Foreign exchange used to be limited to large players such as national banks and multi-national corporations. In the 1980’s the rules were revised to allow smaller investors to participate using margin accounts. Margin accounts are the reason why FOREX trading has become so popular. With a 100:1 margin account, you can control $100,000 with a $1,000 investment.

FOREX is not simple, however, and education is needed to make wise investment decisions. Although it is relatively easy to start trading on the FOREX, there are risks involved, so finding out as much as possible about the market is a good move for any beginner.

FOREX traders usually require a broker to handle transactions. Most brokers are reputable and are associated with large financial institutions such as banks. A reputable broker will be registered as a Futures Commission Merchant (FCM) with the Commodity Futures Trading Commission (CFTC) as protection against fraud and abusive trade practices.

Opening a FOREX account is as simple as filling out a form and providing the necessary ID. The form will include a margin agreement that states that the broker can interfere with any trade it deems to be too risky. This is to protect the interests of the broker – most trades, after all, are done using the broker’s money. Once your account has been established, you can fund it and begin trading.

Many brokers have different types of accounts to suit the needs of individual investors. Mini accounts allow you to get involved in FOREX trading for as little as $250, while standard accounts may have a minimum deposit of $1000 to $2500 depending on the broker. The amount of leverage – using borrowed money – varies with accounts. High leverage gives you more money to trade for a given investment.

HOWEVER – beginner traders are advised get accustomed to FOREX by doing paper trades for a period of time. Paper trades are practice transactions that don’t involve real capital. They allow you to see how the system works while learning how to use the various software tools that are at provided by most FOREX brokers.

Most online brokers have demo accounts that allow you to make free paper trades for up to 30 days. Every new FOREX investor is strongly advised to use these demo accounts at least until they are showing consistently steady profits.

Each broker has their own set of software tools to aid in making transactions, but there are a few tools that are common to all FOREX brokers. Real time quotes, news feeds, technical analyses and charts, and profit and loss analyses are some of the features you should expect to see on most online brokers’ web sites.

Almost every broker operates on the Internet. To access their online services you should have a reasonably modern computer, a fast Internet connection, and an up-to-date operating system such as Windows XP. Once your account is set up, you can access it from any computer – just enter your account name and password. If for some reason you are not able get access to a computer, most brokers will allow you to make trades over the phone.

Trades are commission free, meaning that you can make many trades in one day without worrying about incurring high brokerage fees. Brokers make their money on the ’spread’ – the difference between bid and ask prices.

Technical analysis relies on one key concept: Prices move by trends. The common saying in FOREX is ‘The trend is your friend.’ Market movements have identifiable patterns that have been studied over many years and a thorough understanding of these trends and how they can be read forms the basis of a good trading strategy.

There are many analytical tools available to understand market movements. The beginner FOREX trader is well advised to study each one separately for getting a working knowledge of their concepts and application. Once one has been understood, keep on using it while studying others. Each tool tends to reinforce the others.

Support and resistance levels are used in many FOREX trading strategies. ‘Support’ refers to the price level that is repeatedly seen as the bottom – when the price reaches this level it tends to rise. Resistance levels are upper prices that the currency rarely trades beyond. Support and resistance levels contain price movements for a period of time.

When currency prices break through support or resistance levels, the prices are expected to continue in that direction. For example, if the price rises above the previous resistance level, it is seen as bullish – the price should continue to rise.

To find support and resistance levels, price charts need to be analyzed for unbroken support and resistance levels. Charts can be analyzed in any time frame; however longer time frames establish more important support/resistance levels. Traders can use support/resistance levels to determine when to enter or exit a transaction.

Moving averages are another common tool in FOREX trading strategies. The simple moving average (SMA) shows the average price in a given period of time over a specified period of time. Moving averages serve to eliminate short term price fluctuations giving a clearer picture of price movements. FOREX traders can plot a SMA to determine when prices have a tendency to rise or fall. If prices cross above the SMA they have a tendency to keep on rising. Conversely, prices below the SMA have a tendency to continue their downward motion.

These are two examples of trading strategies that can be used individually or in combination. In practice, the FOREX trader should have a repertoire of trading tools to examine market conditions and to support the findings of one study or another. If several indicators show that the market is moving in a particular direction the trader can act with more assurance than when relying on a single indicator.

Similarly, fundamental analysis can be used to reinforce technical findings, or vice versa. Ideally, the FOREX trader will take several indicators into account when plotting a trading strategy.

Every trading strategy should provide clear guidelines about when to enter a trade, what to expect in terms of market movement, when to exit a trade, and how much loss can be accepted in case the deal moves against the trader. Following these simple guidelines and learning about technical analysis can help you become a successful FOREX trader.

Of course, you can use automated orders such as limits and stops. These allow you to walk away from your computer with the knowledge that your losses will be kept to a minimum, but by doing so, you may miss out on potential profits because your limit order kicks in too soon.

If you don’t have the time to watch your computer monitor and still wish to achieve as much profit as possible, consider signing up for a FOREX signal service. These services monitor and analyze the market for you and send their findings directly to your computer desktop, email, or SMS on your cell phone or pager.

Companies that offer FOREX signals do so on a paid basis, so you have to sign up and pay a monthly or yearly fee. Some brokers may offer this service as an extra which integrates into their trading software. You can receive signals as a popup on your screen or by any of the other methods described above.

There are usually a limited number of currency pairs that are available for FOREX signals. Most services offer signals on EUR/USD, USD/JPY, GBP/USD, USD/CHF, but specialized services may offer other currency pairs.

FOREX signals are primarily based on technical analysis of market conditions. Most companies use a combination of indicators to identify main trends and entry and exit points. The results are sent to subscribers who have the option of acting on them or passing. Some services will even execute the trade for you.

Using a variety of technical studies, various types of signals can be derived from currency charts. The SMA (Simple Moving Average) indicates buy signals when currency prices rise above the average line. Sell signals occur when the price falls below the moving average line.

MACD (Moving Average Convergence Divergence) studies have a signal line that is used to generate a buy signal (above the line) or a sell signal (below the line).

Volume indicators are used to determine market interest. High volume (especially near the bottom of the market) can indicate the start of a new trend while low volume indicates investor uncertainty.

Bollinger Bands indicate potential changes in the market. Sharp price changes tend to occur when the bands tighten while prices that touch one band tend to go all the way to the other band.

Other indicators like volatility and momentum can be used to reinforce signals provided by other sources. Taken together they form a relatively reliable source of information about how the market is behaving.

Are signals a sure thing? Of course not, otherwise we would all be millionaires. Signals can give you good advice about which currencies to trade, but no signal service will guarantee their information is 100% accurate. Reputable services will show you their track record, however, and let you see for yourself how they have done in the past.

FOREX signals cost anywhere from $50 to $200 a month. It’s up to the individual trader to decide if the cost is worth it. Don’t think that signals can take the place of trader education – they are advice, and if you don’t have the knowledge to analyze the advice, you should go back to the books before using a signal service.

There are two basic types of option: Call options and Put options. A call option gives the holder the right to buy a currency while a put option gives the holder the right to sell.

The worth of an option at expiry is equal to the value realised by the holder in exercising the option. If the holder gains nothing, the option is worth nothing. The value at any other time of the contract duration is the ‘intrinsic value’ – the value that can be realized if the holder exercises his option.

Intrinsic value is linked to the ’strike price’ – the value specified by the option contract. A call option has intrinsic value if the spot (current) price is above the strike price. A put option has intrinsic value if the spot price is below the strike price.

If the option contract has intrinsic value it is said to be ‘in the money’, otherwise it is ‘out of the money’ or ‘at the money’ (at par). Options would only be exercised if they are in the money.

Options are priced according to complex formulas that take into consideration both the spot value and time value. Time value is calculated according to expected market conditions including volatility and the difference in interest rates between the two currencies. Options must be priced low enough to attract potential buyers and high enough to attract potential writers (the sellers or guarantors of the option).

Currency options are used in FOREX to minimize risk against unexpected moves in the market. If you buy an option your losses are limited to the cost of the option. Those who sell options are more vulnerable. They gain the premium but they are exposed to unlimited loss if the market moves against them.

As a hedging tool, there are many different types of options available. They are often used by companies that trade overseas to minimize the potential for loss due to fluctuations in the foreign exchange market.

FOREX trades have a special type of option available known as a Digital Option. This option pays a specified amount at expiration if the criteria are met, otherwise it pays nothing.

FOREX traders who wish to use a digital option first decide which direction the market is moving. They then decide on a payoff amount if the market moves as expected within a certain time frame. With this information the cost of the option is calculated.

For example:

The price of the euro is currently trading at about 1.2400 and you expect it to rise to 1.2800 within 3 months. You decide to buy a put digital option with a payoff of $5000. The cost of the option is $800.

If at the end of the 3 months the euro is more than 1.2800 you get $5000. If the price is less, you lose $800.

Margin accounts allow FOREX traders to control large amounts of currency with a relatively small deposit. Establishing a margin account with a FOREX broker enables you to borrow money from the broker to control currency lots which are usually worth $100,000. The amount of borrowing power your margin account gives you is the leverage. Leverage is usually expressed as a ratio – a leverage of 100:1 means you can control assets worth 100 times your deposit.

What this means in FOREX is that with a 1% margin account you can control standard lots of $100,000 with a $1,000 deposit. Trading on margin increases both profits and losses, and the potential exists for the trader to lose more than his original deposit. With proper safeguards, however, loss can be limited, and usually brokers will terminate a transaction that extends beyond the margin deposit.

Benefits

As we mentioned above, trading on margin gives you more buying power and the potential for more profits (and losses). How does this work, exactly? A 1% margin account allows you to control a currency lot of $100,000 for $1,000. When dealing with $100,000 small changes in the price of the currency can result in large profits or losses.

FOREX currencies are traded in much smaller units than cash. The American dollar, for example, is traded in units down to 4 decimal places. Instead of $1.32 FOREX quotes are seen as $1.3256. The smallest unit in FOREX currencies is called the pip, and when you have a $100,000 each pip of your total lot is worth $10 (when trading American dollars).

If the price of American dollars changes from 1.3256 to 1.3356, that’s a difference of 100 pips which represents a profit or loss of $1000. Without margin, if you had $1000 of currency, the price change from 1.3256 to 1.3356 represents a difference of $10. Significant to the tourist, perhaps, but not the investor.

So the benefit of margin is increased profit potential.

Risks

As there is increased profit potential, there is also increased loss potential. If you are not careful, your entire margin account could quickly be wiped out. If your margin account is 1% and the currency moves just one cent against you, you lose $1000.

FOREX trading, however, has several methods to limit loss. Stop loss orders automatically close your position if the value of the currency crosses a pre-determined point. Stop loss orders allow you to limit your losses to a specified amount while still allowing potential profit taking.

An often overlooked risk is the possibility that your broker may close your position if your potential losses approach the balance of your margin account. You may be riding out a down trend with the expectations of a market reversal, but unless you replenish your margin account you may find your position has been closed. If this happens, you lose all of your margin.

For example:

You sell EUR/USD at 1.2144 (sell 100,000 euros and buy 121,440 US dollars) with the expectation that the euro will fall in price. You have a 1% margin account which means the required margin is $1,214.40. You have $1250 in your margin account, so to enter this position your margin account is left with $35.60.

You have not specified a stop loss order, and after you enter this position the euro suddenly rallies, gaining 0.0263 for a price of 1.2407. 100,000 euros are now worth US$124,070 and your 1% margin requirements have risen to $1,240.70. Depending on the policy of your broker, your position may be automatically closed or the extra funds in your margin account may be used to make up the difference. In any case, if the euro continues to gain value and you wish to ride it out (bad idea) you will have to add more funds to your margin account or risk losing everything.

Another example:

You buy USD/CHF at 1.2623 with the expectation that the US dollar will gain against the Swiss franc. You buy a standard lot of 100,000 American dollars for 126,230 Swiss francs with a margin requirement of 1% or $1,000.

As expected, the US dollar rises to 1.2683 at which point you close your position. You sell 100,000 American dollars for 126,830 Swiss francs for a profit of 600 francs or US$473.08 (600 francs divided by the exchange rate of 1.2683).

When the company does well and makes a profit, the value of the stocks rise.  Stock owners can sell their shares for a profit or hold on to the stock for even more gain in the future.  Sometimes companies will issue dividends – part of the profits that are distributed to share holders.

Stocks are traded on stock exchanges.  Most stocks are bought and sold through brokers who charge a commission or fee for this service.  American stock exchanges include the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotation System (NASDAQ).  Most stocks are only listed on one exchange, although large companies may have listings on several exchanges.

Stocks were traditionally seen as long term investments.  So called ‘blue chip’ stocks – those having proven value over many years – may form the backbone of an investment portfolio.  Short term trading is a relatively new phenomenon made possible with the advent of Internet trading.  Day traders attempt to take advantage of large daily fluctuations in the market by buying and selling many times in one trading period.  It is relatively risky and any profits realized are reduced by broker commissions charged on each transaction.

Stocks may sometimes be bought on margin, meaning that the investor borrows money to buy the stocks.  Margin rates are usually around 50% – the investor can borrow as much as half the value of the stock.

FOREX

The Foreign Exchange Market (FOREX) is quite different from the stock exchange.  In contrast to the stock exchange, the FOREX is primarily a short term market.  Most traders enter and exit deals within a 24 hour period – sometimes within a few minutes.  Many FOREX trades can be made in one day without building up a large brokerage fee because FOREX trades are commission free.  Brokers earn money by setting a spread – the difference between asking and selling prices.

The FOREX is the largest financial market in the world.  It is handles transactions worth $1.5 trillion every day.  By comparison, all the American stock exchanges combined handle daily transactions worth about $100 billion.  The huge volume of FOREX means that it is one of the most liquid markets in the world.  There is always a buyer and seller for any type of currency because the world economy relies on the movement of goods from country to country.  The stock market is less liquid because participants may choose to hold their investments or move on to other markets.

The FOREX is not located in any one location.  Trading markets are located world-wide and because of difference in time-zones trades can be made 24 hours a day, 5 days a week.  Trading begins in Sydney, Australia on Monday morning (Sunday afternoon New York time) and continues non-stop until Friday afternoon New York time.

Stock exchanges have more limited trading hours.  While it is possible to trade on exchanges world-wide, each exchange is independent and operates for just 7 hours a day.  There is no way to buy or sell a certain stock that is only traded on one stock exchange when that exchange is closed.

Other advantages of FOREX?  It is more predictable than stocks.  It follows well established trends; it allows high leverage – typically 100:1 instead of 2:1 on the stock market; and it doesn’t require a large investment – mini accounts as small as $250 can get you started in FOREX.

The current futures market includes much more than agricultural products.  It is a worldwide market for all sorts of commodities including manufactured goods, agricultural products, and financial instruments such as currencies and treasury bonds.  A futures contract states what price will be paid for a product at a specified delivery date.

When the futures market is played by speculators, the actual goods are not important and there is no expectation of delivery.  Rather, it is the futures contract itself that is traded as the value of that contract changes daily according the market value of the commodity.

In every futures contract there is a buyer and a seller.  The seller takes the short position and the buyer takes the long position.  The futures contract specifies a buying price, a quantity and a delivery date.  For example:  A farmer agrees to deliver 1000 bushels of wheat to a baker at a price of $5.00 a bushel.  If the daily price of wheat futures falls to $4.00 a bushel, the farmer’s account is credited with $1000 ($5.00 – $4.00 X 1000 bushels) and the baker’s account is debited by the same amount.  Futures accounts are settled every day.

At the end of the contract period, the contract is settled.  If the price of wheat futures is still at $4.00 the farmer will have made $1000 on the futures contract and the baker will have lost the same amount.  However, the baker now buys wheat on the open market at $4.00 a bushel – $1000 less than the original contract, so the amount he lost on the futures contract is made up by the cheaper cost of wheat.  Similarly, the farmer must sell his wheat on the open market for $4.00 a bushel, less than what he anticipated when entering the futures contract, but the profit generated by the futures contract makes up the difference.

The baker, however, is still in effect buying the wheat at $5.00 a bushel, and if he hadn’t entered into a futures contract he would have been able to buy wheat at $4.00 a bushel.  He protected himself against rising prices but he loses if the market price drops.

Speculators hope to profit by the daily fluctuations in the futures market by buying long (from the buyer) if they expect prices to rise or by buying short (from the seller) if they expect prices to fall.

FOREX

The foreign exchange market (FOREX) has several advantages over the futures market.  FOREX is a more liquid market – as the largest financial market in the world it dwarfs the futures market in daily exchanges.  This means that stop orders can be executed more easily and with less slippage in the FOREX.

The FOREX is open 24 hours a day, 5 days a week.  Most futures exchanges are open 7 hours a day.  This makes FOREX more liquid and allows FOREX traders to take advantage of trading opportunities as they arise rather than waiting for the market to open.

FOREX transactions are commission-free.  Brokers earn money by setting a spread – the difference between what a currency can be bought at and what it can be sold at.  In contrast, traders must pay a commission or brokerage fee for each futures transaction they enter into.

Because of the high volume of trading FOREX transactions are almost instantly executed.  This minimizes slippage and increases price certainty.  Brokers in the futures market often quote prices reflecting the last trade – not necessarily the price of your transaction.

The FOREX is less risky than the futures market because of built-in safeguards in the trading system.  Debits in futures are always a possiblility because of market gap and slippage.

The Foreign Exchange Market was established in 1971 with the abolishment of fixed currency exchanges.  Currencies became valued at ‘floating’ rates determined by supply and demand.  The FOREX grew steadily throughout the 1970’s, but with the technological advances of the 80’s FOREX grew from trading levels of $70 billion a day to the current level of $1.5 trillion.

The FOREX is made up of about 5000 trading institutions such as international banks, central government banks (such as the US Federal Reserve), and commercial companies and brokers for all types of foreign currency exchange.  There is no centralized location of FOREX – major trading centers are located in New York, Tokyo, London, Hong Kong, Singapore, Paris, and Frankfurt, and all trading is by telephone or over the Internet.  Businesses use the market to buy and sell products in other countries, but most of the activity on the FOREX is from currency traders who use it to generate profits from small movements in the market.

Even though there are many huge players in FOREX, it is accessible to the small investor thanks to recent changes in the regulations.  Previously, there was a minimum transaction size and traders were required to meet strict financial requirements.  With the advent of Internet trading, regulations have been changed to allow large interbank units to be broken down into smaller lots.  Each lot is worth about $100,000 and is accessible to the individual investor through ‘leverage’ – loans extended for trading.  Typically, lots can be controlled with a leverage of 100:1 meaning that US$1,000 will allow you to control a $100,000 currency exchange.

There are many advantages to trading in FOREX.

·    Liquidity – Because of the size of the Foreign Exchange Market, investments are extremely liquid.  International banks are continuously providing bid and ask offers and the high number of transactions each day means there is always a buyer or a seller for any currency.
·    Accessibility – The market is open 24 hours a day, 5 days a week.  The market opens Monday morning Australian time and closes Friday afternoon New York time.  Trades can be done on the Internet from your home or office.
·    Open Market – Currency fluctuations are usually caused by changes in national economies.  News about these changes is accessible to everyone at the same time – there can be no ‘insider trading’ in FOREX.
·    No commission – Brokers earn money by setting a ’spread’ – the difference between what a currency can be bought at and what it can be sold at.

How does it work?

Currencies are always traded in pairs – the US dollar against the Japanese yen, or the English pound against the euro.  Every transaction involves selling one currency and buying another, so if an investor believes the euro will gain against the dollar, he will sell dollars and buy euros.

The potential for profit exists because there is always movement between currencies.  Even small changes can result in substantial profits because of the large amount of money involved in each transaction.  At the same time, it can be a relatively safe market for the individual investor.  There are safeguards built in to protect both the broker and the investor and a number of software tools exist to minimize loss.