2007-11-28T22:10:00.000+02:00

Casual explanation

For a casual person, FOREX is something mysterious where a friend has either lost a lot of money or won a lot of money. It's thought of as a complicated casino, where winners exist but they most likely have a forehead twice as big as would be normal, they work under international banks and wear suits. To me, FOREX is something completely different.

FOREX is a market where instead of physical goods, money (currencies) is traded. FOREX is not a casino! Although, you can perfectly make a casino out of it, if not exercised properly. Yes it is possible to lose all your money in a matter of minutes (as well as make a fortune). It's also possible to fall unto a kitchen knife and die as a result.

Imagine, that there is a marketplace, where millions of people can trade with each-other and do it so efficiently that it would not disturb anybody else wanting to trade at the same time. There is no physical counter or market-hall to trade FOREX. You may imagine, there is a virtual market-hall while technically there is actually only a connection between World's largest banks, broker firms and clients.

To trade on FOREX you have to buy one currency and sell another at the same time. It may sound a little awkward at first, but is quite simple if you think about it. Imagine, that you're going abroad and need to change your US dollars to British pounds. You go to bank, sell your dollars and receive pounds in return. At that exact moment you have not lost any money (if the banks didn't buy cheaper and sell higher). Let's assume you were abroad for a month, but didn't need to use any of your money and came back with the same amount of pounds. You go to bank and want to sell your pounds in exchange for US dollars. Now you're left with an amount of money that is either bigger or smaller than you first had. It's because the value of the dollar has changed against the pound's value during that month's time.

So what does FOREX have in common with all of this? How's exchanging money in bank to go abroad connected to loosing all of it or gaining a fortune in a matter of minutes? The answer is leverage. How fast you make or lose money is all connected to leverage. A few examples.

Example #1:
You bought 100kg of sugar in anticipation to sell it for profit. It cost you 1 euro per kilogram. You have risked 100 euros in case sugar becomes worthless or you don't find a buyer. You find a person that is interested in buying all the sugar at 1,05 euros a kilogram. If you sell all of the sugar you have made 5 euros of profit, that is 5% of your initial capital. To put it more simply: 5% change in the price has resulted in 5% change in your capital!

Example #2:
You bought a house that cost 5 millions. As you didn't have such kind of money in your back pocket, you decided to take a bank loan to spread the cost over a longer period of time. You also hoped to sell the house for profit in the future as real estate market had been healthy with no signs of a major weakness for years. The bank made you an offer where you'd have to make a down payment of 1 million and the bank would loan you the other 4 millions, reserving your house for backup. In a year's time you decide to sell the house and manage to get 6 millions for it. You pay bank the 4 millions and are left with 2 millions of YOUR MONEY (minus the monthly interest payments you payed to bank which is really insignifficant amount compared to the gains). Conclusion: 20% change in price has resulted in 100% change in your capital!

Example #3:
You want to buy euros for 100 USD and that's all the money you have (this can be compared to lighting a fire on your 100). You put 100 USD down and broker lends you the other 9900!!! So now you control 10000 USD worth of money with only putting 100 on the table! Any insignificant price change will result in a great change of your profit or loss. Conclusion: 1% change in price will result in 100% change in your risked capital!

Right now it may definitely seem like a casino, but it isn't if done properly, which I will discuss in Making money with FOREX section (currently under construction).

Advanced explanation

FOREX is currency market. It has about 2 trillion average daily volume. About 60% of the volume is traded in London. FOREX is open 24 hours a day, 5 days a week. About 95% of retail traders lose money on FOREX.

The currencies are presented as pairs like GBP/JPY, EUR/USD, EUR/CHF and so forth. The first part of the quote is called the base currency. You can buy and sell currencies through a broker. There are basically two different kind of brokers, ECN brokers and market makers. The difference is explained under the brokers section (currently under construction).

It is possible to profit from either declining market or rising market. For exmple, suppose you want to buy GBP/JPY pair - this means that you're buying pounds and selling yens at the same time. If the pound's value increases against yen, you're making profit, if it declines, you're loosing money. If you sell the same pair, the opposite is true.

The currencies' prices are presented in the following way: EUR/USD 1.4772 The smallest change in price is called a pip. If the EUR/USD increases by 1 pip, it becomes 1.4773

Trading is done by units that are called lots. One lot is worth 100000 of base currency. But you don't have to own 100000 worth of euros to buy 1 lot of EUR/USD. That's because a broker lends you 99000 euros if you have 1000 euros to back up the deal (that's leverage of 1:100 that most brokers offer to regular retail clients). Some brokers offer minilots that are 1/10 of a regular lot, some brokers offer microlots that is 1/100 of a regular lot.

An example: You have 10000 euros on your FOREX account. You decide to buy EUR/USD with 1000 euros. You put 1000 euros into the deal while broker lends you the remaining 99000. Suppose the price of EUR/USD pair was 1.4773. It means that you bought 100000 euros and sold 100000*1.4773=147730 dollars. If the price raises by 1 pip, you have earned 10 euros (0.0001*100000=10). Of course it's suicidal risking 10% of all your trading capital in a single trade, but it's just an example.

Conclusion

That's a brief review of what FOREX is. There are many great sites that have more detailed educational materials about FOREX that are listed under my links section (currently under construction).

The next section is a brief overview about trading on FOREX.

What is FOREX?