The Mechanics of Forex

Many people think that because they know how to trade stocks and shares, and may even be experienced in it, they can automatically go on to trade in the Forex, or foreign exchange market. In some senses, that is correct, as the market is still driven by people trading, who have common psychological traits throughout the world, but in other ways, you may need to have a primer on the mechanics of Forex trading in order to not be left floundering at the first try.

Firstly, you should understand what is meant by the common currency listings. Take for example GBP/USD at 2.0130/2.0133. Let’s break this down. The currencies are represented by three character abbreviations, in this case GBP is Great Britain Pounds and USD is US Dollars, which are both really self-evident. The first currency listed is always the base currency, and you can read this quote as one (of the base currency) is 2.0130 of the second currency, in this case £1 = $2.0130 is meaning of the quote. This particular pair accounts for 14% of Forex trades, and the pound sterling is actually one of three exceptions in the way it is quoted, the others being the Australian Dollar (AUD) and the Euro (EUR). These currencies appear first, as the base currency, in their listings. In all other currency trading, the US Dollar is the base currency.

As you can realize, currency is always traded in pairs, and when one currency is bought, another is sold, of necessity. It’s not really possible to think of bull and bear markets for Forex, because a bull on one side is a bear for the other currency. The heaviest traded pair is the EUR/USD, at 28%, and the next is USD/JPY (Japanese Yen) at 18%. 95% of all Forex trading is speculative, the remaining 5% is trading for commercial purposes, because the currency is needed, for example when a company operates internationally, and wants to bring back some profit in its own currency.

Forex trading happens 24 hours a day during the working week, as there are markets around the world – there is no central exchange for Forex, but all the markets try to keep in sync with each other, to avoid arbitrage, which is someone trading to profit from exploiting arbitrary differences. The Forex market is not as volatile as the stock market, and the profit potential is maintained or increased by having a tremendous amount of leverage available.

A Forex quote consists of two numbers, the Bid and the Ask – bid is the price you can sell the base currency at, and the ask is the price where you buy the base currency. The difference between bid and ask is the amount you pay for trading in them – there is no commission to be paid to a broker. The prices tend to be very close to each other, so the market has a term, “pip”, for a very small amount. “Pip” is short for “percentage in point”, which is actually a per cent of a per cent. One per cent is the same as 0.01, so a pip is 0.0001. The one exception among major currencies to this rule about the size of a pip is the Japanese yen. For the yen, the size of a pip is one per cent, or 0.01, for practical reasons, as there are about 100 yen to a US dollar. In the traders’ market, which is called the “spot” market and is the most common place to trade, it is not unusual for the difference between bid and ask, or spread, to be as little as 3 pips or less. You can compare this to the massive spread that you have to pay if you buy currency for a vacation abroad. Retail customers at banks are regularly charged 200 pips for a transfer, or maybe 300 pips for banknote exchange.

There are various ways of trading in Forex, but the basic currency trading takes place in lots, which is where the leverage of the market comes in. Lot size varies with the currency, and is commonly 100,000 units of the currency. You don’t have to have this much money to trade, however! You have a margin account, which will typically enable you to leverage about 100 times – for instance, to trade a lot of $100,000, you need to have $1,000 in your account, a much more reasonable number. With your trading capital, you are not actually buying the currency, but buying the right to control a “lot” of the currency, and profit or lose on that basis. To learn more about the ways to profit from Forex trading, you would be well advised to consult an established trader, such as Stu Whisson at www.insightsupport.com, and he offers a free trading guide as advice for beginners.