ForexInvestment & Trading

Free PDF Guide: Forex for Beginners, A Comprehensive Guide to Profiting from the Global Currency Markets

Forex for Beginners, A Comprehensive Guide to Profiting from the Global Currency Markets

Introduction

Forex is short for foreign exchange and refers simply to the conversion of one currency into another. Currency exchange is vital to the functioning of the global economy. Goods that are produced in one country and sold in another necessitate currency conversion. Consider, by way of example, that the popular iPhone is assembled using components from at least five countries and is exported to no fewer than 87 countries.

Given that Apple accounts for its earnings and pays dividends in US dollars, payments to suppliers and the repatriation of profits will require nearly a hundred separate foreign exchange transactions for only this one product! When you apply this notion to the whole of the global economy, you begin to understand the scope of currency exchange.

In fact, average daily turnover in the forex markets now exceeds $4 trillion. Spot trading in the USD/EUR alone represents $400 billion—enough to earn it the designated status of most traded financial asset in the world. By comparison, the NYSE and Nasdaq combined account for perhaps $150 billion in daily equities volume. Global foreign exchange volume has doubled over the last six years, while equities volume has stagnated. Of course, this isn’t an apples-to-apples comparison, but the point stands that the forex market is truly massive.

Meanwhile, the retail penetration of forex is minimal. As I will explain in due time, while many stockbrokers, bond brokers, and options brokers are all now household names, retail forex brokers tend to be small and specialized and have very little brand recognition outside of the forex niche. Ever heard of Charles Schwab or E-Trade? How about FXCM or Gain Capital, two of the industry leaders in retail forex? Case in point.

This contradiction is amazing to behold. It also partially explains the tremendous retail growth in forex over the last few years and the inevitable continuation of this growth over the next decade. Simply, it seems that forex trading has moved from a dark corner of the financial universe into the mainstream. An opportunity that has long been ignored by the majority of individual investors has been
brought to the foreground, and the battle to profit from it has begun.

 

PIPs and Interest

So how do you make money trading forex? With most assets (the notable exception being commodities), there are two sources of profit: rents (in economics terminology) and appreciation. In the case of equities, that refers to a rise in the stock price and the receipt of periodic dividend payments. With bonds, it’s rising bond prices (also known as falling interest rates) and the receipt of interest. With real estate, it’s home price appreciation and rental income. With currencies, it’s appreciation and interest income. Simply, forex traders generate profit by selling a currency for a more favorable exchange rate than they paid to buy it, and by capturing interest in the interim.

Exchange rates are quoted to at least four decimal places, and the smallest unit— equivalent to 1/10000th of one unit of currency—is referred to as a PIP, which is short for percentage in point. Forex traders will typically brag about how many IPs they cleared on a trade, which is just another way of accounting for how much profit they earned.

Currency traders also earn interest on their open positions. For example, if the interest rate associated with one currency (i.e., the approximate rate paid on a savings account in the country where that currency is used) is higher than the corresponding rate for a second currency, a trader can earn interest on the difference by selling the second against the first.

To make this example more concrete, let’s imagine that the current Eurozone interest rate is 5% while the corresponding US interest rate is only 1%. By buying the euro against the US dollar, you can effectively earn interest at an annualized rate of 4% (the difference between the two rates). Of course, the reverse is also true, as you would be charged interest on a long position in the dollar, against the euro.

Ultimately, any positive interest income will either supplement or offset any gains or losses, respectively, from exchange rate fluctuations.

 

Liquidity, Simplicity, and Convenience

While the $4 trillion in daily forex market turnover is spread over a variety of different instruments and hundreds of unique currency pairs, its liquidity is still nothing short of immense. In practice, that means you can enjoy the ability to move into and out of positions instantaneously and at low cost.

In addition, since trading takes place in many different trading centers and involves many different broker-dealers, the forex markets are basically  immune to market manipulation. To be sure, there is unscrupulous activity in forex just as there is unscrupulous activity in stocks, but because of its size and structure, it is nearly impossible for individual traders to influence the market and/or profit from inside information. At this point, is there really anyone who believes that the same can be said about the stock market?

One of the peculiar features of forex is that there is never a bear market. That’s not to say that currencies can’t decline dramatically over a prolonged period of time. Rather, it means that when one currency is falling, another one is necessarily rising. When stocks are stagnating—as they have for most of the last decade—there is very little that long-term investors can do.

Some intrepid traders will turn to shorting, but this is risky and complicated. In contrast, a forex bear market in one currency will create opportunities in another. Those that believe that the US dollar is due to depreciate, for example, need not sit around and twiddle their thumbs. They can turn to the euro or Japanese yen or an emerging currency, such as the Chinese yuan or Brazilian real.

Currencies also compare favorably to equities in terms of simplicity. There are tens of thousands of equities. To be thoroughly fluent in a single equity requires complete dedication and constant vigilance. As you can see from Table I-1, however, the overwhelming majority of currency transactions are conducted in less than a dozen currencies. The US dollar and euro alone are represented in more than half of all trades.

currency distribution of global foreign exchange market turnover

To be fair, there are 45 different combinations in which the 10 currencies in Table 1-1 can be exchanged, but there are certain mathematical and psychological truisms that ensure a tight correlation between many of these pairs. Besides, the fact remains that a small overall number of individual currencies and currency pairs means that tracking the currency market is inherently more manageable than following any other financial market. One need not resort to following market indices or sector indices; it is reasonable to be able to follow the currencies themselves.

Then there is the aspect of convenience. Because currencies trade on different exchanges around the world (unlike most other securities, which tend to trade on a single exchange or a cluster of exchanges all located within a tight geographic region), it is possible to trade 24 hours a day, 6 days a week. When the market in Sydney opens on Monday morning, it is still only 6:00 p.m. (EST) on Sunday in the United States. An hour later, the market in Tokyo opens, followed by Singapore, Frankfurt, London, and then New York City.

 

Investing Versus Trading

For those with some previous exposure to forex, you may be under the impression that forex investing is an oxymoron. And with advertisements promoting 50:1 leverage, profits measured in cents, and so-called commission- free trading, you can certainly be forgiven for holding that belief.

Anecdotally, it does indeed seem that the majority of those active in the forex market fall into the category of trader. What do I mean by this? In a nutshell, forex traders have very short time horizons and aim to generate only a modicum of profit per trade. The goal is to magnify gains through the use of leverage and/or dozens (or even hundreds) of trades per day. Traders pay very little attention to the news (and even then, only for the purpose of planning coffee breaks) and focus instead on market psychology—on the ebbs and flows in market sentiment that drives second-to-second and minute-to-minute fluctuations. Instead of trafficking in terms like gross domestic product (GDP) and inflation, traders ply their trade with charts. Instead of models that are based on economic variables, they rely on technical analysis to discern barely perceptible patterns in exchange rates, with the intention of profiting from them before the majority of other traders discover them.

I don’t have to tell you that forex trading is more difficult and more stressful than forex investing. With such short time horizons, there is intense pressure to time trades perfectly. In addition, the algorithms used by financial institutions are becoming increasingly adept at performing this same kind of analysis, and high- frequency trading is rapidly colonizing the forex markets in the same way that it came to dominate the other financial markets. It should come as no surprise then that a recent study by the Federal Reserve Bank concluded that the profitability of forex trading (as distinct from forex investing) is declining.

It’s fair to say that my personal approach leans toward investing. That means that I have a longer time horizon and that I prefer fundamental economic and financial analysis to the technical analysis that is based solely on charts and price patterns.

The time horizon for investors is necessarily longer than it is for traders, and is typically measured in weeks, months, or years. While exchange rates should revert to the mean over the long-term, multiyear rallies are not uncommon. There are certain strategies that will theoretically allow you to check your forex portfolio only once a week, as you would with a portfolio of stocks and bonds.

The downside to this approach is that overall profit tends to be smaller, and it’s more suitable for padding your retirement account than as a means of generating substantial income. In addition, since currencies don’t directly pay dividends, a buy-and-hold strategy probably won’t generate the same returns as a similarly value-oriented approach to equities investing.

Thus, the approach to the forex market that I have come to espouse is swing trading, or trend trading. This approach aims to blend the best aspects of technical and fundamental analysis, and of trading and investing. The time horizon is three to six weeks, and a small amount of leverage can be applied. The goal is to spot severe fundamental mis-valuations, and to profit from them with the aid of technical analysis.

 

Developing Realistic Expectations

As I underscored in the preface, the forex approach advocated herein is intended to yield modest, steady profits. Currency pairs will typically rise or fall by about 10%–15% over any twelve-month period, and a back-of-the-envelope estimate suggests that total fluctuations (the sum of all substantial spikes and dips) might approach 80%, or about 7% each month. Given that perfect timing is difficult and that for every three trades, one trade will probably lose money, I think it’s reasonable for a successful trader to expect a monthly return of 2%, or an annual return of 25%.

Some months will undoubtedly be better than others, and returns will be impacted by interest and leverage. Even with good luck and hard work, returns are likely to be modest. Using these numbers as a starting point, an investment of $50,000 could yield an annual return of $12,500 for a successful trader. This is certainly nothing to scoff at, but likewise, it probably isn’t a basis for turning forex into a full-time pursuit.

 

Back to top button
Close