Understanding the Forex Market

Every successful forex investor begins with a solid foundation of knowledge upon which to build. Initially we will focus on currency pairs which are the foundation of the Forex market and you will be using them continually in your trading. The following will explain a currency pair, trading a currency pair and mechanics of trading a currency pair.

Everything is relative in the forex market, no single currency is stronger or weaker that another currency. Currencies need to be compared to other currencies and only then can you determine their strengths and weaknesses. For example, the euro could be getting stronger compared to the U.S. dollar. However, the euro could also be getting weaker compared to the British pound at the same time.

If you believe the euro is gaining strength compared to the U.S. dollar, you buy Euros and sell U.S. dollars at the same time. If you believe the U.S. dollar is gaining strength compared to the euro, you buy U.S. dollars and sell Euros at the same time. You always buy the stronger currency and sell the weaker currency.

Currency pairs are typically divided into the following three major groups:

Major currency pairs

Exotic currency pairs

Currency crosses

The majors are those currency pairs that are comprised of the most important currency in the global markets—the U.S. dollar (USD)—crossed with one of seven other globally significant currencies—the euro (EUR), the Great British pound (GBP), the Swiss franc (CHF), the Japanese yen (JPY), the Canadian dollar (CAD), the Australian dollar (AUD) and the New Zealand dollar (NZD).

The exotic currency pairs, or the exotics, are the currency pairs that are comprised of the most important currency in the global markets—the U.S. dollar (USD)—crossed with any currency that is not considered a major currency. Exotic currencies—like the Swedish krone (SEK), the South African rand (ZAR), or the Mexican peso (MXN)—are called exotic because they are associated with illiquid currencies that might not be available in a standard trading account.

Currency crosses, or the crosses, are the currency pairs that are comprised of any two currencies—so long as neither of them is not the U.S. dollar (USD). The euro (EUR) paired with the British pound (GBP) or the Australian dollar (AUD) paired with the Japanese yen (JPY) would be considered currency crosses.

Exotic currencies are usually lightly traded and have large bid/ask spreads. However, many so-called “exotic” currencies are becoming more popular and more and more investors are trading them.

If a currency pair is going up, down or sideways, you firstly need to determine which currency in the pair is getting stronger and which currency is getting weaker, compared to the other currency.  The first currency listed in the currency pair is called the base currency and the second currency listed in the currency pair is called the quote currency. When you look at the price of a currency pair, it tells you how many of the quote currency it would take to buy one unit of the base currency.

If the base currency is strengthening against the quote currency, the currency pair will be moving up. If the quote currency is strengthening against the base currency, the currency pair will be moving down. If the base currency and the quote currency are equally strong, the currency pair will be moving sideways.

The following is a quick reference to help you remember which way a currency pair will be moving;

Base > Quote = Up

Base < Quote = Down

Base = Quote = Sideways

Therefore buying a currency pair is normally as easy as pushing the “buy” button on your trading software. To exit a trade, you simply have to do the opposite of whatever you did to enter the trade. If you bought a currency pair to enter the trade, you must sell that same currency pair to exit the trade. You are also able to “sell” the currency pair and therefore to exit the trade you need to buy the currency.

The main 3 points in regards to making money in the forex market are;

Leverage

Margin

Spread

In Forex you can leverage or increase the investing power of your forex accounts by using some of your own money to enter a trade and then borrowing the rest from your dealer. For example, the forex market allows you to control $100,000 with as little as $1,000 of your own money. That means you only have to pay for 1 percent of the position with your own money. You can borrow the remaining 99 percent of the purchase price from your dealer. The leverage you enjoy in the forex market is determined by the margin you are required to post for each trade.

The next point is Margin, For example, if you buy the EUR/USD, you will be required to set aside 1 percent of the position size as margin. That means if the position size is 100,000 Euros, you will be required to set aside the equivalent of 1,000 Euros to prove to your dealer that you can cover losses of at least 1,000 Euros should your trade move against you. Different currency pairs have different margin requirements, major currency pairs have lower margin requirements because of their high levels of liquidity which make it easier to enter and exit your trades. Exotic currency pairs have higher margin requirements because their low levels of liquidity make it harder to enter and exit your trades quickly.

And finally the spread is the distance between the price at which you can buy a currency pair and the price at which you can sell a currency pair at any given moment. The price at which you can buy a currency pair (the “Ask” price), is always higher than the price at which you can sell a currency pair (the “Bid” price).

Whenever you enter a trade, you start out with a small loss because of the spread. You must overcome the spread or the difference between the “Bid and Ask” before you will be profitable on your trade.