The forex market is the largest financial market in the world. As of 2012, the daily turnover was nearly $4 trillion (Australian Securities Exchange). The Australian economy itself has an annual GDP of about $1.5 trillion. Given that the overwhelming majority of all transactions are done electronically, it makes sense to understand how these transactions work.
It should be noted that individuals entering this market should do so only if they wish to trade. There is no necessary reason for this other than individual preference, as the forex market will continue to function without any individuals trading whatsoever. However, there are significant reasons why professional traders might benefit from understanding how their actions could influence currency prices and thus diversify investment portfolios in a way previously unavailable.
The most straightforward way to gain familiarity with the forex market is to watch the transactions. You can do this by watching currency prices on several financial websites. The forex market will always have two currencies listed; for example, USD/CAD means US Dollars vs Canadian Dollars. The exchange rate quoted here represents how many American dollars one can get in return for purchasing one Canadian dollar. If USD/CAD were 3.65, it would cost $3.65 to buy a single Canadian dollar.
If a trader were to purchase 100 units of the CAD using these quotes and sell them later when CAD /USD is 3.50, this trader would make a profit of about $350 (assuming there were no transaction costs). Said another way, with the same initial investment ($3,650), the trader could buy 35 more Canadian dollars than before, thus increasing their holdings by roughly 10%.
This example doesn’t account for transaction costs such as brokerage fees and spreads. The bid-ask spread is the differentiation between what someone will buy a currency for and its value in selling it. For instance, if CAD/USD was 3.6500/3.6600, one can sell at 3.65 and buy at 3.66. Note here in particular that CAD/CAD trades in 0.01 increments (a pip is 0.0001).
Another substantial transaction cost to consider is brokerage fees; this is a flat fee or percentage charged by the broker every time you make a transaction. The best brokers will offer meagre fees and even fixed spreads, and thanks to technology and deregulation, they’re becoming cheaper than ever before. Brokerage fees can quickly eat away at gains – it’s no coincidence that many of the most successful forex traders started as hedge fund managers who could trade with ultra-low brokerage rates due to their massive trading volume.
The following fundamental involves how currencies can be bought using margin. In general, if one wanted to purchase $3,650 worth of CAD at 3.65, one would need to have this sum available in their account. However, this can occur using margin. The trader only has to put up a small fraction of the total amount needed as collateral and borrows or purchases the remainder on credit. Most brokers offer up to 100:1 margin, meaning that if someone had $3,650, they could purchase up to $365,000 worth of CAD.
Traders can go long or short on currencies without having any capital of their own – essentially speculating with other people’s money. Because you can trade forex 24 hours per day, there are no limits on buying or selling currencies (aside from margin regulations, of course).
However, forex traders are still subject to the Federal Reserve system’s ES. Although forex trades in 0.0001 increments, ES trades in 0.25 increments, meaning that one can buy or sell far more currencies for each dollar of capital than with forex.
The most crucial fundamental behind understanding how prices change is supply and demand. The simple explanation is that when there are more buyers than sellers, the price goes up, but the price goes down when there are more sellers than buyers. A slightly more complex version of this theory states that supply will go down when the price rises and demand increases.
As a result, supply and demand make prices go up and down, making trading the most critical concept. Supply and demand exist for everything from stocks to oil to purple clogs (if you can even imagine such a thing!), but foreign currencies are by far the most sought after products with these two forces at work.