as seen on Data Driven Investor https://medium.com/datadriveninvestor/the-basics-of-forex-5475ee6ccae4
The current global concerns about Coronavirus have caused a downturn in the market. Some people might think that shorting the market is a good idea — but with such volatility, there is no telling when it will shoot back up.
Considering this, there may be an easier way to take advantage of the volatility rather than common stocks.
With many different countries taking different actions, the foreign exchange market may be a profitable area to exploit.
For those who are interested in Forex, I will give an introduction about how it works. It’s always a good idea to do a fair amount of research when entering into a niche trading field. People spend their lives learning about commodities and how certain factors affect their futures or options trading.
What is the Foreign Exchange Market?
The foreign exchange market, or Forex for short, is a global marketplace that determines the exchange rate for different currencies around the world.
It is the largest financial market in the world and provides an arena to buy, sell, exchange, speculate on, and covert foreign currencies. Its daily trading volume is $5.1 Trillion as opposed to $84 billion for equities.
It is an over the counter marketplace, which means that there is no centralized, physical market, like the New York Stock Exchange. Rather, people have to buy from brokers to speculate on or purchase different currencies.
Foreign exchange markets are comprised of banks, dealers, commercial companies, central banks, investment management firms hedge funds, retail dealers, and investors.
The foreign exchange market is important because it allows for globalized trade between different countries and in that way, provides the structure for the world economy.
Many companies use the market to hedge — reduce the risk of adverse price movements in an asset. It can also be used to speculate on a currency based on the world, domestic, and natural events. Individual traders represent a very small portion of this market and usually participate in speculation and day trading.
How are Currencies Valued?
Currencies are always valued in reference to other currencies. In other words, the price you pay to exchange one currency for another. This is called an exchange rate.
For example, USD/JPY represents the exchange rate for United States Dollars and Japanese Yen. The currency to the left of the slash is termed the base currency — the currency you are buying. The currency to the right of the slash is the quote currency — the one you are selling.
It is the value of the Yen in terms of Dollars — or how many Dollars are equivalent to one Yen. Conversely, JPY/USD represents the value of the Dollar in terms of yen — how many Yen it takes to purchase a Dollar.
A currency appreciates when its value rises with respect to another. The Dollar appreciates when the JPY/USD exchange rate goes up because then it takes more Yen to buy Dollars — and as a result, dollars are more valuable.
A currency depreciates when its value decreases with respect to another. The Dollar depreciates when the JPY/USD exchange rate does down because now it takes fewer Yen to purchase a Dollar, making dollars less valuable.
How do Central Banks affect Forex?
Central banks that usually control their nation’s government use Forex to conduct open market operations. Central banks are often tasked with controlling interest rates for a country.
They do this by buying and selling treasuries — government debt instruments to fund spending. When a central bank sells treasuries, it is taking away liquidity from the general market and is decreasing the money supply. Since now there is less money available in the economy, the cost of borrowing money — the interest rate — gets higher. It makes sense because if there is less money, it should cost more to borrow it.
The selling of treasuries is the result of a contractionary policy. This is done to slow down the economy if it is going too fast.
During a recession, people hold onto their money and don’t want to spend. The response by a central bank is expansionary policy. This involves the bank buying treasuries from financial institutions and injecting more money into the economy and banks as a result. This increases the money supply and decreases interest on borrowing money.
When I talk about interest rates, I mostly refer to the Federal Funds Rate. That is because this rate determines what other rates in the economy will be. Most other rates are based on it. The Federal Funds Rate is the interest that banks charge one another to borrow from each other.
The United States Federal Reserve’s Federal Open Market Committee (FOMC) is a group that gets together to set the rate and decide on what policy they need to achieve it. Major countries are effected by what one country’s Central Bank decides to do.
For example, if the U.S. Federal Reserve decides to expand the money supply and cut rates, the Dollar will devaluate against every other currency. This is because more Dollars are now available in the market which causes them to decrease in value, and as a result, decrease in value against the Yen. As a result, currencies are not only determined by one country, but by the interplay of many countries. How to get involved
Forex is so popular because it doesn’t take a lot of money to get into. The market is highly leveraged, meaning that you can make many trades on borrowed funds. Leverage can be as much as 100:1 meaning that if you have $1000, you can have a position that is valued at $100,000!
This is a good and bad thing. Good, because you don’t need much money to start trading, and bad, because with borrowed funds, the winning and loss potentials are magnified. A good rule of thumb is to not take more than a 1% risk per trade. If you have $5,000 for example, each trade should be worth about $50.
Also, it is important to be aware of your win-rate. This represents the number of trades that are profitable out of all your trades. As long as this is above 50%, you are in a good position to make money.
As previously mentioned, many factors influence exchange rates. The goal of a forex trader is to exploit and expect these changes.
Let’s say that you expect the United States to enact expansionary policy and begin injecting more money into the economy. You hear that Japan just released a press statement saying that they would not pursue the expansionary policy. Since the U.S. is injecting more Dollars into the market, the Dollar will get weaker.
Let’s say the Japanese Yen is now 104.86 Yen/Dollar. We can expect the Yen to appreciate so we can now buy more dollars for fewer Yen. We have $10,000 and we want to make a profit in forex. So what we do is we take that $10,000, and change it to Yen — $10,000 x 104.86 Yen/Dollar = 1,048,600 Yen.
A few days later, when the United States enacts its expansionary policy let’s assume the Yen appreciates and now it is 98.95 Yen/Dollar. We can now take our 1,048,600 Yen and convert it back to dollars — 1,048,600 Yen x 1 Dollar/98.95 Yen = 10,597.27 Dollars. You have made 597.27 on this transaction.
There are fees for exchanging money, but this was ignored for simplicity.
Also, just as in stocks, you can go long or short. The example above is long — where you want your currency to gain in value.
Shorting is when you want a currency to lose in value so you can sell it and buy it back at a lower price.
Understanding Forex Quotes
In forex trading, there is a bid and ask price.
The bid price is the price at which a broker is willing to buy the base currency you have in exchange for the quote currency you want.
The ask price is the price at which a broker will sell you the base currency for the quote currency.
The ask price is usually higher than the bid price and the difference is known as the spread. The ask is higher because dealers want to make a profit off of trading and would never buy for more than they would sell.
In Conclusion
Tread any active trading with extreme caution. Do more complete research before attempting any of this. That being said, if you pay enough attention to politics and the policies of central banks across the world, there may be some profit to be made. As certain governments attempt to avoid recessions, they will inevitably pump money into their banks to provide liquidity. This will provide a great opportunity to make a lot of profit in trading currencies.