Forex Trading Course: Chapter 1: What is forex trading and how does it work?

What is The Forex Market?

The Forex market is an acronym of The Foreign Exchange Market also called The Currency Market.

What is traded in the Forex Market?

Money, as simple as that!

Currencies are bought and sold freely. This is the simultaneous buying of one currency and the selling of another.

For instance, you have some inside information that leads you to think that the Euro will go up, you want to buy the Euro pair (or EUR/USD). When you buy the EUR/USD pair you are actually buying the EUR and selling the US dollar. When you buy the EUR it is also said that you are “long” the EUR. When you sell the EUR it is also said that you are “short” the EUR.

More than 80% of the volume is generated by what we call the seven major currencies:

 The US dollar (USD)
 The Euro (EUR)
 The British Pound (GBP)
 The Swiss Franc (CHF)
 The Canadian dollar (CAD)
 The Australian dollar (AUD)
 The Japanese Yen (JPY)

When did it at all start?

You could not say it all started after a sole event. A series of events happened and in the end it resulted in the Forex market, as we know it today.

It all started when the Bretton Woods agreement was finally abandoned around 1971.

In this agreement, participating countries had their currency pegged to either the gold or the US dollar. By 1973 the most powerful countries around the globe introduced a free exchange rate regime where they let their currencies fluctuate driven by the market or more precisely by the forces of supply and demand. It was then when the Forex market was available to speculate, hedge as well as other reasons.

It was not until 1997 when the Forex market became available to individual investors and traders through online trading capabilities and leverage (margin trading), offering traders around the world great opportunities to profit from the Forex market.

The Forex market is now the most liquid financial market of the world, with a generated volume of nearly 2 trillion US dollars (source: BIS) on a daily basis (more than all other US financial markets combined).

Where do all trades take place?

Unlike other financial markets, there is no physical location where all trades take place in the Forex market. All transactions are conducted via telecommunications (phone, online platforms, etc.) between banks, large institutions, investors, trader, etc.

This is called an Over the Counter market or OTC.

How does the Forex Market move?

I wish there is an easy answer that we can come up with. Like a special report titled “the 20 attributes of EUR/USD” or something alike. But the matter of the fact is there isn’t a simple answer for this question. But then the key to understanding the market lies within the principles, not the actual answer itself.

Let me explain…

Every currency pair moves differently. Every single pair has its own personality, or in this case, their own daily ranges, support/resistance levels, and/or market shares. The key to become a successful trader is to understand and trade only a few currency pairs that you feel comfortable with.

When we look at the chart of a currency pair, we can see the history of HOW does the particular currency pair moves, and when we start to look at the same chart in a longer time compressions, such as the 4H to the Weekly charts, we can see HOW it moves in a longer term. However, this still does not answer HOW it moves, but only shows you how it moved in the past.

The best exercise to understand how a particular currency pair moves is to do a scalping exercise. Get out a sheet of paper and start looking at only one currency pair, EUR/USD for example, and use only a simple candlestick chart or just by looking at the prices, then try to enter 100 trades going for 30 pips of profit with 30 pips of stop loss. In about a week’s time, you should have developed some kind of understanding to EUR/USD. You’ll learn to see that:

• Usually a bullish day will be followed by a bearish day. (If you have an extreme bullish day, then the next day you might see extreme retracement or continuation of bullish momentum, vice versa)
• Movements are usually retraced around 7:30am and 11:30am NY Time.
• EUR/USD usually moves within a range of about 1% its current value.
• Certain price points, such as 50 and 00, tend to support or resist market continuation.

Every currency pair differs from the other; for example, GBP/USD tends to make major moves then retraces up to 70% of its move, whereas EUR/USD might only retrace a small portion in comparison. The key to become a successful Forex trader is to learn your currency, learn to spot its characteristics and use them to your advantage. This “feeling” that you develop will give you an edge in trading.

Some of the best traders that I know only trade one currency pair. As a matter of fact, professional bank traders generally only concentrate on one currency pair, with different traders focusing on different pairs. There must be a reason why they do what they do; it is only wise that we learn to do the same.

Learn to identify the daily movement ranges, key support and resistance areas, and correlation to other currencies…

Correlation is defined as the degree to which economic variables are observed to move together. If they move in the same direction, then there is positive correlation; if they move in opposite directions, then there is negative correlation.

For example, let’s say that EUR/USD has a negative correlation of -93.0 with USD/CHF. Basically it means that if EUR/USD moves up about 100 pips, USD/CHF will move down 93 pips. Below is a side-by-side 1-hour chart of EUR/USD and USD/CHF showing that both pairs are highly correlated… Although these 2 currency pairs do not move alongside of each other pip by pip, the final results in a given time period are very similar. And most of the times you will see USD/CHF (in real-time) making a major move first, then EUR/USD will follow. You won’t see it on a 1-minute chart, but you may see it if you compare a TICK by TICK chart.

Again, understanding how the Forex market moves is also to understand the correlation of each other. There is an excellent website, http://www.mataf.net/ that displays real-time Correlations between currencies in its Trading Tools area, and I strongly suggest that you visit.

Correlation Relationships can be used to confirm movements of currencies. In the previous example of USD/CHF making the first movement before EUR/USD follows suit, is not based just on a feeling or past history, but rooted in a strong fundamental principle. EURO makes up about 58% of the US Dollar Index and EUR/USD is responsible for about 50% of all activities in the Forex Market. USD/CHF, on the other hand, only covers 4% of all activities of the market. Since USD is the dominant currency, about 90% of the exchanges involve USD, when USD loses value (USD Index Drops), EUR/USD goes up. Since it takes much more to move EUR/USD (50%), we see USD/CHF (4%) making the move first on a general USD weakness.

Another important correlation relationship is EUR/USD, GBP/USD, and EUR/GBP. It is vital to watch the movements between these 3 currency pairs if you plan to trade any one of them. It is important to identify what is moving the market at the time, is it USD, EUR, or GBP? By keeping an eye on the EUR/GBP pair, you can validate or eliminate either currencies, and concentrate on the one that is making the most movement.

It would take a complete new book to fully cover the subject of correlation. But for the purpose of fundamental trading, just understand this fact that one currency cannot move far without affecting the other. Look at this simple calculation and see if you can notice the big picture.

(211.73 / 1.9945) = 106.15

Now do these numbers seem familiar?

GBP/JPY = 211.73 (BID)
Divided by GBP/USD at its current price of 1.9945 (BID)
You get the current price of USD/JPY at 106.15 (BID)

In essence, you can take any price you have on the GBP/JPY and divided in with USD/JPY, and you’ll get GBP/USD price at the time or multiply USD/JPY with GBP/USD and get GBP/JPY current quote.

Market is not perfect. Sometimes we will see slight discrepancies in pricing quotes, but one will not move far from the other. Therefore, when we see related pairs making strong moves one way or the other, it just gives us more confirmation of the direction.

Another interesting point, since GBP/JPY is about twice the value of USD/JPY, a single pip change of value in USD/JPY usually becomes 2 pips of change in GBP/JPY. If both USD/JPY and GBP/JPY are hitting support/resistance areas, then these support/resistance areas might just be stronger.

Important Concepts

Every currency pairs moves differently. Learn about daily ranges, support & resistance areas, and correlation to other currency pairs is key to understanding HOW they move. Use correlation as confirmation to your existing trades or the planning of your future entries. Limit your trading only to a few currency pairs, generally don’t trade more than 4 currency pairs. It is better to be focused on a few and know that you can catch most of the movements than to be focused on all and worry about missing out.