What is Forex?
Forex stands for Foreign Exchange and it’s essentially the global currency market. It’s an absolutely massive beast and is the largest market in the world. Something like 5 trillion – yes, that’s trillion – dollars are traded every day. The bulk of this trading is done by the larger international banks.
If you’ve ever travelled abroad you’ve dipped your toes in this market. You’ve perhaps sold British Pounds and bought Euros for your holiday in Greece, at an exchange rate determined by this market.
… and how do we trade it?
So, as a Forex trader, how do we interact with this market and make money from it?
If you’re new to Forex it can be quite hard to visualise, so I’m going to use horse racing as an analogy. You’re familiar with horse racing, right? Ok, so each trade we take is like betting on a two-horse race. Let’s imagine we want to trade the EUR/USD (the euro against the US dollar). So, one horse is euro, one horse is US dollar.
Let’s say we turn up to the race track and we know nothing about either horse. We pick one at random to bet on, so we have a 50:50 chance of winning. Not a great strategy, I’m sure you’ll agree. Now imagine you do a bit of homework.
You look at when the horses last ran to give you a clue about their fitness. You look at the distances they ran previously – are they running the same distance this time? Or is this race further than one of the horses has run before? How well did they do in their previous races? Did it rain last night? Is the going soft today, but one horse prefers it firm?
Do you see what we’re doing? Building up a picture to help us make an informed decision about which horse to bet on. We’re not guaranteed to win, of course. Horses are flesh and blood and who knows what they’re going to do on the day.
But it gives us an edge. Maybe only a slight edge. Maybe we win 55% of the races we bet on. It’s not massive, but it’s enough to make us profitable.
Forex trading is the same principle. I could randomly buy or sell the EUR/USD and, over time, I’d win approximately 50% of my trades. But, if I check a few indicators first – is it overbought or oversold, is price in an area of prior support or resistance, do we have divergence – I increase the probability that I will have a winning trade. Traders call this confluence; where multiple factors converge to reinforce your decision.
Other factors come into play, too, to determine whether we’re consistently profitable. The most important of these is money/risk management. I’ll talk about that another time as it certainly deserves a post to itself.