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Foreign Exchange Trading

"The key insight of Adam Smith’s Wealth of Nations is misleadingly simple: if an exchange between two parties is voluntary, it will not take place unless both believe they will benefit from it. Most economic fallacies derive from the neglect of this simple insight, from the tendency to assume that there is a fixed pie, that one party can gain only at the expense of another."
    - Milton Friedman (1912 - 2006)

Introduction

Foreign exchange trading (generally, and for the remainder of this writeup, known as Forex) is the act of purchasing floating international currencies in an attempt to resell at profit. There are other kinds of exchange trading, and non-floating currency trade, but unless you are a bank or a country (of which I will presume you're neither), the scope of this writeup is, necessarily, at the individual or company level.

A floating currency is, to simplify, a currency with a constantly changing exchange rate against other currencies. Many factors can affect the exchange rate for a given pair of currencies. Cost of goods in a country, various economic or political indicators, and even the trading of the currency in question.

If you've ever wondered where all the stock day traders went after the dot-com collapse, the answer is generally "Forex". In 2001, the NYSE and NASDAQ under the guidance of the SEC, modified their rules to restrict day-trading, and among the many changes were a minimum margin account of $25,000 USD. Most day traders didn't have that kind of margin, so most of the day trading of stocks vanished. Forex, on the other hand, is largely unregulated, features a 24 hour market during the week, and has become the Big New Thing in nearly instant gratification trading. It's also a great way to lose your shirt. There are a couple dozen established online Forex trading companies, as well as probably hundreds of smaller, and more dangerous, companies. Forex scam companies are nothing new, so beware of anything new and shiny. Or, really, just beware in general.

WARNING: Before continuing on to the meat of the writeup, I need to make certain that you understand that Forex trading is DANGEROUS. There is little governance, massive volatility, and high margins, which all add up to DANGER. There is so much involved even in the most elementary Forex trade that this writeup can't even begin to scratch the surface. If the things herein interest you, I highly recommend you buy some books on Forex, or trading in general and study them before you use real money in this unusually crazy market. Better yet, hire a professional financial advisor who will probably blurt out "Do not trade in Forex!" as soon as the words come out of your mouth. In short, Forex trading is for all intents and purposes, a slightly more scientific form of gambling, and should be approached as such.1

ANOTHER WARNING: I am not a financial advisor, merely a Forex trader passing on some very basic information on the various aspects of Forex trade. Do not consider anything here to be financial advice. Writing this is not an endorsement of Forex trading, and reading this is no substitute for professional advice. I do not endorse using any particular company or website, and any mention of either is simply for the sake of example.

Important Terms

  • Currency Pair - The currencies which are traded against each other. For instance, EUR/USD is the Euro against the U.S. Dollar. It is the most popular trading pair. The pairs which are comprised of the major world currencies (floating only, so, not Chinese currency, for instance) are known as "Major Pairs" and are traded everywhere. Lesser pairs, known as "Exotic" pairs, are often much more volatile and availability of these pairs varies from broker to broker.
  • Pips - Pips are the basic decimal point level upon which you are trading. For instance, at this moment (on the weekend with a closed market), EUR/USD is at 1.35242. Generally the last point of precision after the decimal is the pip level, so, in this case 1/10,000 is one pip.
  • Bid/Ask Spread - The difference between the best outstanding buy and sell orders, generally set by the broker. This is expressed in pips, so if EUR/USD was at 1.3522/1.3526 the spread would be four pips. Some brokers deal in fractional pips as well, and so add another point of precision after the decimal. This spread is where brokers make their money, so if the spread seems unusually large at some trading site, you might want to consider trading elsewhere.
  • Dealing Desk - The dealing desk is manned by employees of the brokerage firm you're dealing with. Their job is to make money for the broker. They can manipulate prices, make margin calls, etc. Some traders consider the dealing desk to be their enemy. The dealing desk in some places also authorize orders, which can create delays. A few brokerages have no dealing desk and handle everything through automation.
  • Long/Short - Long and short trading are essentially the same in practice, but are the reverse of each other in concept. For instance, in EUR/USD a long trade is buying Euros with US Dollars and hoping that the Euro rises against the dollar. The short trade is the opposite, trading against the pair on the assumption that the dollar will rise against the Euro.
  • Stop Order - A stop order is an order to buy or sell when the market reaches a certain point. It can be used to minimize losses if your trade moves in the wrong direction, or to automatically realize profit when the market hits a certain point.
  • Margin - Margin trading is, to put it simply, trading with more money than you have. All Forex trading is done on margin. Brokers vary on how much leverage they offer, and they sometimes offer different leverage for different accounts. So, for instance, if your leverage is 40:1, ever dollar you trade is worth 40. I've seen margins as low as 20:1, and as high as 400:1. Be careful with this, though because if you lose enough to expend your margin account on any trade, the broker can and will issue a "Margin Call" which liquidates your trade at current value. While you stand to gain more with margin trading, the simple fact is you're more likely to lose more than you expected.
  • Lots - Lots are the size of currency bundles you can buy for trading. Some brokers require you to buy 100,000 unit lots, some go as low as 1 unit transactions. Like most of these other aspects, it varies widely from broker to broker.

Time

The Forex market is a 24/5 market, with the main markets in New York, London, Sydney, and Tokyo rotating hours around the clock during the week. Different currencies behave differently under the various markets, understandably, and sometimes the short periods of overlap where two markets are open simultaneously are the most volatile periods for the most heavily traded currencies.

Methods

Every brokerage with an online presence has an associated application with most of the information you need on a minute-by-minute basis. You can watch the prices rise and fall in real time or back out for an historical view to see if you spot trends. You can get economic and political news, and also execute your trades. There are as many different styles of trading as there are traders. Some work, most don't. There are, however, two schools of thought in trading. Technical and fundamental. Many traders use some of each (your humble author among them), although there are die-hard adherents to each school as well.

  • Technical - The technical school of thought boils down to the belief that all needed information for trading exists within historical data. Analysis and comparison of various types of charting, hunting down trends, and at a primitive level, even just eyeballing charts and making an educated guess (not recommended) falls under the technical school.
  • Fundamental - Fundamental traders use news and economic indicators to trade. There are many types of economic or political news that can affect the currency of a country for better or worse, and fundamentalists use this information to ply their trade.

As I stated above, a lot of traders use a mixed-bag of techniques. Some use fundamental analysis to inform their technical trade, and vice versa. You'll probably be hard-pressed to find a book which covers both methods with any real level of detail, though, since the folks who write them tend to belong to one school or the other.

Misinformation

Most of the information regarding Forex trade on the web is written by representatives of various brokerage firms. The job of a brokerage firm is to make money. Not necessarily at your expense, as it's quite possible for both sides to make money, but that's not in their job description, so beware of "traders" who talk a lot about specific companies. Also common are books written by brokerage employees calling themselves experienced traders which lean heavily toward one firm or another and often give terrible advice. There are also handy things put out by brokers, like Forex news sites, newsletters, and so on, but by and large, their main goal is getting you as a customer. Most people lose money in Forex, and the money you lose is in an account at the brokerage. The brokers make money whether you win or lose, but many traders try it out, make an account, and when they lose their initial investment, quit. That's fast bucks for the brokers.

Choosing a Broker

After all this, you might be asking yourself, "Do I have to use a broker at all?" The answer is yes. Brokers aren't inherently evil, regardless of the impression you might have from my summaries. The important thing to remember is brokerage firms are more interested in themselves than they are in you. Any interest they have in you exists solely from a money-making point of view.

There are a lot of things to consider when choosing a broker, and most of them are subjective and should be weighed by you in accordance to your financial abilities, actual interest, and personal preferences. Obviously, you want to avoid fly-by-night companies, as they're as likely as not to run off with your money, but from the established firms there are a wide variety of choices.

  • Initial Investment - Most brokers have a minimum account size. Many have different levels of service based on the size of your margin account. Some offer better leverage, among other perks if you open a larger account.
  • Fees - Some brokers charge fees for various things. Some charge you to open an account. Some also charge you to place certain kinds of orders. Some even charge commissions above their take from the spread.
  • Pip Spread - Since brokers and traders both make their money off pips, pip spread can be an important factor. The spread is usually the difference between what the bank is offering the brokerage firm, and what you're being offered. Smaller spreads are often attractive, since it takes less upward (or downward, in the case of a short trade) movement to realize profit. Some pip spreads change at various times as well.
  • Trading Software - All online brokers use some kind of trading software to facilitate trade. While, on the surface they all look very similar: lots of charts, readouts, and buttons, they vary greatly in their ease of use and actual usefulness. Some have very frequently updated charts, others do not. Some have up-to-the-minute news, while others don't. Even just how the application works can be a deciding factor in whether or not to use a certain broker. Fortunately, one thing most of them have is a "learning" account, or game version of the application, where you can both get used to the application and execute trades against the real market with play money to get used to how things work. Even experienced traders often use these learning accounts to test new trade theories. So trying out the software is often a key part of deciding on a broker.
  • Pair Availability - If you're totally crazy and want to trade on exotic pairs, this might be a factor in your decision too. Not all exotic pairs are available from each broker, so if you're into that sort of thing, this may narrow the brokers you can choose from as well.
  • Delays - This is, sadly, something you might not be able to see before you open an account with a broker. Brokerages with a dealing desk sometimes have manual approval of trades, and with the extreme volatility of the market, even one minute can sometimes make a massive difference in your profit or loss.
  • Leverage - Some people are comfortable trading at 400:1 leverage, others prefer more conservative leverage, like 20:1 or 50:1. The amount of leverage your account can use can sometimes be set in your account with certain brokers who offer a flexible range, but it is more often an integral part of the account you sign up for, so bear that in mind. While a margin call will minimize your loss, it is not guaranteed to stop you before your account hits zero, especially in a human run environment, and you are financially responsible for any deficit you create.

In Closing

This writeup only scratches the very surface of the complex topic known as Forex trade. Really, though, nothing beats hard work and critical thinking when it comes to doing your own research on this subject. Forex is not for everyone, and some would argue that it's not for anyone. It's risky, volatile, largely unregulated, and dangerous. However, if the warnings herein and elsewhere don't convince you, it is an interesting way to spend your time if you like poring over charts and news and think you can buck the system. Even just opening a learning account to play with can be very educational (not to mention, free).


This writeup, save for the EUR/USD quote, has no sources but my own experience. It is geared to be accessible to anyone, but due to the amount of terminology necessary to articulate the writeup, that may have failed in places. If there are confusing pieces, please let me know and I will update this writeup to clarify to the best of my ability.


1 For a warning from the National Futures Association, please read: http://www.nfa.futures.org/compliance/forexInvestorAlert_020107.asp

2 Source: http://www.forexnews.com/

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