Part 1: The Basics
The term FOREX, which is an acronym for Foreign Exchange, refers to an international exchange market where currencies are bought and sold. The contemporary market began in the 1970’s with the introduction of floating currencies and free exchange rates, where supply and demand strictly determine the price of one currency against another.
The FOREX market is unique for a number of reasons. It is, for instance, virtually free of any external controls, making it almost impossible for anyone to manipulate it. It is also the largest liquid financial market, with trading reaching nearly 2 trillion US dollars daily. With this volume of money moving frequently, it’s not difficult to understand why any single investor could significantly affect the price of any major currency. And because of its liquidity, positions in the market can be opened and closed extremely quickly.
Some investors participate in the FOREX market for long-term hedge positions, while others utilize marginal trading to try to obtain large short-term gains. The combination of small but generally constant daily fluctuations in currency prices creates an attractive environment for a wide range of investors with differing investment strategies.
There is no central FOREX exchange which handles all trading. Transactions take place all over the world via telecommunications. Trading is conducted twenty-four hours a day, from Monday 00:00 GMT to Friday at 10:00 pm GMT. (This equates to late Sunday afternoon through Friday afternoon in the U.S.) FOREX dealers operate literally around the globe, quoting the exchange rates of all major currencies. Investors can purchase currencies through these dealers. It’s a common practice for investors to speculate on currency prices by obtaining a credit line (which is available with as little as $500), thus vastly increasing their potential for gains, as well as losses. This is called marginal trading.
Marginal trading simply means trading with borrowed capital. It has its appeal in the fact that FOREX investments can be made without a huge supply of capital. This allows traders to invest much more money, establishing bigger positions in the market, with much smaller amounts of actual money. This makes FOREX trading very easy to enter into for the new investor.
Marginal trading in an exchange market is quantified in lots. The term lot designates approximately $100,000. This amount can potentially be obtained with as little as one-half of one percent down, or $500. Here’s an example: You believe that signals in the market indicate that the British Pound will go up against the US Dollar. You open 1 lot for buying the Pound with a 1 percent margin at the price of 1.49889, and then you wait for the exchange rate to climb. At some point in the future, your predictions prove accurate; the exchange rate climbs, and you decide to sell. You close the position at 1.5050, thus earning 61 pips, or about $405. So, on an initial capital investment of $1,000 you realized over 40% in profits. When you close a position, the deposit that you originally made is returned to you and a calculation of your profits or losses is performed. This profit or loss is then credited to or debited from your account.
In Part 2 of this series, we’ll take a look at the two types of investment strategies used in FOREX trading: Technical Analysis and Fundamental Analysis.