CTS Lesson 11: What is Forex?

What Is Forex?

By: Carley Garner

The term FOREX is an acronym for Foreign Exchange. It is a worldwide cash inter-bank market

used as a floating exchange rate system to trade spot market currencies. FOREX is becoming

increasingly popular among speculators for several reasons. This is the largest and most liquid

market in the world, with an estimated daily average of more than $1.5 trillion trading hands. To

give you some perspective, it would take several months of trade at the New York Stock Exchange

to match the amount of capital traded daily in FOREX.

Similar to the NASDAQ platform, FOREX is an over the counter market. In other words, there is no

physical location in which trades are executed. Most of the trades executed on the exchange are

transactions between the over 600 large international banks, with each of these banks acting on

behalf of large firms and governments.

When does trading occur?

Due to the global nature of the market, FOREX trading can be done 22 hours per day. The Asian

session gets underway on Sunday evening at 7:00 pm EST, the London session begins at 2:00 pm

EST, and the final New York session begins trade at 7:00 am EST and ends at 5:00pm EST.

How does the FOREX market work?

A trade in the foreign exchange market is the simultaneous purchase of one currency and sale of

another. In other words, in every transaction a trader is long one currency and short the other. A

position is expressed in terms of the first currency in the pair. For this reason, currencies are

always traded in pairs. If you have purchased Euros and sold dollars, it would be stated as a

Euro/Dollar pair.

Margin and Leverage

The FOREX market allows traders to control massive amounts of leverage with minimal margin

requirements, some firms offer as much as 100:1 leverage. For example, traders can control a

$100,000 position with $1,000, or 1%.

Obviously, leverage can be a powerful tool for currency traders. While it does contribute to the risk

of a given position, leverage is necessary in the FOREX market. This is because the average daily

move of a major currency is about 1%, while a stock typically sees much more substantial moves.

Leverage can be seen as a free short-term credit allowance, allowing traders to purchase an

amount of currency exceeding that of their account balance. As a result, traders are exposed to an

increased level of both risk and opportunity. The most effective way to manage the risk of trading

with leverage is to diligently follow a disciplined trading style by using stop and limit orders. It is

imperative that traders “obey” the system, rather than trading on emotion.

What is Short Selling?

Short selling in FOREX is similar to that in the futures market. By definition, when a trader goes

short, he is selling a currency with the expectation that the price will drop allowing a profitable

offset. If the market moves against the trader’s position, he will be forced to buy back the contract

at a higher price. The result is a loss on the trade.

There is no limit to how high a currency can go, giving short sellers a unlimited loss scenario.

Theoretically, a short seller is exposed to more risk than a trader with a long position; however,

through use of stop orders, traders can mitigate their risk regardless of long or short. It is

imperative that traders are well disciplined, and execute previously planned trades as opposed to

spontaneous triggers.

There are obvious benefits to short selling. This aspect of the FOREX market allows traders to

profit from declining markets. The ease of selling contracts before buying it first is in contrast to

typical stock trades. Market prices have a tendency to drop faster than they rise, giving short

sellers an opportunity to capitalize on this phenomenon. Similarly, prices will often rally gradually

with increasing volume. As prices begin to reach a peak, trading volume will typically taper off. This

is a signal that many short sellers look for to initiate a trade. When a reversal does occur, there will

typically be more momentum than the corresponding up move. Volume will increase throughout

the sell-off until the prices reach a point in which sellers begin to back off.

Fundamental Analysis

Speculators attempt to forecast future price movements based on a combination of fundamental

factors. Predictions are often based on economics, politics, and statistical studies of supply and

demand factors. The use of fundamentals in price forecasting requires traders to have an in-depth

knowledge of a particular market.

Basic Technical Analysis

Technical analysis is the study of historical prices in an attempt to predict future price movements.

There are two basic components to which technical analysis is based on: prices and volume. Use

of indicators that incorporate these two components exploit the impact of supply and demand in

the marketplace.

Due to the nature of the FOREX markets, positions are normally short lived. For this reason entry

and exit points are crucial for success and must be based on various technical analysis tools.

While fundamental analysis focuses on what “should” happen, technical analysis is based on what

“has” happened.

Identifying the overall trend, whether it is short term or long term, is the most elementary element

of trading with technical analysis. A weekly or monthly chart should be used to identify a longer-

term trend, while a daily or intraday chart must be used for examining the shorter-term trend. After

determining the direction of the market, it is important to identify the time horizon of potential

trades and apply those strategies to the appropriate trend.

Support and Resistance

In their simplest form, support and resistance act as the floor and ceiling of a current trading

channel. Theoretically, this is the price at which the market should reverse its direction.

Resistance is a price level above the current market price. At this level, selling pressure should be

strong enough to overcome the buying. As a result, prices will likely experience a reversal of an

uptrend. Similarly, support is a price level below where the market is currently trading. At support

levels, buying interest should deter a down trending market. If the market price penetrates support

or resistance, the levels may reverse. For example, if the market breaks out to the upside above

levels of resistance, new support will be at the previous resistance.

Support and resistance can be identified by recurring prices. If the market reaches a certain

threshold before reversing, and then repeats the pattern, this would fit the criteria. Perhaps the

biggest advantage of support/resistance identification is to determine advantageous entry and exit

points. For example, if the market is approaching support and it seems unlikely that prices will

have enough momentum to penetrate below this level, traders should look for a long entry.

Averages

One of the easiest indicators to understand is the moving average. Although there are variations,

the moving average shows the average price of a currency over a specified period of time. Most

traders opt to use moving averages to supplement other indicators; however, it may be useful to

combine the use of MA’s with different time frames. Buy signals are usually triggered when the

shorter-term average crosses the longer-term average. Sell signals occur when the shorter

averages crosses below the longer one. Uses of such indicators are based on the premise that

“the trend is your friend.”

Pivot Points

The definition of a pivot point is the average of the high, low, and settlement price. Pivot points are

primarily used as support and resistance levels. The primary Pivot Point acts as the best

support/resistance level. Many traders use pivot points in intra-day trading, even many that don’t

trade according to pivot points keep track of them as a way to predict the transactions of other

traders. These points can be calculated using the following formulas:

Pivot = (H+L+C)/3

R1 = 2P-L

S1 = 2P-H

R2 = (P-S1)+R1

S2 =P- (R1-S1)

R3 = (P-S1)+ R2

S3 = P- (R2-S1)

Resistance Level 2: The market often sees significant resistance at this price level. Price

movement above R2 is normally in a strong trend and will often continue higher (during the

session).

Resistance Level 1: Prices often reverse at R1, penetration of this point may lead to a substantial

rally (during the session).

Primary Pivot: The strongest of S/R level, prices will normally trade above or below this area

before breaking in one direction or the other. Beware of false signals, it is often advantageous to

wait for a few shake-outs before entering the market. If the market is above the Primary Pivot, be a

buyer on dips. If the market is trading below this level, get short following a rally.

Support Level 1: Prices tend to reverse at S1, if the market successfully breaks the S1 a

substantial sell-off may follow (in the trading session).

Support Level 2: Prices often see strong support at S2, a break below this level typically signifies a

strong trend, and the market often continues to fall lower (in the trading session).

Price Volume Rules

Increasing volume in a rising price environment signals excessive buying pressure and could lead

to a substantial advances.

Increasing volume while prices are falling may signal a bear move.

Decreasing volume while prices are climbing may indicate a plateau, and can be used to predict a

reversal.

Decreasing volume with a weaker price environment shows that fresh sellers are reluctant to enter

the market and could be a sign of a future downtrend.

Excessive volume while prices are high indicates that traders are selling into strength and often

creates a price ceiling.

Excessively low volume while prices are low indicates that traders are buying on weakness and

often creates a floor.

While many financial scholars insist that technical analysis is a waste of time, history is an

undeniable resource. Analyzing charts can be looked at as a roadmap to success. It is obvious

that past events do not guarantee future price movements, but identifying and understanding

recurring patterns can be helpful in speculation.

It is a worldwide cash

inter-bank market

using as floating

exchange rate system

to trade spot market

currencies.

Leverage can be seen

as a free short-term

credit allowance,

allowing traders to

purchase an amount

of currency

exceeding that of

their account

balance.

Although there are

variations, the

moving average

shows the average

price of a currency

over a specified

period of time.

Futures Traders Helping Future Traders