The Basics of The Forex Market

The foreign-exchange market, or forex, is the largest market in the world by volume. That is, more money exchanges hands on the foreign exchange than in any market in the world. Some $1.5 Trillion is exchanged daily, compared to $25 billion on the New York Stock Exchange. Across the world, the daily volume of stock exchanges is till just one third of the volume of the foreign exchange market! It’s easy to see why the foreign exchange market has grown to be so big, brought about by greater interest in the market by retail investors like you and I.

So What is the Foreign Exchange?
The foreign exchange market is simply a market for money. Currency pairs, such as GBP/USD and USD/JPY are simply the value of one currency against another, in effect the exchange rate of the currencies. In the pairs above, the pairs represent the value of the Great British Pound against the Dollar (GBP/USD) and the US Dollar against the Japanese Yen (USD/JPY).

A Uncentralized Market
There is no central processing market for the foreign exchange. Instead, the market is made up of interbanks, which operate the foreign exchange market by processing orders to trade one currency for another. The market exists only among banks, it does not exist as a market itself. This makes the foreign-exchange market a over-the-counter (OTC) marketplace.

Until the internet opened up online trading for people like you and I, the foreign exchange market was dominated by the banks and other larger players. Small investors could not easily trade the forex market, and could not access leverage and other tools which make it so profitable. In fact, in order to trade the foreign exchange market, you would have to have as much as $10 to $50 million dollars. Today, many brokers allow investors to open up an account for as little as $500, and some even $1!

Tools of the Trade
Today’s investors need little more than a high speed internet connection, a computer and a willingness to learn the foreign exchange market. In the next many pages, we’ll explain everything you need to know about trading the market. From opening an account, to making your first trade, we’ll cover it all at ForexOnlineLearning.com

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Forex Market Trading Times

The foreign exchange market is the only market in the world that is open 24/7. Investors are able to place trades every single day of the week, however, most pairs will move very little on the weekends as very few investors stick around to trade.

When Various Markets Open
When one market closes, another one opens, allowing traders to trade the market 24/7. Below is a list of the various open and closing times for the Tokyo, London, and New York forex markets.

The Best Times to Trade Forex
The best times to trade the foreign exchange market is when the most traders are trading. As such, investors should look to trade when more than one major market is open. As you can see in the chart above, the Tokyo and London markets overlap for 1 hour each day, and the London and New York markets overlap for 4 hours each day. This is when the most currency is traded, as more than one location is actively buying and selling different currency pairs.

Different Times, Different Currencies
Though anyone can trade any currency regardless of their country of origin, some currencies are more often traded during certain periods of the day. During the London trading session, the US Dollar (USD), the Great British Pound (GBP), and the Euro (EUR) are the most actively traded currencies. During the Tokyo session, the Japanese Yen (JPY) grows in volume. If your broker offers sliding spreads, those that change depending on volume, your best bet is to place trades during these market times in order to pay the lowest price in spreads and maintain the highest amount of market movements.

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How Money is Made With Forex

So, you know how the forex market works, now its time to find out how investors make money with forex. The premise of the foreign exchange market is simple, to exchange one currency for another currency which you believe will go up in value. The basics are much like the stock market, so anyone with any financial experience should pick up the foreign exchange market rather quickly.

Making Money With Forex
You make money in the foreign exchange market when one currency rises in value against another. For this portion of the tutorial, we’ll use the pair GBP/USD as our example.

We’ll start with 1 lot, or 100,000 units of GBP/USD. We think the Pound will strengthen against the US Dollar, so we buy one lot at 50:1 leverage and a price of 1.60. This means that we are buying $160,000 of the Pound, and staking $3200 and “borrowing” the other $156,200 through leverage. In the backend, our forex broker is moving $160,000 from a US bank account to a Pound denominated account. We’ve essentially sold, or traded, $160,000 for 100,000 pounds.

Cashing In
Four hours have passed and the GBP has strengthened against the USD by 50 pips. The forex broker’s quote is now 1.6050 and our 100,000 pounds are now worth $160,500, giving us a total profit of $500 on a $3200 investment. That’s not a bad return at all, it’s a gain of nearly 15% in just a few hours. Granted, we have used 50:1 leverage, but even then, results like these are more than typical!

Is Making Money in Forex Really That Easy?
Actually, it is. Making money on the foreign exchange market is as easy as knowing in which direction a currency pair is likely to travel. See, the difficulty is not in making money itself, but in knowing how to make money. In the following chapters we’ll reveal how to know in which direction a currency pair will go, but we still have a lot more to learn about the foreign exchange market itself.

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The Spread, A Forex Brokers Profit

In our example from the previous article, we actually alluded to a few things. The first, is that there were a few costs in our example trade of 1 lot of GBP/USD. The hidden cost is the “spread” or the commission the broker earns for completing our trade.

How Forex Spreads Work
Unlike stocks or other tradeable securities, there is no set commission rate. With stocks, you may be accustomed to paying $6.95 to complete an online trade. In forex, we don’t pay commissions, instead the cost to trade is built into the forex bid and ask prices.

Bid and Ask
The bid and ask prices can be confusing, but we’ll make as much sense of the two prices as we can. The bid price is the price you would get when selling the pair. The ask price, is the price the market is asking for the pair. For instance, the pair GBP/USD may offer a bid price of 1.6101 and an ask price of 1.6104. If you bought the pair at 1.6104, you would immediately be able to sell the pair, at a loss, for 1.6101. Your net profit/loss would be negative 3 pips.

Why the Difference?
The difference between the bid and ask price is the illusive spread mentioned above. This spread is for the broker, for completing our trades. By selling to traders at one price, and buying from traders at another price, the broker is able to make money by completing our trades. A spread of 3 pips would create a profit of $30 for the broker, for each lot traded. This may seem to be horribly expensive, $30 a trade vs $6-7 for stocks, however the spread in forex is actually less than in the stock market.

Stock spreads vs. Forex Spreads
Spreads occur naturally in the stock market as well as in the foreign exchange market. The difference is that the forex market is not a centralized market like the stock markets. When you go to buy stock, there is a spread in the bid/ask price which is profit for the marketmaker, or the person who sits on an exchange and completes orders. In forex, the spread goes to the broker, who is a market maker in that they pair two orders to complete a trade.

All in all, spreads on the stock market are much, much higher than on the foreign exchange. The spread on the foreign exchange market adds up to roughly .03% of a trade. In the stock market, the spread is often 20 times greater, or about .6% of the cost of the trade PLUS the commission to complete the trade. All in all, the costs of trading the foreign exchange market are much cheaper than the stock market.

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Rollovers and Carry Interest, The Money You Make For Making Money in Forex

Believe it or not, you can actually make money when a currency pair goes neither up nor down in price. Yes, that is right, you can make money for just holding a position in forex!

Carry Trade Interest
You remember from the third article of our comprehensive guide that when you buy or sell a currency pair, you’re essentially moving money from one currency denominated bank account to another. And the crazy thing about borrowing and lending money, is that you receive interest for it!

How Carry Trade Interest Works
Carry trade interest works by borrowing in one currency to buy another currency. Back to the original example, when you buy the GBP/USD at 1.6000, you are trading $160,000 for 100,000 British Pounds. In effect, you debited $160,000 from one account, in which you owe interest, and credited another with 100,000 British Pounds, in which you gain interest.

Let’s assume that the bid and ask interest rates for US Dollars and Great British Pounds are as follows:
GBP Bid 2.5% Ask 3%
USD Bid 1% Ask 1.25%

Just like the spreads, the bid price is the price you get paid for depositing. The ask price, is the price the lender asks in interest.

Calculating Your Profit/Loss
Each year, you will pay $2,000 in interest to borrow the US Dollars, and you will gain 2,500 Pounds ($4000) in interest for depositing. Your net gain, even if the currency prices go absolutely nowhere, will be $2000 each and every year. Per day, it equates to $5.48, or about ½ pip per day.

It Really Adds Up
The cost of carry, or in some cases, the gain of carrying, really adds up over time. In the example above, an investor would have made $2000 with a leveraged investment of $160,000. In real terms, at 50:1 leverage, the profit would have been $2000 on a $3200 investment, not too shabby! Many investors have started trading forex just to make money from carry trades, but we’ll get to that later.

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Types of Forex Market Orders: Market and Limit

Now that we know what goes into a trade, we need to also know how to enter the trade to a broker. There are two main types of orders to buy currency, the first of which is a market order, the second is a limit order.

Market Orders
A market order is an order at the current market ask price for a certain currency pair. This type of order is filled instantaneously at whatever price the broker can match up with your entry. Market orders are used by virtually every trader, but are more often used by traders that want to buy at a certain time (now) rather than a certain price.

Limit Orders
A limit order is a special order put into a broker to buy a currency pair at a predetermined price. Let’s say that the current value of the GBP/USD pair is 1.5050 and you want to buy the pair, but at a price lower or higher than the current price. For the sake of discussion, we’ll say you’re interested in buying GBPUSD only at a price of $1.5025 and do not wish to buy it at the current price.

By entering a limit order, you are able to enter the price at which you’d like to buy ($1.5025) and how long you’re willing to wait for the order to be filled. If at any time the price falls to $1.5025, your broker will automatically enter the trade, choosing to buy X number of lots at this predetermined price.

Limit Order Operations
Most brokers will not require you, or your platform, to be logged into your account to execute a limit order. This is both a benefit and a negative, as you’ll be able to log out of your account and still have your orders in place, but should you forget, you might find yourself holding a position that you forgot about. Holding positions unknowingly is dangerous, due to the fact that the market may move wildly without you to close the position either for a profit or loss.

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Forex Stop Loss and Take Profit

Arguably, the stop loss and take profit orders are the two most important order types for foreign exchange traders. The two orders are essentially orders on top of another order. The stop loss allows you to determine at what price you want to cut your losing trades and the take profit allows you to enter what price you’d like to close a position for a profit.

The Stop Loss
A stop loss should be entered for each and every trade you ever make on the foreign exchange market. A stop loss prevents you from runaway losers, due to the fact that it will automatically close a losing position before your account balance is depleted. It would never be recommended to trade without a stop loss as doing so is like risking your entire account balance on one trade.

If you were to buy a lot of GBP/USD but wished not to lose more than $250 on this single trade, you would set your stop loss 25 pips below the price at which you entered the trade. If you bought GBP/USD at $1.50, you’d want to enter a stop loss at $1.4975, thus preventing a loss greater than $250.

The Trailing Stop
The trailing stop is a different kind of stop loss order offered by a few brokerage accounts. Many investors, particularly momentum traders, like to use trailing stops to both limit their losses, and also to lock in gains. The trailing stop lags the current price by the amount set. For instance, if you were to buy EUR/USD at 1.3150, and wish to lose no more than 50 pips, your trailing stop would sit at 1.3100. If the price were to advance to 1.3175, your trailing stop would then move to 1.3125, lagging the market by the 50 pip differential that you set.

The trailing stop is a more advanced type of stop loss but can be used by any trader. Ultimately, the trailing stop will activate at a price that is X number of pips lower than the price you set. If the EUR/USD was to advance from 1.3150 to 1.3350 without ever dipping more than 50 pips at any given time, you would be in the position all the way to 1.3350. If it had dipped deeper than 50 pips, your stop loss would have been executed.

Take Profits
Take profit orders are the opposite of a stop loss. The take profit is a price at which you would like to close your position for a profit, above or below the current price of the currency. Just like a stop loss, you can enter this order either during your initial entry to buy a currency, or after, and it can be changed at any time.

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Fundamental And Technical Analysis Forex Trading

There are two different ways to study the foreign exchange market. The first of which, is fundamental analysis which relies on studying the impacts of the world economy on exchange rates. The second of which is technical analysis, which employs studying charts to make profits.

There is no right or wrong way to trade
There is absolutely no right or wrong way to trade the foreign exchange market as both fundamental analysts and technical analysts find the possibility of profit near equal. The different types of analysis have sparked an ongoing debate among the trading community, however, it is our belief that no matter how you profit, you’re still profiting! Making money is making money, no matter how you do it.

Find What Works for You
We’d like to offer you the opportunity to read up on both technical and fundamental analysis and decide for yourself what works better for you. Both trading types can be profitable and both can produce both long and short term results.

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Forex And Fundamental Analysis

Fundamental analysis utilizes data points such as Gross Domestic Product, trade balance, and actions by central banks to decide how a currency will perform. Fundamental analysis is essentially doing all the math and fact finding to see how the market should value a currency, then buying or selling to await the market’s movement in your direction.

Fundamental Analysis Basics
It should only be expected that an economy with a trade surplus, that is selling more goods than they are buying, would go up in value. Generally, this is the case, but not the rule of law.

Monetary Policy and Fundamental Analysis
Other important factors, such as monetary policy play into the market direction. For instance, when the Federal Reserve of the United States decided to print money to fight inflation, the value of the dollar dropped. This is the result of inflation, or the increase in the money supply that ultimately drives the value of the dollar down.

Inflation and Forex
Understanding inflation is easiest when comparing it to a collectible. Let’s say you own a super rare 1909 Honus Wagner baseball card, and there are only 100 in the world. Now, the value of each of these cards is $1 million each. If someone were to stumble on 100 cards in a dumpster outside the card factory, the supply of the cards known around the world would double to 200. Because scarcity is ultimately what creates prices, the value of the cards would be cut in half. As there are twice as many cards! This is exactly how money works.

Fundamentals are a Long Term Study
Fundamental analysis is usually best used in the long term, as in the short term markets can be incredibly irrational, or move against what should be the true value. As was stated earlier in the tutorial, nearly $2 Trillion trades hands each day on the foreign exchange, so the day to day operations often overweight the greater picture.

The Short Term
That doesn’t mean that fundamental factors do not play into the changes in price in the short term, but rather it often takes a period of months for investors to factor in all the variables that would change the perceived value of a currency. For example, scientists would not decide Global Warming was a myth based on one cool day in the middle of the summer. Rather, scientists study temperature over a period of years to solidify their data.

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Forex Technical Analysis

Technical analysis is very much different from fundamental analysis in that a technical analyst assumes that the price shows all known information about a currency pair. For the most part, forex technical analysts study charts rather than economic indicators to find the best entry and exit prices.

How Technical Analysis Works
Technical analysts use indicators and chart patterns to find where a currency pair’s price is likely to go. A technical analysts job is to see how investors are changing the price of a currency, and to see who is buying and selling and at what price.

Support and Resistance Basics
Support and resistance lines are some of the most basic technical trading tools. The support line is drawn at an area where the price is likely to rise. A resistance line is drawn where the price is likely to fall. Generally, support and resistance lines work for the small trader because larger investors like banks, hedge funds, and institutions have large buy or sell orders at the price specified. Retail forex investors can make a profit by riding the waves in price created by big investors.

More Complicated than Just Trendlines
There is far more to technical trading than just support and resistance lines, however. There are various indicators like the Relative Strength Index, the Moving Average Convergence Divergence, and even candlestick patterns. But we’ll get into all the small details in individual articles.

Shorter Term than Fundamental Analysis
Though technical analysis can be applied on long term charts, typically it is best suited for short term trading, or trades that last less than a month. Over time, the power of chart patterns and technical analysis is eroded by fundamental factors which play a larger role in the long term movements of a currency pair.

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Forex Line Charts and Graphs

Line charts are some the least used charts in all of trading. Though line charts are incredibly simple to read and understand, often they do not show enough data to make intelligible decisions. Though the use of these charts is not at all recommended, I will explain what they are and how they work so you can make your own decision.

How Forex Line Charts Work
Line charts are generally calculated by using the open or close value of a currency pair, then drawing a straight line to connect the points. What this does it show a relatively smooth chart, factoring in only the values at which the currency was priced at certain times.

What The Charts Don’t Show
The worst part about forex line charts is not what they show, but what they do not. For the sake of this discussion, we’ll use a one hour line chart with each point on the chart equal to the price the currency pair opened for that hour.

Here are a few fictional values for our example currency pair, EURUSD, over a 3 hour period. For educational purposes, a value will be posted for 2:30, to show the inherent problems of a line chart.

EURUSD
1:00 value = $1.50
2:00 value = $1.4950
2:30 value = $1.47
3:00 value = $1.50

What You Don’t See In the Data
Now, when we draw the chart with the price being calculated each hour, we see very little in the price. For all we know, the price fell 50 pips to $1.4950 by 2:00 but rose back to $1.50 by 3:00. Because line charts only show the price for one point in time each hour, there is a lot of market data missing. As you can see, the price actually fell more than 300 pips to $1.47 before rebounding, but according to our line graph it only fell as low as 50 pips to $1.4950.

Only Half the Story
You see, a line chart set on a hourly timeframe will only accurately report the price of a currency once every 60 minutes. You’ll only know the price at one point during the whole trading time. This is insufficient data, and making trades based on a lack of data is a sure way to lose money. For this reason, we at ForexOnlineLearning.com suggest utilizing bar or OHLC charts, or candlestick charts as a more accurate way to trade.

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Bar Charts and OHLC Charts

Bar charts and OHLC charts are one step up from line charts, in that they offer more data about the price changes that happen during the bar, not just one point in time. Bar charts and OHLC are excellent, but are still one step lower than candlestick charts, which show all relevant data in graphical form and can be read more quickly, but we’ll get to candlesticks in the next tutorial

Bar Charts and OHLC, What Do You Mean?
Bar charts and OHLC are virtually the same. OHLC means Open, High, Low and Close, representing all the data that is shown in just one bar within the chart. A typical bar in an OHLC or Bar Chart looks like the image below:
Reading a Bar (OHLC) Chart
Just as you are reading this tutorial, bar charts are read left to right. As you can see, the stick coming off the left side of the bar is the open price, or the price at which the currency pair opened that bar. At the top of the bar is the highest price the currency pair reached during that time period, and likewise the bottom point on the line is the lowest price the currency pair hit. The right most stick coming off the bar is the price the currency pair closed that time period. As you can see, the price rose during the time period, with the open price lower than the close price, however, the price also dipped lower than the open and also, at one point, moved higher than the price at which it closed.

Bar Charts vs. Line Charts vs. Candlestick Charts
As you can see from the illustration above, there is simply no comparison between bar charts and line charts. The comparison between bar (OHLC) and candlestick charts is irrelevant, as both show the same data. However, all things considered the difference is staggering. Rather than have just one point in time reflect the overall strength or weakness of a currency pair, bar chart (OHLC) users have much more data to reflect upon before making a trade.

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Candlestick Charts

Candlestick charts are the most popularly used charts of all forex charts. Candlesticks offer all the data of bar (OHLC) charts, all in an easy to read and graphical dataset. After learning the basics of candlestick charts, you’ll be able to decipher data faster and make decisions quicker, a valuable skill in the world of forex trading.

What are Candlestick Charts
Candlesticks have been in use for centuries, first created as a way to easily see the changes in price of rice on Japan commodity exchanges. The image below will give you a better idea of what candlestick charts are:
Reading the Candlestick
Colors are used to differentiate between a candlestick that is positive (price going up) and a negative candlestick (price going down). For this tutorial, we have utilized the colors green for advancing candlesticks and red for declining candlesticks, a popular color combination on a plurality of forex trading platforms.

Candlestick Terminology
Candlesticks show all the data of a OHLC bar, but do so in a graphical way and utilize a different terminology. The middle colored portion of the candlestick is called the “real body” or “solid body.” The real body indicates the total realized changed in price of the currency pair during trading. The sticks or “wicks” below the candlestick are called shadows. Just like a bar chart, this is where the price dipped or rose to reach, but did not stay at this price.

Why Candlestick Charts
Why not? Candlestick charts are arguably the best type of chart to use due to the fact that they allow you to easily understand the changes in price of a currency, but also allow you to employ candlestick analysis to decided how to place your trade. Candlestick analysis is a very profitable and easy to learn, and later in the tutorial we’ll teach you everything you need to know about candlestick analysis.

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Dark Cloud Cover Candlestick Pattern

Dark cloud cover is a bearish signal to investors, indicating that the price of a currency pair is soon the fall. Dark cloud cover begins with an advancing candlestick that is overshadowed by a declining candlestick that opens higher than the last close but also closes below the midpoint of the fist candlstick.

Here is an example of the dark cloud cover candlestick pattern:

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Evening Doji Star Candlestick Pattern

The evening doji star is one of the most bearish candlesticks, consisting of a large uptick in price, followed by a doji, then a decreasing candlestick. This three candlestick pattern is extremely effective in finding market tops, as it reflects a move to the upside, indecision, then a large dip in the current price. This candlestick pattern is only found at market tops.

Here is an example of the Evening Doji Star candlestick pattern:

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Evening Star Candlestick Pattern

Very much like the evening doji star, the evening star consists of a positive candlestick followed by a small body candlestick poised above the first candle, and one last candlestick that opens lower and declines deep into the first candlestick. This candlestick pattern appears only at the top of charts.

Here is an example of the Evening Star candlestick pattern:



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Engulfing Candlestick Pattern

The engulfing candestick pattern can be both a bullish and bearish signal depending on how the candlesticks form. The first candlestick is comprised of a small body candlestick followed by a large candlestick (either positive or negative) that “engulfs” the previous candlestick.

Here is an example of the engulfing candlestick pattern:

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Doji Candlestick Pattern

The Doji candlestick pattern is made up of a candlestick that goes both postive and negative, but ultimately closes at the same price of the open. A doji indicates indecision in the market, in that the currency pair edged higher, but ultimately closed at exactly the same price of open. Typically these are found at the top and bottom of charts, due to opposing forces of the market.

Here is an example of the doji candlestick pattern:



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Dragonfly Doji Candlestick Pattern

Just like the regular doji, in a dragonfly doji pattern the price of the currency opens and closes at the same point. However, a dragonfly doji differs in that the open and close price are at the very top of the candlestick. The dragonfly doji usually only appears at market turning points, where a new direction is likely to occur.
Here is an example of the dragonfly doji candlestick pattern:


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