or rent. Of course, governments, banks and businesses also have the need to obtain foreign currencies for investment purposes, or for the purpose of repatriating foreign-derived profits and payments.

Foreign currencies are traded in pairs, such as USD/EUR. In each pair, one currency’s price is quoted in terms of one unit of the other. The currency on the left is considered to be the “base” currency, with the currency on the right being the “quote”, thus, in our example, USD/EUR represents the price in Euros of one dollar (currently equal to roughly 80 euro cents; conversely, EUR/USD quotes the dollar price of a Euro, currently costing roughly $1.22). Most currencies are quoted against each other to four decimal places, with each decimal place, known individually as a “pip”, being the smallest unit in foreign exchange. Although a pip may appear to be an irrelevantly minute quantity, when engaging in multimillion-dollar (or euro, or yen, or pound sterling) FX transactions, the difference of just one small pip can be equal to a difference of significant thousands of dollars.

There are two types of forex transactions. The first type, known again as a “spot” transaction, involves the sale of one currency and the simultaneous purchase of another at the currently prevailing exchange rate. This type of transaction encompasses not only the casual traveler’s need for locally-denominated pocket change, but also the importer’s need to pay for foreign goods delivered or the government’s need to settle current international debts. The second type of forex transaction is known as a “forward” transaction, wherein a contract is entered into today, at a price agreed-to today, for the delivery of foreign exchange at a future date. Such transactions are typically entered into by those who seek to hedge their perceived future foreign exchange risks, such as a large multinational corporation preparing to meet overseas obligations in the future in the face of a strengthening foreign currency.

The price of any given currency against another is fluid, and changes depending on such economic factors as supply and demand, interest rates and inflation, as well as on such less quantifiable factors as the perceived strength of the economy of the issuing country. As with stocks, therefore, there will always be a disparity between the bid price and the ask price for any currency pair, and it is this difference in price, known as the “spread”, and its movement throughout the course of a trading day, which determines whether forex traders and investors will experience a profit or a loss in any given trading session. More than any other single item or piece of data, it is the spread, and the attempt on the part of retail forex traders to exploit movements in the spread to their advantage, that is the single most important focus of foreign exchange trading. Retail foreign exchange traders will utilize a variety of technical tools and indicators to assist them in analyzing how they believe the spread will move; they will utilize multiple charting and mapping methodologies to identify the points where they believe the price for any given currency pair will encounter support (bolstering the price from moving any lower) or resistance (preventing the price from moving any higher); and, having calculated the price levels at which they will buy and sell a given currency pair, they will enter into spot contracts with their broker, utilizing the generous amounts of leverage offered by forex dealers to retail clients to maximize their potential profit from the movement of just a small pip or two before quickly exiting their position in a process known as “scalping”.

Beginner's Guide to Foreign ExchangeAs is the case with investing in the stock markets, a forex trader must place their orders through a broker in order to participate in the foreign exchange markets. These brokers, also known as forex “dealers” are almost exclusively found online, and offer a variety of services at a variety of price levels intended to attract retail clients to their firms. Most such brokers fall into one of two categories: firstly, the “market makers”, who cater to the forex trading novice, offering webinars, seminars, online education and even a free demo account in which the neophyte foreign exchange investor can practice his skills before jumping in with real money, and the “ECN” brokers who cater to a more experienced clientele and generally offer their clients less bells and whistles, but who make up for it by offering their clients increased price transparency in comparison to market makers. In general, market makers make their profits off of the spread, by increasing the price of currencies to their retail clients, while ECN brokers make their profits by charging a commission for each trade, typically denominated in pips.

A beginner wishing to get involved in foreign exchange trading should begin by learning as much as they can about the markets, and by supplementing this knowledge by learning equally as much about the various forex brokers, such that they can pick the optimal broker for their needs. One should trade in a demo account (or in multiple demo accounts) for as long as possible, in order to not only sharpen their skill set but also to become familiar with different broker platforms in order to identify which might be the most comfortable and user-friendly. Grow your confidence by focusing initially on only one currency pair, studying its history and movement and becoming familiar with its nuances and patterns until you feel that you have come to understand its peculiarities. Become familiar with a variety of technical indicators and tools until you find the ones that are the easiest for you to interpret and manipulate, so that you can apply them to your chosen currency pair and supplement your hunches with quantifiable analytical data. When the time is right, start small by staking yourself in a mini or micro trading account, being careful to avoid utilizing too much of the liberal leverage offered by forex brokers until you feel capable of handling the responsibility that goes with it. As with any form of investing, never stake your trading activities with monies that you cannot afford to lose, and be certain to move profits out of your trading account on a regular basis, leaving only enough to continue your activities. If you know your market, know your currency pair and know how to manage both your emotions and your expectations, it won’t be long until you’re a practiced foreign exchange investor and no longer a beginner.

For further information or for any questions, please do not hesitate to contact us.

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