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What is the Foreign Exchange Market?

The description below is very basic. There are lots of websites devoted to explaining what forex is. My job here is not to give a treatise on forex, but rather give my perspective on some of the technical aspects of forex and how to apply such analysis to make money. Nevertheless, I think a short intro is in order just in case you need some background.

The retail foreign exchange market (forex or FX for short) is a system of banks, interconnected in a worldwide network. The purpose of this network is to allow individual (or institutions) the ability to buy and sell currencies, much as they would in a stock market or commodities market. The sheer trading volume of the forex market dwarfs any equity or commodity market (literally trillions of dollars are traded each day!!!). Of course, the vast, vast majority of all retail activity is generated by speculators (such as yours truly) and professional traders. True hedging activities account for a relatively low percentage of the volume daily. Basically, this means that everyone thinks they know what is going on, but the truth is no one really has any cluse (we only think we do).

In the forex market, there are a plethora of "currency pairs" that one can trade (e.g., EUR/USD, USD/JPY). Each trades kind of like a stock in that the speculator buys and sells (at spread) the pair through a broker (sometimes a bank, sometimes not). Experienced traders often say that each pair has a personality. This may be true - but I woudln't know since I haven't done much forex trading yet.

Again, the price on each currency pair is quoted much as a price on a stock is quoted (bid/ask). The primary difference is that the price for most pairs is extended through the fourth decimal (e.g., 1.1234/1.1236). For some reason the JPY is only quoted to two decimals (e.g., 98.04/98.09). The smallest increment of the price (in this case 1/10000) is called a PIP (which I think means price interest point; there are lots of names, pick one you like). The dollar (or pound, euro, yen) value of each pip is different depending the pair being quoted and the currency of interest (e.g., 1 pip of EUR/JPY in USD is not $1USD, but 1 pip of EUR/USD in USD is $1USD). Confused? Me too.

The forex market is a day trader's dream (or nightmare, depending on the results). With so many time frames to choose from, the market can be tailored to fit almost any trading style (the same can almost be said of stocks, but it is not entirely accurate since stock market trades generally incur commission costs, whereas most cash forex brokers do not charge commissions, but rather eat up alive through the spreads). Thus, in the forex market, the trader can: scalp (a single PIP to maybe five or ten), short term (5 minutes, 15 minutes), intermediate term (30 minutes, 1 hour), long term (4 hours, 1 day), or position trade (daily, weekly, monthly). I try to never hold a position overnight (to avoid the swap charges), but sometimes a trade is so good I can't close it out...

What makes the forex market so dangerous? (See next page for key characteristics). The main reason is leverage. Retail cash forex is traded on margin, where insanely high leverage (sometimes 500:1). Because the leverage is so huge, even a few pips could mean a lot of money (in USD, a pip move on a standard lot of EUR/USD is $10, so a relatively small move of say 10 pips is already $100 USD. Now imagine that you find a consistently profitable (not likely 100% profitable unless you are from the future and took excellent notes), then you can lever up: 2 lots = $100 x 2 = $200, 10 lots = $100 * 10 = $1,000). I'm sure you get the idea. Now you know why I like forex so much :) Of course, remember that it cuts both ways, so losses will mount as quickly as gains (maybe even faster, depending on how you structure your trades and the win percentage).

I highly recommend at least a cursory glance at the money management discussion, since the very sharp dual-edge sword that is forex will slice you and dice you faster than a Cuisinart on steroids unless you employ a good risk and money management system.

That's pretty much all I know about the forex market. Not a lot, I know (I am not claiming any measure of expertise), but I think I know just enough to be dangerous to myself. With that said, I have enough background now to discuss some of the technical aspects of forex trading.

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