Around forty years ago, my lifelong obsession with trading and markets began when I started work in the interbank forex market. Even after all these years, I can remember all too well what I felt during my first few weeks in a dealing room, and it was mainly confusion. There was no formal training program back then, at least not at the firm where I worked, and trainees were just expected to absorb knowledge and ask the right questions.
But for those looking to trade forex from home these days, who don’t have direct contact with the ten- or twenty-year veterans whose brains you can pick, a basic explanation of what forex is and how it works is needed. No market should be entered blindly, but forex, with its large amounts of leverage, can be particularly harmful to your wealth if you don’t understand the basics of the market.
The following are some of the things that everyone should understand before getting involved.
What is Forex?
The word “forex” is a shortening of the term “foreign exchange,” or the trading of currencies. Although we usually think of our own currency in terms of the goods and services it buys in our country, each currency also has a value relative to others. It used to be that the exchange rate between most currencies was fixed, either by deliberate policy as it is now in some cases like China, or by the fact that the currency’s value was tied to the country’s reserves of gold. That all changed in 1971 when Richard Nixon took the bold step of taking the Dollar off the gold standard and allowing its exchange rates to be set by freely traded markets. Other countries quickly followed suit, and the forex market as we know it was born.
The forex market is not one physical entity with the equivalent of a stock exchange. It is a product of pricing and trading by individuals and institutions around the world. It never closes, although trading at certain hours of the day and on certain widely observed holidays can be very thin, with relatively big gaps between traded prices. It is fast moving, and generally employs a lot of leverage, making it potentially very rewarding for traders, but also potentially very dangerous.
The most important thing to understand about forex initially is the concept of currency pairs. When you buy one currency, you pay for it with another, so when you execute a forex trade, you are actually trading in two currencies. Those currencies are typically represented by three letter abbreviations such as USD for the US Dollar, EUR for the Euro, GBP for the British Pound, and YEN for the Japanese Yen. A full list of those abbreviations can be found here.
In a forex trade, when you buy one thing, you simultaneously sell another, and that has important implications for traders. First, it means that your analysis must include more than one currency. If you think the Dollar is going to gain in value, for example, you must decide against which paired currency those gains will be maximized.
Second, it means that when you have an open forex position, you are almost always short of one currency. In effect, that is an overdraft, so banks and brokers will charge you interest on that shortage until you square the position. On the flip side, you may earn interest on the currency that you are long in, for the same period of time.
Interest Rates and the Carry Trade
Most forex trades are left open for short periods of time, making that difference non-existent or so minimal as to be irrelevant. However, for major players in the interbank market who trade in tens of millions of dollars, even a position left open overnight can have a big impact on the bottom line. That is important to understand because it explains one of the biggest movers of the forex markets: interest rate moves.
When a central bank raises rates, it makes their currency more attractive to forex traders because they get a better return if they buy and hold it, and they pay less interest if they sell it short. Logically enough, more people looking to buy and hold a currency means its price relative to other currencies will increase: higher interest rates mean higher forex rates. If the difference is large enough that the currency you buy has a higher interest rate on deposits than the one you sell charges on shortfalls, then you can, in theory, hold that position indefinitely and make money overall every day interest is assessed. That is what is known as a “carry trade.”
Despite that, interest rates aren’t the only thing that moves forex markets. Just as important is the state of the economy of the country whose currency is being traded, both now and what is expected in the future. Again, that is on a relative basis. In late 2022 and early 2023, for example, after most central banks around the world had been raising rates for a while, the data began to show that the U.S. economy was absorbing those rate hikes better than most countries, and the Dollar gained ground against almost every other currency.
Then there is the short-term influence of charts and technical signals. Most forex trading is done intraday, with positions run for a very short time. While rate differentials and economic strength are the most important fundamental movers of a market over time, intraday moves within those longer-term trends are usually driven by technical factors ranging from simple support and resistance levels to much more advanced analyses based on things like momentum or relative strength.
As you can tell from everything I’ve written so far, trading in the forex market is not simple. In fact, I would go so far as to say that, in many ways, it is the most difficult market for the average trader. Still, a huge number get involved every year, drawn to it by low account funding requirements and potential for big profits. There is nothing wrong with that. I know better than most that a grounding in the complex and often dazzlingly fast forex market can set you up for trading other things successfully later in life, so I wouldn’t try to dissuade you.
What I would say, though, is that you should make sure you understand as much about it as you can before committing real money to it. Know what moves markets, keep abreast of economic news, and understand at least some basics of chart reading and you can get involved in the market that I still see as the most important and purest there is.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.