Eight (8) Basic Forex Market Concepts

You don't have to be a daily trader to take wholesomeness of the forex market—every time you travel overseas and mart your money into a foreign currency, you are participating in the foreign exchange, or forex, market. In fact, the forex market is the quiet giant of finance, dwarfing all other wanted markets in its world.

Despite this market’s overwhelming size, when it comes to trading currencies, the concepts are simple. Let’s take a squint at some of the vital concepts that all forex investors need to understand.
Eight Majors

Unlike the stock market, where investors have thousands of stocks to segregate from, in the currency market you only need to follow eight major economies and then determine which will provide the weightier undervalued or overvalued opportunities. The pursuit eight countries make up the majority of trade in the currency market:

    United States
    Eurozone (the ones to watch are Germany, France, Italy and Spain)
    Japan
    United Kingdom
    Switzerland
    Canada
    Australia
    New Zealand

These economies have the largest and most sophisticated financial markets in the world. By strictly focusing on these eight countries, we can take wholesomeness of earning interest income on the most creditworthy and liquid instruments in the financial markets.

Economic data is released from these countries on an scrutinizingly daily basis, permitting investors to stay on top of the game when it comes to assessing the health of each country and its economy.
Yield and Return

When it comes to trading currencies, the key to remember is that yield drives return.

When you trade in the foreign mart spot market (where trading happens immediately or on the spot), you are unquestionably ownership and selling two underlying currencies. All currencies are quoted in pairs, considering each currency is valued in relation to another. For example, if the EUR/USD pair is quoted as 1.2200 that ways it takes $1.22 to purchase one euro.

In every foreign mart transaction, you are simultaneously ownership one currency and selling another. In effect, you are using the proceeds from the currency you sold to purchase the currency you are buying. Furthermore, every currency in the world comes tying with an interest rate set by the inside wall of that currency's country. You are obligated to pay the interest on the currency that you have sold, but you moreover have the privilege of earning interest on the currency that you have bought. For example, let’s squint at the New Zealand dollar/Japanese yen pair (NZD/JPY). Let’s seem that New Zealand has an interest rate of 8% and that Japan has an interest rate of 0.5% In the currency market, interest rates are calculated in understructure points. A understructure point is simply 1/100th of 1%. So, New Zealand rates are 800 understructure points and Japanese rates are 50 understructure points. If you decide to go long NZD/JPY you will earn 8% in annualized interest, but have to pay 0.5% for a net return of 7.5%, or 750 understructure points.

The forex market moreover offers tremendous leverage—often as upper as 100:1—which ways that you can tenancy $10,000 worth of resources with as little as $100 of capital. However, leverage can be a double-edged sword; it can create massive profits when you are correct, but may moreover generate huge losses when you are wrong.

Clearly, leverage should be used judiciously, but plane with relatively inobtrusive 10:1 leverage, the 7.5% yield on NZD/JPY pair would translate into a 75% return on an yearly basis. So, if you were to hold a 100,000 unit position in NZD/JPY using $5,000 worth of equity, you would earn $9.40 in interest every day. That’s $94 dollars in interest without only 10 days, $940 worth of interest without three months, or $3,760 annually. Not too shabby given the fact that the same value of money would only earn you $250 in a wall savings worth (with a rate of 5% interest) without a whole year. The only real whet the wall worth provides is that the $250 return would be risk-free.

The use of leverage basically exacerbates any sort of market movements. As hands as it increases profits, it can just as quickly rationalization large losses. However, these losses can be capped through the use of stops. Furthermore, scrutinizingly all forex brokers offer the protection of a margin watcher—a piece of software that watches your position 24 hours a day, five days per week and automatically liquidates it once margin requirements are breached. This process ensures that your worth will never post a negative wastefulness and your risk will be limited to the value of money in your account.
Carry Trades

Currency values never remain stationary, and it is this dynamic that gave lineage to one of the most popular trading strategies of all time, the siphon trade. Siphon traders hope to earn not only the interest rate differential between the two currencies (discussed above), but moreover squint for their positions to fathom in value. There have been plenty of opportunities for big profits in the past. Let’s take a squint at some historical examples.

Between 2003 and the end of 2004, the AUD/USD currency pair offered a positive yield spread of 2.5%. Although this may seem very small, the return would wilt 25% with the use of 10:1 leverage. During that same time, the Australian dollar moreover rallied from 56 cents to tropical at 80 cents versus the U.S. dollar, which represented a 42% appreciation in the currency pair. This ways that if you were in this trade—and many hedge funds at the time were—you would have not only earned the positive yield, but you would have moreover seen tremendous wanted gains in your underlying investment.

The carry trade opportunity was also seen in USD/JPY in 2005. Between January and December of that year, the currency rallied from 102 to a high of 121.40 before ending at 117.80. This is equal to an appreciation from low to high of 19%, which was far more attractive than the 2.9% return in the S&P 500 during that same year. In addition, at the time, the interest rate spread between the U.S. dollar and the Japanese yen averaged around 3.25%. Unleveraged, this means that a trader could have earned as much as 22.25% over the course of the year. Introduce 10:1 leverage, and that could be as much as 220% gain.

Japanese Yen Composite, 2005.  

Carry Trade Success

The key to creating a successful carry trade strategy is not simply to pair up the currency with the highest interest rate against a currency with the lowest rate. Rather, far more important than the absolute spread itself is the direction of the spread. In order for carry trades to work best, you need to be long in a currency with an interest rate that is in the process of expanding against a currency with a stationary or contracting interest rate. This dynamic can be true if the central bank of the country that you are long in is looking to raise interest rates or if the central bank of the country that you are short in is looking to lower interest rates.

In the previous USD/JPY example, between 2005 and 2006 the U.S. Federal Reserve was aggressively raising interest rates from 2.25% in January to 4.25%, an increase of 200 basis points. During that same time, the Bank of Japan sat on its hands and left interest rates at zero. Therefore, the spread between U.S. and Japanese interest rates grew from 2.25% (2.25% - 0%) to 4.25% (4.25% - 0%). This is what we call an expanding interest rate spread.

The bottom line is that you want to pick carry trades that benefit not only from a positive and growing yield, but that also have the potential to appreciate in value. This is important because just as currency appreciation can increase the value of your carry trade earnings, currency depreciation can erase all of your carry trade gains—and then some. 

Getting to Know Interest Rates

Knowing where interest rates are headed is important in forex trading and requires a good understanding of the underlying economics of the country in question. Generally speaking, countries that are performing very well, with strong growth rates and increasing inflation will probably raise interest rates to tame inflation and control growth. On the flip side, countries that are facing difficult economic conditions ranging from a broad slowdown in demand to a full recession will consider the possibility of reducing interest rates. 

The Bottom Line

Thanks to the widespread availability of electronic trading networks, forex trading is now more accessible than ever. The largest financial market in the world offers vast opportunities for investors who take the time to get to understand it and learn how to mitigate the risk of trading here.