A Beginner’s Guide to the Foreign Exchange Markets

The world’s largest marketplace can certainly be intimidating. The $3.98 trillion in daily turnover can overwhelm the uninitiated. However, to the informed investor, the magnitude and scope of the foreign exchange markets represent limitless opportunity.

The foreign exchange markets exist primarily for currency conversion. Anytime an international transaction takes place, the purchaser has to pay for the goods or services in the currency demanded by the supplier and therefore will often have to exchange one currency for another. Foreign exchange markets also allow governments and central banks to tighten or expand the supply of their nation’s currency. Many banks, hedge funds, and individual traders also use the foreign exchange markets for speculation. Many fortunes have been made by these investors; with a marketplace so big, the opportunities are endless.

Currencies are traded in pairs. One currency is quoted in terms of another. For example, EUR/USD represents the dollar price of €1. The first term is known as the “base currency” and always equals one unit. With the exception of the Japanese yen, currency prices are quoted to four decimal places. The smallest unit that a currency can therefore move, .0001, is known as a “pip.” As with most financial markets, prospective buyers post bids, and sellers post asking prices. The difference between the two prices, known as the spread, is often shown right after the quoted price. A full quote would therefore be stated as EUR/USD = 1.3700/05. Currencies generally move very little in a day; a usual daily range for most currencies is between 100 and 150 pips per day. Because of this relatively low volatility, large amounts of leverage are very common.

As with all things economic, supply and demand govern the price of the given currency. An increase in the supply of a currency will cause a drop in its price while an increase in the demand for a currency will cause an increase in price. Investors try to take advantage of disparities in the pricing of a currency as it adjusts to changing conditions. Investors closely watch news releases involving economic data such as gross domestic product, unemployment, inflation and interest rates. The strength of a country’s economy will be reflected in its currency. Higher production and employment numbers are a sign of strength and will therefore lead to higher demand for the currency. Higher inflation, or a decrease in purchasing power, corresponds to a decrease in the value of the currency. Interest rates essentially represent the domestic price of money and therefore have a significant effect on the price of a currency relative to others. Changes in interest rates also usually signal a deliberate attempt by a central bank to increase or decrease the money supply. The Federal Open Market Committee determines the bank rate in the U.S., and any news from the Committee’s meetings is watched very closely by currency traders. Market psychology can also be very important in determining exchange rates. Uncertain political conditions cause investors to move away from the source of unrest and toward more stable currencies.

Many investors also closely watch technical indicators. This type of analysis, known as charting, involves finding and reacting to patterns and trends that form on the charts of many currency pairs. Technical analysis can be simple: identifying major trend lines, levels of support and levels of resistance. However, technical analysis is often very involved. For example, some theories of technical analysis include Fibonacci retracement, Bollinger bands and stochastics.

In order to begin trading in the foreign exchange markets, the first step is to find a broker. There are many options when it comes to brokerage firms; the important thing is to find one that matches your needs. One feature to insist on from your brokerage firm is a free practice, or paper trading, account. Paper trading allows beginners to learn how trading works and develop confidence in their strategies before risking real money. Being patient in the beginning and spending a sufficient amount of time paper trading can prevent some very costly mistakes. With enough practice and experience, you can make the most of the opportunities in the world’s largest marketplace.