Understanding Forex in Two Words
Any time you own something you have risk that it will lose value. This is one of the primary reasons why markets come into existence. To understand this dilemma let me give you a hypothetical one billion units of a third world currency and ask you to take care of it for me.
How can you accomplish the objective of not letting this one billion units of third world currency depreciate? As you wrestle with this problem you will quickly come to appreciate that all multinational companies wrestle with this problem every single day. Specifically, it is called foreign exchange risk.
You very clearly know what the value of the currency is today, but you have no idea what its value will be in the future.
Forex can best be described in two words: Price Insurance.
The only way that you can protect the one billion units of third world currency that I asked you to take care of for me is by hedging your position in the marketplace. What does this mean? Well I gave you one billion units of third world currency which represents your cash position. To hedge that position, you would take an equal, yet opposite position in the forex market. The end result of this transaction, in theory, is that you would be safeguarding the original value you received.
Let say the cash asset goes down 10% over a three month period. On the cash position your ledger would show a 10% loss. But your forex position, SOLD 1 billion units of the same third world currency has a 10% gain. The Net effect of your action is that you’ve protected the purchasing power of your initial cash position. Regardless which way the market moves you are insured. You are hedged. If the market moves up, you make money on your cash position and lose on the forex position. If the market moves down, you lose money on the cash position but make money on the forex position.
Essentially this is what multinational companies try to do whenever they are transacting in other countries. They have no interest in assuming foreign exchange risk. So, the second they enter a transaction which creates a receivable for them, they use the forex market to hedge their exposure and protect their balance sheet.
Imagine you enter into a business deal today for one billion South African Rand. You are delivering a product to a company domiciled in South Africa. You know what the RAND is worth today, but the customer is not paying you for 60 days. Your profit margins are narrow. Whether you like it or not the second you enter this transaction there is counter-party foreign exchange risk. The only way to completely protect yourself on this deal is to take an equal and opposite position in the forex market.
Foreign Exchange is as old as countries. Whenever one country needed to trade goods or services with another country the need to exchange currencies was necessary. The currency market had been the domain of large financial institutions, central banks, corporations, hedge funds and extremely wealthy individuals. The internet has changed all of this, and now it’s possible for average investors to trade forex with a simple click of the mouse.
The majority of forex traders are unaware of price insurance being the main reason for the currency market coming into existence. Instead, forex traders serve the function of providing liquidity for this price insurance marketplace. Forex brokerage platforms offer forex traders very low margin requirements (also known as higher leverage) to be able to trade the underlying asset. Traders who like to chase higher yielding returns are immediately attracted to this feature. The forex marketplace however consists of primarily large hedgers who are trying to protect their receivables and speculators who are trying to profit from small price swings.
Most forex platforms allow you to open an account with as little as $100. While this might be a good starting point as you learn the market, most professionals are extremely well capitalized.
Leverage is created in forex trading because the forex broker gives traders CREDIT to use as they see fit. Some forex brokers will give you as much as 500 to 1 leverage which means that for every dollar you deposit you can control $500 of the underlying currency. This leverage is what makes forex trading exciting, dangerous, and highly speculative. Just because a forex broker offers you credit does not mean you have to utilize it.
The opportunity or risk in forex trading is created because even with a small $100 stake a trader can theoretically control currency basket that is valued at $10,000 to $50,000. While this is available most experienced traders have learned that managing their leverage is essential to long term success in trading.
Daily currency fluctuations are usually very small. Most currency pairs move less than one cent per day, representing a less than 1% change in the value of the currency. This makes foreign exchange one of the least volatile financial markets around. Thus, most currency speculators rely on the availability of enormous leverage to increase the value of potential movements. In the retail forex market, leverage can be as much as 500:1. This means that for every dollar they put in the account they can control up to $500 in the underlying asset. Higher leverage offers massive potential upside when a trader is correct on the direction of the market, but it can also be extremely risky. Because of 24/7, round-the-clock trading and deep liquidity, foreign exchange brokers have been able to make high leverage an industry standard in order to make the movements meaningful for currency traders. Trading positions can be opened and closed within minutes or can be held for months. All these features have helped spur on forex’s rapid growth and made forex trading an ideal high leverage trading instrument.
The foreign exchange market is traded in a unique manner when compared with other major financial markets like stocks. More specifically, currencies are traded and priced in pairs. When forex traders talk about trading the U.S. dollar, for example, they are really talking about trading the U.S. dollar ’ s relative value against another currency. Whenever you trade, price is always a ratio of exchange. In forex this reality becomes very clear because prices are always represented with many decimals. The most dominant foreign exchange pairs are:
USD = US Dollar
Euro = Euro
GBP = British Pound
JY = Japanese Yen
CHF = Swiss Franc
NZD = New Zealand Dollar
AUD = Australian Dollar
CAD = Canadian Dollar
These 8 pairs control a majority of the volume in the foreign exchange market. Each individual currency is matched against another currency to create a quote. The first currency in a currency pair is called the base currency, while the second currency is called the counter currency. For example, if you see the price of EUR/USD at 1.1755 this means that one EURO is worth $1.1755 U.S. dollars. If you calculate the inverse of this number, you will come up with the value of what each USD is worth in Euros. In this instance 1 divided by 1.1755 = .8507 cents.
There are more than 100 different kinds of official currencies in the world. However, most international forex trades and payments are made using the U.S. dollar, British pound, Japanese yen, and the Euro. The same is true for ALL currencies and all goods and services. They are valued in relation to other currencies. The process through which they find fair value is referred to as the price discovery mechanism in markets.
All currencies are quoted in pairs and the numerical value tells you how much of one currency is worth 1 unit of the other currency. Up to this point, pips have not been properly defined. An extremely important concept in foreign exchange trading, a pip is simply the smallest unit of price movement in the exchange rate of a currency pair. Pip stands for “percentage in point.” Traders trade forex to earn pips. Earned pips are the monetary reward for a good trade, while lost pips are the losses experienced for a bad trade.
Think about forex the next time you go shopping.
For example, if you go to the store and purchase one pound of cheese for $7.50, you are valuing cheese in relation to the US dollar.
The lens through which you are valuing Cheese becomes an analytical tool. If the next time you go to the store the price of cheese is $8.00 you have the most fundamental question in currency trading to confront? Did the cheese become more valuable because of a supply-demand imbalance? Or did the dollar simply get debased?
When the price goes up on an asset this is the question that all great traders and investors ask.
Over the last 50 years, we have seen gold rally from $35 an ounce to over $2000 per ounce. Was gold becoming more scarce? Or was the currency being debased? The answer is debasement was occurring.
While Gold is traditionally not viewed as a currency it can prove to be very valuable to price assets in Gold to determine historical values and benchmarks.
A few weeks ago I wrote an article titled “Scrutinizing Money”.
In that article, I shared examples of FIAT currencies that had suffered the ravages of massive inflation which destroyed the purchasing power of their paper money. Review those examples, so you can consider how you would navigate the trading landscape of having those currencies in your trading portfolio. The rewards can be beyond exponential, as can the risk. I highly recommend that you find and study the charts of those examples to be able to simulate how you would’ve traded those massive trends. These lesser-known currencies are referred to as the exotics because they have much less volume than the major currencies.
Forex trading will see more volatility today because the printing press of governments is running 24/7. This will ensure higher than normal volatility in the markets and create more opportunities for the educated forex trader. What is almost certainly guaranteed is that many smaller countries’ currencies will be debased very quickly in the post-COVID-19 environment.
It is exactly these types of scenarios that can create legacy fortunes for a forex trader.
Whenever you study and analyze forex there are a handful of questions which quickly will dominate your attention.
What is the value of money?
Why does it have value?
Why does it lose value?
Why does its value increase?
However, as you study and trade the forex market you will quickly come to recognize that you don’t necessarily need scholastic answers to these questions to be a successful trader.
To be successful you need a method that will help you accurately define the trend and risk.
What I highly recommend that all traders do before they begin trading forex is to open an actual demo (or ‘paper’) account with a forex broker. Opening the demo account is free. This demo account allows you to familiarize yourself with the process of placing orders and understanding leverage before you trade in real time.
IF YOU WANT TO TRADE LIKE A PRO LEARN TO TRADE SMALL until you have proven that you can handle the leverage associated with forex trading.
Please carve this into your subconscious trading mind.
It is not how much money you make when you are right that is important.
But rather how little you lose when you are wrong.
The losing transactions in your trading career are the ones that you need to study thoroughly. They are the trades that will allow you to learn and understand the nuances that differentiate Great traders from wannabes.
Forex trading is the arena of huge egos.
Braggarts are everywhere proclaiming their dominance.
Traders all love to scream how much they are making.
Your function and purpose at the outset is to track your trades and study your losers.
In capitalism, the losing side of the ledger is the catalyst that perpetuates real wealth in society. When businesses and traders learn what doesn’t work, real progress and advances are made.
Classical economic theory contends that what makes bailouts so treacherous is that the mistakes which led to the bailout will be perpetuated again and again. this prevents society, producers and traders from learning the lessons about ideas, policies and strategies which simply do not work.
Trading is a business.
As such you must study the losing side of the ledger and learn from the wisdom of hard-won experience.
When we coach Vantagepoint traders we usually tell them right at the outset that we want to see their metrics.
We want to see what their performance looks like after 100 trades.
What is their win/loss ratio? What is their average win? What is their average loss? What is their biggest win? What is their biggest loss? Etc.
The sad reality is that with the absence of metrics, better than 65% of forex traders draw down their trading accounts more than 50% in their first 100 trades. Like amateur poker players they live for the thrill of going, “ALL IN.” You need to understand this at the outset of forex trading if you genuinely want to be successful. It is never how much money you make when you are right that determines your skillset. Rather it is always how little you lose when you are wrong.
We live in very exciting times where understanding “price insurance” is a required skillset.
“Government Stimulus” is a major part of the American vocabulary today.
Currency debasement is no longer a theoretical argument. It is a transparent government policy from almost every government in the world.
Learn to see opportunity in highly leveraged trends and position yourself accordingly.
Remember, artificial intelligence has decimated humans at Poker, Jeopardy, Go! and Chess. Why should trading forex be any different?
Visit with us and check out the a.i. at our Next Live Training.
Discover why Vantagepoint’s artificial intelligence is the solution professional traders go-to for less risk, more rewards, and guaranteed peace of mind.
Think about these things as you learn forex and master your understanding of price insurance.
It’s not magic. It’s machine learning.
Make it count.
THERE IS SUBSTANTIAL RISK OF LOSS ASSOCIATED WITH TRADING. ONLY RISK CAPITAL SHOULD BE USED TO TRADE. TRADING STOCKS, FUTURES, OPTIONS, FOREX, AND ETFs IS NOT SUITABLE FOR EVERYONE.
DISCLAIMER: STOCKS, FUTURES, OPTIONS, ETFs AND CURRENCY TRADING ALL HAVE LARGE POTENTIAL REWARDS, BUT THEY ALSO HAVE LARGE POTENTIAL RISK. YOU MUST BE AWARE OF THE RISKS AND BE WILLING TO ACCEPT THEM IN ORDER TO INVEST IN THESE MARKETS. DON’T TRADE WITH MONEY YOU CAN’T AFFORD TO LOSE. THIS ARTICLE AND WEBSITE IS NEITHER A SOLICITATION NOR AN OFFER TO BUY/SELL FUTURES, OPTIONS, STOCKS, OR CURRENCIES. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE DISCUSSED ON THIS ARTICLE OR WEBSITE. THE PAST PERFORMANCE OF ANY TRADING SYSTEM OR METHODOLOGY IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. CFTC RULE 4.41 – HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.