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Introduction to FOREX Investing

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500 Euro BillForeign exchange has been a hot topic lately with the weakness of the US Dollar and has always been an area rife with scams and rip-off artists (even the SEC warns about it on their website for forex transactions). Trading in foreign currencies works off the same principles are trading anything else, you want to buy low and sell high. Scammers would like you to believe FOREX is magic, that there are sure-fire trading systems that work 100% of the time, but Forex isn’t magic and there are no sure-fire trading systems… it’s just another way to invest.

So for years, the Foreign exchange market has been a secret and somewhat of a mystery to many traders, including myself. If you thought about investing, you mostly looked to the stock market or to bonds as places to invest. If you were like me, you knew about people trading in currency on the foreign exchange market but you never knew much more about it.

While I’m not advocating anyone jump into Forex investing today, I think there’s value in understanding how it works, even if you never plan on investing in it. To help demystify the Forex market, I thought I’d write a Foundation article about the basics of FOREX.

What is FOREX?

Forex is the shorthand name for the foreign exchange or currency market. The Forex market is the largest capital market in the world with an estimated 2-3 trillion dollars changing hands every single day.

So where is the Forex market? It’s kind of everywhere people exchange currency and there is no central clearinghouse, unlike stocks and options. Stocks that trade on the New York Stock Exchange are bought and sold in New York. Many futures and options are traded on the Chicago Board of Ttade in Chicago. With forex, it’s everywhere.

Another interesting distinction is that forex is traded twenty four hours a day from 20:15 UTC on Sunday until 22:00 UTC on Friday. The NYSE trading hours are only from 9:30 AM ET until 4 PM ET, with some pre-market and after-hours trading.

Also, unlike other markets where everyone is presumably on the same footing, there are different levels of access in the forex market. At the very top are commercial banks and securities dealers in the “inter-bank market,” which accounts for about 53% of all transactions. That’s where bid and ask prices vary by only a pip or two (more on that later). Below that level are the smaller banks, then multi-national corporations, hedge funds, and then retail investor/speculators. As you move down the hierarchy, the bid and ask spreads on transactions widens (which is where market makers earn a profit).

How does a trade work?

First, currencies are quoted in pairs. The majority of currencies are traded against the US Dollar. The Eur.Usd (Euro/US Dollar), Gbp.Usd (Pound/US Dollar), Usd.Chf (US Dollar/Swiss Franc) and the Usd.Jpy (US Dolar/Japanese Yen) are considered the “majors” and are the most actively traded currencies. Trading in the majors equates to approximately 80% of all volume transacted in the Forex market.

Let’s take the Eur.Usd pair as our example. We are buying the first currency using the second, so we’re buying Euros with Dollars. We do this if we believe that the Euro will increase in value versus the US Dollar. In other words, we are taking a long position in Euros at the current market price and expecting to close our position at a higher price at a later time in the future.

Also, there are no restrictions in short selling because. If you think that a currency will lose value, you can take a short position and sell that currency immediately. Regardless of which direction the market is moving you will be able to make the appropriate decision that fits your trading plan.

Forex Commissions & Fees

The interesting thing about the Forex market is that brokers are compensated through the difference in bid and ask prices. When you go to sell a currency pair, you sell it at the bid price. If you go to buy a currency pair, you buy it at the ask price. The more liquid the pair, the lower the spread and the lower the commission.

You don’t pay a per transaction commission in the traditional sense, the commission is built right into the bid/ask spread. The transaction fee can be very high for the small time investor because spreads can be very wide on some of the more illiquid pairs. Whereas TradeKing always charges you a flat $4.95 a trade, you have to pay careful attention to spreads when making forex trades because the price, percentage-wise, can vary greatly.

In addition to the transaction fees, there are all the other fees common associated with any broker. Review to see what the minimum balance requirements are, if there are inactivity fees, fund transfer fees and the like.

So Why Forex?

If it sounds like forex is mostly for speculators, you’re not far off. Forex isn’t for the buy and hold investor because every site I read touted features of the forex market that appealed to speculators. The 24 hour nature of the market, the massive liquidity, speed of trade executions, and the number one reason forex is so popular – leverage.

Many brokers enable their clients to trade over 200-1 leverage. This allows you to increase your position size exponentially. You can increase your over all return while tying up less capital. This is like trading stocks on margin and increases your risk exponentially.

If you are utilizing 200-1 leverage, starting with $2000 in margin would allow you to control upwards of $400,000 in currency! With stocks, you’re usually only talking leverage around 2-1, not 200-1.

For all the scams and rip-off artists claiming you can become very very rich in a short period of time, you can also become very very poor just as quickly. With leverage, gains are magnified… but so are losses.

Picking a FOREX Broker

If this sounds like the game for you, because it’s a game for speculators, you will want to find a reputable broker.

Most brokers offer paper accounts, letting you paper or demo trade for a month or so. This lets you familiarize yourself with their software package, how the market works, and let’s you lose fake money without real penalty. :) You can take a test drive of their charting packages and analysis services, just to get a feel for it.

Here’s something important though, you have to figure out how they execute trades. Brokers will do one of two things when they take your currency transaction:

  • they will either use a dealing desk,
  • or no-dealing desk model of execution.

A dealing desk firm will offset your transactions internally. In other words, when you place an order, your broker will be the direct counter party for your trade. You will buy or sell directly to your broker, which means you probably aren’t getting the best price. When executing your trades, a dealing desk is taking an open market position which immediately creates a conflict of interest against you.

A no-dealing desk broker will pass your order through directly to an interbank counter party. This means that your orders are anonymous and your broker does not take an active interest against your positions. When deciding on a broker, be sure to ask these types of questions. Good brokers will be happy to explain their dealing methods and inform you of any other restrictions they may have.

My Conclusion

I can see why forex trading can be very exciting and why there are so many “get rich quick” schemes. When you can leverage 200-1, you can earn a lot of money very quickly (and lose it just as quickly). With 24 hour trading, it’s a lot like gambling in the casino… the lights are always on and the clocks are always off. I’m fairly certain forex trading isn’t for me but it was fun reading about it.

Do you have any experience in Forex trading? Words of warning or advice?

(Photo: matze_ott)

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23 Responses to “Introduction to FOREX Investing”

  1. Mike Piper says:

    To me, the biggest difference between FOREX investing and stock/bond investing is that in FOREX, it’s a zero-sum game. You only make money to the extent that somebody else loses it.

    When investing in the stock and bond market, there are real profits being generated by the underlying companies, and investors are simply determining how they’ll be divvied up.

  2. Chris says:

    In line with Mike’s comment. FOREX is pure speculation. I would like to hear from someone who does this successfully to see what their win ratio is.

  3. HT says:

    Yeah, Forex is crazy. I opened a free account once to get a $50 starting bonus, they had a minimum leverage… I had planned on goofing off losing my $50 for fun, but wasn’t given the chance (without risking other money).

    A lower risk way to protect against say weakness in the US dollar is to invest in either commodities, or better yet companies that will benefit if the price (in US dollars) goes up. For instance buying gold or barrels of oil, or an oil refining company or a gold mining company.
    -HT

  4. Chuck says:

    As soon as I saw the title I was going to reply with my “FOREX is most definitely NOT ‘investing.’” A couple of other wise souls beat me to it, with a very good explanation of why.

    The article explains the risks well, and correctly identifies it as speculation. I’d recommend changing the title to “Intro to FOREX trading,” at least to be neutral.

    Anyone who gets involved with currency exchange with an eye for profit is absolutely nuts. I can see a few legitimate uses (for example, if your income and living expenses are in different currencies, you might want to hedge some of your savings), but not to get rich quick. Of course simple hedging can be done with simpler vehicles like foreign currency money market ETFs. (Well, at least that’s simpler for me.)

  5. zapeta says:

    Sounds like an easy way to lose a lot of money. As a small investor you’re playing at a huge disadvantage.

  6. Chris says:

    If you are investing using this leverage as in the example above, you can win as if you were investing with $400,000 but if you loose you can only loose the $2,000?

  7. I liked your comparison of Forex to a casino. It could really turn into internet gambling for some people. Makes it pretty easy to click your money away if your not careful.

  8. Mike Piper says:

    Chris: Nope, you can lose all $400,000 (your $2,000 and the $398,000 that you now owe your broker).

    • Chris says:

      Have fun trying to collect that $398k!

    • NateUVM says:

      While in theory it IS possible to lose the entire $400k, such an outcome would require the currency that you have your position in to have become 100% worthless. Not terribly likely. At least, not in the short-term, which is how most of these positions are taken.

      This is NOT to say there is less risk than is being mentioned here…this is a purely speculative form of “investing,” and people should be aware of the EXTREME possibility of loss. Just let’s be sure what we are talking about.

      Or, maybe I’m wrong…am I missing something?

  9. CK says:

    If you’re not a pro it’s almost a pure gamble.

  10. Jim,

    Forex trading is not for those who live a frugal lifestyle and who are careful with investments.

    This is pure speculation. With emphasis on the word ‘pure.’

    • Jim says:

      It’s starting to sound like it. I didn’t really understand it until I started doing the research and I think my post highlights what I found – it’s like a casino without the free drinks!

  11. kenyantykoon says:

    this is light years before it gets into the heads of investors in my country. the stock market is barely on its feet. But it seems that investors have more securities to play with than just the stock markets

  12. First, Forex has nothing to do with investing. It is speculating. Second, you could do better at the blackjack tables if you had any skill.

  13. Forex Rebate says:

    There are people who are really good in Forex trading. For me forex Trading is just like any other businesses that needs a lot of homework before jumping into it, especially it involves a lot of money, and never expecting for returns. When these two things being compared (casino and forex), it shows that there are more lossing than winning.

  14. aua868s says:

    with oil-rich gulf states going for a a currency of their own instead on USD, there’s some quick money to be made…wish I could get my head around this FOREX trading in the meantime!

  15. Izalot says:

    Forex trading seems extremely risky…It would be neat if there was a small amount to test the waters (under $100).

  16. SE says:

    I’m confused. Is forex trading the same thing as day trading stocks with margin? or even day trading with puts and calls? imho, there are many speculative investments you can make… some people think buying options, contracts, real estate, commodities. There’s more risk. Just like others said, speculative “investing” is like casino gambling. It becomes a numbers game; and it can lead into problems such as compulsive behavior. If you owed a signficant amount of money from leverage and couldnt afford it, then what happens if you declar chapter 7 bankruptcy? Is it considered a legit creditor? Why are some forex brokers (or really retailers dealers for forex) inviting newbies with $50 or $100 bonus to try.. with minimum roundtrip transactions required? Shouldnt these speculatory accounts have scrutiny with government?

    • Jim says:

      No, forex is trading in currency. Trading stocks on margin means you’re borrowing money to trade stocks. “day trading with puts and calls” probably refers to options, which is the trading of the right to either sell or buy an underlying stock at a pre-specified price.

      I have no idea about the legal ramifications but I imagine it’s like any other unsecured line of credit… or maybe Bubba comes and breaks your legs if you don’t pay. :)

  17. Cheap Bastard says:

    Folks are mixing up “spread betting” with forex deliverables. The comments posted so far are correct with respect to *spread betting* (ie. gambling).

    FX is also a means to invest – to hedge against a currency. As the USD strength swings like a stock, keeping all your investments tied to one currency is a compromise in diversity. Buying assets that are based in other strong currencies like EUR and GBP (and perhaps even gold) can create more diversity. This way if the dollar tanks, all your assets don’t tank with it.

    If you want to diversify, you need not get into the tricky and scam-saturated FX market. There are euro CDs (for example), which are sold in the US. Your US dollars are transparently converted into euros when you buy the CD. The CD is held in euros for it’s lifetime, and it’s value is obviously tied to the euro the whole time. When you decide to cash out, the euros are automatically converted back to USD at the market value on that day, and you receive USD back.

    If you want to invest in foreign stocks instead, or something with better gains (more risk) than a CD, you can open an offshore account in the other currency, and use the deliverable FX market to buy the other currency, and buy assets with that currency, ultimately giving you complete control. Or perhaps just leave it in a savings acct for both stability and liquidity. The trick here is finding a FX broker that supports deliverables. Most FX brokers are set up for spread betting, and most brokers do not publish whether their assets are deliverable, so you have to ask them.

  18. eric says:

    Informative post Jim. Learned a lot (the most important being to stay away from it lol)

  19. cdiver says:

    I would love to learn how people decide which way they speculate in this market and how the measure/time their shorts and longs.


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