Few forms of investment are advertised as intensively as Forex. This is a difficult and dangerous market where you can make a fortune and quickly lose one.
What is Forex?
Forex is short for Foreign Exchange Market. In short, it is a gigantic worldwide currency exchange shop. But there is no one entity in charge of Forex. The platform operates on the interbank market and is accessible through brokers.
According to the information of the Bank for International Settlements, daily Forex transactions reach 5.3 trillion dollars. This is big money, although most of it is not covered with cash (which we will discuss in a moment).
The currency market is open 24 hours, five days a week. Trading starts on Sunday at 11 PM Polish time when Australians start (it is 8 AM Monday morning in Australia) and ends at 11 PM on Friday when Americans finish (it is 5 PM in New York).
Forex is used to trade currencies, specifically currency pairs. You can also trade futures contracts for exchange indexes, raw materials, etc., but most transactions cover currencies (about 80% for the EUR/USD pair alone) and, since this article is for beginners, this is what I will focus on.
The currencies on Forex are specified by three-letter abbreviations, which are rather easy to deduce. Every transaction is made on a currency pair, which takes on e.g. EUR/USD format. The currency in front of the slash (in this case, the euro) is called the base currency. The currency following the slash (in this case, the US dollar) is the quote currency. Keep these terms in mind because they will come in handy later.
You can go either long or short on every currency pair. Long position means that you are buying the first currency for the second one. Short position means that you are selling the first for the second one. In other works, by taking long position on EUR/USD you are buying euros for dollars and by taking short position you are selling euros for dollars.
The currency pair values are presented in a table, much like in an exchange shop. And, just like in an exchange shop, you can see the spread (the difference between the purchase and sale price). For example, as I am writing this column, the pair of EUR/USD has the purchase price (Bid) of 1.13120 and the sale price (Ask) of 1.13150. Please note two things here. First of all, the price is listed to the fourth decimal point (even to the fifth for “majors”, the main currency pairs). Second, the spread is much smaller than in a traditional exchange shop. These numbers mean that you will pay 1.13150 dollars for every euro you buy.
Merchants Feed Error: This is not a valid RSS 2.0 Feed
But what if your account is limited to the Polish currency? In this case, you are unfortunately exposed to a double spread. Your currency will first be converted into dollars according to the spread of the USD/PLN pair to allow for transaction in the USD/EUR pair.
Pips, lots, and leverage
The Forex market uses plenty of terms not used anywhere else. Let’s start with lots.
Lot is simply the basic trading unit on Forex and its value corresponds to 100 thousand units of the base currency, i.e. 100 thousand euros for the EUR/USD pair. For convenience and to reduce risk, you can also trade in minilots (10 thousand units of the base currency) and microlots (1 thousand units of the base currency). And so, you need to buy one microlot in order to open a long 1 thousand euro position on the EUR/USD pair.
Losses and profits are often presented in pips. What are pips? They are the fourth decimal points corresponding to the minimum price movement in pairs with value presented to the fourth decimal point. If you go long on EUR/PLN at 4.16030 and close it at 4.17590 (move of 1.56) you make 156 pips. All right, but how much does that give in PLN?
It all depends on the value of the position. And this is where the financial lever, the essence of Forex, comes into play. All brokers let you open positions, which are multiple times higher than the deposit. The leverage depends on liquidity of the currency pair (the more liquid the pair, the higher the leverage) and the broker. The leverage on less popular pairs is 1:25 (which means that with a deposit of PLN 400 you can open a position with value corresponding to PLN 10 000). It can reach 1:100 on the more popular ones (but there are some aggressive brokers who go as high as 1:1000).
But let’s return to the hypothetical transaction on EUR/PLN. You go long on a minilot (i.e. 10 thousand euros. The opening rate is 4.16030, which means that you will need PLN 41 603. Since you are using 1:100 leverage, all you need is a deposit of PLN 416.03 (most brokers do not permit you to engage 100% of your capital in a single transaction, but we will go into the details later). The pip value for a minilot is PLN 1 (it would be PLN 0.1 for a microlot and PLN 10 for a lot). In the example presented above, you come out with profit of 156 pips, or PLN 156. This means that the (approximate) profit on the invested capital is 156/416.03 = 37.5%. Not bad, right?
Risk on Forex
And things are great as long as you keep making the right decisions. But what happens if the currency moves the other way? All it would take for you to lose all of your invested capital is a loss of 416 pips (a drop by PLN 0.0416 PLN, by only one percent). And if the movement is greater, the losses can be greater as well.
Most brokers protect themselves from such situations by reserving the right to automatically close the position before this happens. But when the Bank of Switzerland stopped protecting the frank a few weeks ago the market went crazy. Polish holders of credits in franks saw their rates rise, but some Forex investors were left with debts reaching as high as several hundred dollars. Brokers were unable to close the positions because no one on the market was opening opposing ones, chaos ensued, and some people ended up with lifelong debts. This is obviously an extreme situation, the likes of which occur only once every decade or so, but the risk is real.
According to the Polish Financial Supervision Authority, 81% of Forex clients lost all of their deposited capital in 2013. And what about those who experienced “common” losses? Financial leverage is a capricious tool and, as always, a perspective of greater profit entails a greater risk of loss.
Every position opened on Forex must be counterbalanced with an opposite position. In other words, when you buy a minilot for PLN, someone has to sell the minilot. PLN offers relatively low liquidity and it is often the case that the one opening the opposite position is your own broker. And everything will be fine as long as he secures it by opening the opposite (your) position in some cooperating bank to actually insure the transaction. But if he does not (and some less than honest brokers never do), a major conflict of interests emerges, because your loss is the broker’s gain. Before you start investing, make sure that you have an honest broker.
Most brokers offer demo accounts, which you can use to learn about Forex operations and trade “virtual” currency. But don’t be fooled. When you start playing with real money, your mindset will change completely. Demo results mean nothing.
Please note that Forex is more than just speculation. When used right, it allows for e.g. hedging, which is protection of e.g. holders of credits in currencies from currency risk. But most users tend to dive into leverage and speculation in hope of turning a quick profit.
Forex is kind of like poker. You have considerable influence and you can make money by playing the game the right way. But you have to remember that most poker players are just there to supply tokens for the more experienced ones.
Fot. epSos .de, Flickr.com, CC BY 2.0