Post by Mr Oakmont on Sept 2, 2016 22:31:10 GMT -8
How Forex Works
Supply and Demand
In economics, supply and demand is a model that explains price formation in a free competitive marketplace. The price of goods is settled at a point where the quantity demanded by consumer is balanced by the quantity supplied by producer.
Let's say, you are out there one day doing grocery shopping. You need apples and there happens to be only a single vendor with just the right amount of apples. You negotiate, agree on the price and make the exchange - a set amount of money for a set amount of apples. Both you and the vendor made a trade, getting what you wanted. The next day you are out there again looking to buy the same amount of apples, only now there are two vendors, both having the amount of apples you need. This means that there is higher supply of apples then there is demand for them. The competition between vendors will push the price of apples down since both of them realise you will probably go for the cheaper apples, assuming all other things are equal. A new price will be set and you will make a deal with whichever vendor you see fit. Alternatively, if that day you came with a friend who is also interested in apples, but only one vendor was there, there would be more demand for apples than supply. A vendor would recognise this and up the price of his apples, knowing that both you and your friend will definitely buy all of his apples.
This is the ABC of economics and it is absolutely vital that you, as an aspiring trader, understand the simple logic of how does this little apple-market works, since it will help you understand how the Forex market works.
Things may start to get more complicated from here on. Applying the apple market scenario to the foreign exchange market, every time a particular currency is bought, surplus demand is created on the market, throwing the price off balance and pushing it higher. Similarly, every time a particular currency is sold, a surplus supply is created, again, throwing the price off balance and pushing it down. The amount of impact is directly proportionate to the trading volume per deal. Big players, like national banks, for example can cause a lot of disequilibrium by tampering with the supply of their home currency. Small players, like retail traders can only influence the market ever so slightly, but still do through their sheer numbers.
The ever-changing supply and demand of currencies is what makes Forex charts tick. The philosophy of price balancing is key to understanding how online Forex trading works, since all the economic events in the world are relevant to the market only in terms of how much they influence the supply and demand of an asset. Or, it is worth mentioning, how much they influence the projected supply and demand of an asset.
Using our apple market as an example, if one of the apple vendors went bankrupt this season, both you and your friend can expect the price of apples to rise before you even show up at the market.
What does any of this have to do with the powers that be?
Forex is the currencies market, as you should be aware by now, and currencies, unlike most other tradable assets, are economic tools as much as they are economic indicators. Roughly speaking, if countries were companies, currencies would be their stock.
Policy makers at central banks are the biggest tweakers of money supply, which makes their monetary policy decisions a major price-influencing factor on Forex trading and how it works.
The most obvious and simple example would be the interest rates set by the national bank of every country in the world that has one. Since the US dollar, euro, British pound and Japanese yen are the most traded currencies in the world, the Federal Reserve Bank, European Central Bank, Bank of England and Bank of Japan are respectively the biggest fish in the ocean.
Understanding how this can affect the economy will help you understand, how the Forex market works.
When interest rates are increased, and they can be solely on the national bank's word, it gets more expensive for market participants to borrow that currency from that bank. Momentarily, this causes a shortage in currency supply and pushes the currency price up. Which is a good thing, right? Who wouldn't want a strong national currency? Well, not really. Short term, this means less money to play with for business developments, less expendable household income and, ultimately, a slower rate of economic growth. However, this slows down inflation and slows down the inevitable build-up of debt, which in the long term is a very good thing.
Alternatively, when interest rates are cut all market participants borrow more money. Momentarily, a surplus money supply is created and the currency price goes down. Short term, this means business expansions, increased household spending and a growing economy. Sounds really good? Well, again, not really. The more money that is borrowed means the more money that is owed. Over the long term, the accumulated bank credit comes down on everybody's head like a big storm creating a financial crisis. This is called the macro economic cycle.
This pinnacle is common to all capitalistic-type economies. National banks are continually trying to balance the scales by periodically raising and lowering interest rates. This is called the micro economic cycle. These economic cycles are much like climate change cycles - slow, unstoppable and very dangerous to the market participants that can't see them coming.
How does Forex trading work from a practical standpoint?
A currency value is measured through how much of another currency it can buy. This is called a price quote. There are always two prices in a price quote - bid and ask. The ask price is used when buying a currency, while the bid price is used when selling. Note that the ask price of any financial instrument is at all times higher than the bid price. Thus, a bank will always buy your currency a bit cheaper and sell it to you at a higher rate. The difference between bid and ask is called the spread.
Both bid and ask prices are communicated between market participants almost instantaneously at all times except when the market is closed. A trader receives quotes via the internet from the brokerage firm who provided the trading account for him. In turn, the broker firm receives price quotes from its liquidity providers - banks. Generally speaking, the more liquidity, the tighter the spread, which is better for everybody. Usually, trading is ongoing, conducted smoothly and liquidity is plentiful. However, there are times, like during major news releases, when price gaps occur due to major price shifts over the shortest periods of time.
The rest is simple Forex mechanics. Trading takes place on the chosen Forex platform at the click of a mouse. When, for example, a buy order is placed on EUR/USD pair, a portion of funds from the trader's account is used to purchase the pair's base currency - in this case the euro, and sells the pair's quoted currency - US dollar. The broker does this and it is called placing a buy order. The order is placed either with the broker (Market Maker) or communicated directly to the Forex interbank market (ECN execution), where the big players are. It is important to understand that a trader can place an order to sell a currency that he does not 'own'.
Next, depending on the trading strategy, a trader waits until the purchased currency grows in value, relative to the sold one. When the accumulated profit is satisfying to the trader, he closes the order and the broker does the opposite set of transactions - sells euros and buys dollars. A reverse process takes place when a trader places a sell order.
The concepts of buying and selling in Forex can be confusing at first, since in every trade one currency is exchanged for another, meaning there is always both buy and sell in every trade. For a beginner trader, it might be easier to think of a currency pair as an abstract financial instrument to which a price is assigned by the market.
Currency trading
If you follow the value of a currency, such as the American dollar (USD), you will know that daily currency movements are usually very small. Most currency pairs, on average, move no more than 1 cent per day, which is less than a 1% change. Therefore, to make a respectable return, many currency traders rely on the use of leverage (using margin) to increase their potential returns for small moves in the exchange rate. In the retail forex market, leverage can be as high as 200:1 if you're trading with less than $50,000 or as low as 50:1. For example, to trade $200,000 worth of currency, if the broker is requiring 1% margin, you would only need $2,000 deposited to your account – giving you leverage of 100:1. This is not as risky as it sounds, because currencies don't fluctuate as much as stocks. (Learn to cut out losses quickly, leaving profits room to grow.
The availability of leverage, and massive size of the market and the ease of making fast transactions has increased the popularity of the forex market. Positions can be opened and closed instantaneously at the exact price shown to you, and typically with no commission or transaction fees. Also, unlike the stock market, in which one large buyer or seller can adversely move the stock price, currency prices are much harder to manipulate because the sheer size of the market prevents any one player from significantly moving the currency price. Currency prices are largely based on supply and demand.
Another reason why forex is so popular with traders is because the market is open 24 hrs, meaning you can choose when you want to trade – regardless of whether you're a early bird or night owl.
The very popular forex market also provides plenty of opportunity for investors. However, in order to trade profitably in this market, currency traders have to take the time to learn about forex trading and dedicate enough time to practice what they've learned.
