Engaging in the Exchange of Currency for Profit

I. 

Chapter 1: Introduction to Foreign Exchange Trading

1.  Engaging in the Exchange of Currency for Profit

At its core, foreign exchange trading revolves around the exchange of currency to generate profits. Various motives drive individuals and institutions to trade money, with the predominant reasons being currency conversion and speculation. Currency conversion entails converting money from one currency to another, primarily for the purpose of acquiring goods, services, or assets from a foreign country. For instance, if an American company wishes to purchase British goods, it would involve converting U.S. dollars to British pounds.

This book exclusively delves into foreign exchange trading for speculative purposes – trading money with the explicit aim of making a profit. The speculative process closely resembles trading in stocks or futures. Whether pursued on a long-term or short-term basis, the objective is to garner profits from fluctuations in prices. Similar to how the stock price of companies like Microsoft fluctuates, currencies also experience upward and downward movements in price. The key challenge lies in predicting and capitalizing on the correct direction of the movement, thus earning profits while assuming the inherent risks of the trade.

While there are significant distinctions between trading foreign exchange and trading stocks or futures, the primary goal remains consistent. When a trader invests in shares of a company like Microsoft, the anticipation is that the value of the shares will rise, yielding profits. Similarly, when a trader acquires Japanese yen, the expectation is for the yen's value to increase, resulting in a profit from owning that currency.

Mastering the art of making money through trading money is a complex undertaking. Success in foreign exchange trading hinges on a myriad of factors that collectively contribute to a trader's proficiency. This amalgamation typically encompasses various aspects, each playing a crucial role in the trader's effectiveness.

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Amassing a wealth of often challenging trading experiences, coupled with adept risk management skills, robust technical and fundamental analytical abilities, and a resilient psychological makeup, are all crucial components of achieving success in foreign exchange trading. These elements will be thoroughly explored later in the book.

To initiate our exploration, an introduction to the realm of foreign exchange trading is essential. This section will cover all the fundamentals and commence with a concise history lesson.

2.  Embarking on the Quest for Wealth

While forms of currency have existed since time immemorial, modern speculative foreign exchange trading, also known as FX, forex, or currency trading, gained significant prominence relatively recently. In the early 1970s, following the collapse of the Bretton Woods Agreements, the world's currencies began to float freely and trade extensively.

The Bretton Woods Agreements, established in July 1944 at the conclusion of World War II through meetings in Bretton Woods, New Hampshire, involved representatives from all Allied nations. One noteworthy outcome of these agreements was that each nation pledged to adopt a monetary policy fixing the exchange rate of its currency relative to the U.S. dollar. Simultaneously, the U.S. dollar was pegged to gold at a rate of USD $35.00 per ounce. These adjustments resembled a reinstatement of certain features of the Gold Standard, this time facilitated through the U.S. dollar.

Evidently, the presence of the Bretton Woods Agreements rendered foreign exchange trading on a significant scale nearly impossible and unproductive, given the fixed nature of currency values. Although Bretton Woods aimed to control conflicts, maintain monetary stability, and discourage currency speculation, the agreements faced mounting challenges when the U.S. suspended the convertibility of the dollar into gold in 1971, ultimately leading to their collapse in the same year.

By 1973, following the complete breakdown of Bretton Woods and similar agreements attempting to regulate the global currency system, world currencies began to float more freely. This shift meant that market forces, driven by supply and demand, would prevail over international political consensus, and widespread speculation by banks and institutions would soon become prevalent. While most individual traders were initially excluded from this new market landscape, this era marked the inception of modern-day forex trading as we recognize it today.

3.  Engaging in Retail Transactions:

Advancing to approximately 1996, the rise of computers and the Internet facilitated the practicality and demand for online financial trading. As stock trading transitioned to the online realm, foreign exchange brokers and market-makers emerged to cater to a burgeoning demand for retail forex trading. Previously, speculative forex trading had been primarily reserved for banks and large institutions. However, the advent of online platform trading significantly expanded access for the average individual trader and investor.

This emerging frontier in retail currency trading focused on spot forex, a distinct arena set apart from futures and forwards. Spot foreign exchange trading stands out for its almost instantaneous delivery of currency, as opposed to deferred delivery in the future. In speculative currency trading, the physical currency itself is not physically delivered; instead, the delivery is consistently rolled over to the subsequent delivery date indefinitely, or until the trading position is closed. The foreign exchange broker assumes a crucial role in managing this continuous rollover process to facilitate speculative trading, eliminating the need for customers to physically convert money to or from a foreign currency. In spot forex, the standard settlement timeframe for most currency trades is the trade execution date plus two days (T+2).

4.  Large and Liquid, Resembling the Vastness of the Ocean

Numerous characteristics distinguish the modern-day foreign exchange market from other financial markets, such as equities (stocks) and futures. Many of these traits contribute to making the foreign exchange market an attractive choice for traders and investors transitioning from alternative financial markets.

When individuals initially encounter information about the foreign exchange market, they are typically introduced to its sheer size on a global scale. This vastness is accompanied by an unprecedented level of liquidity, a feature that is challenging to fathom in comparison to other financial markets. Liquidity is essentially defined as the extent to which an asset, like a currency, can be bought or sold in the market without causing a significant impact on its price. The liquidity of currencies, particularly major ones like the U.S. dollar and the euro, surpasses that of any other financial instrument, including stocks, bonds, and futures contracts.

One noteworthy consequence of the remarkably high liquidity in the foreign exchange market, attributed to the overwhelming volume of transactions and the multitude of involved traders (both institutional and retail), is the formidable difficulty for any individual participant to artificially manipulate foreign exchange prices in a significant manner. However, this generalization does not extend to the world's central banks (such as the U.S. Federal Reserve, the European Central Bank, and the Bank of Japan), which have the capacity and occasionally attempt to influence the markets. It is crucial to acknowledge that this kind of manipulation is widely recognized as a part of the forex trading landscape and does not typically provide an unfair advantage to speculative market participants. Moreover, central bank efforts to manipulate currencies for the purpose of advancing national economic policy are generally more acceptable than profit-driven manipulation of individual stocks by unscrupulous traders.

Beyond the potential influence exerted by central banks, the scale of the foreign exchange market is a key factor in its claim as the most liquid market in the world. According to the latest statistics from the Bank for International Settlements (BIS), an international organization acting as a bank for central banks, the estimated average daily turnover in the primary foreign exchange markets is around $3.2 trillion (as of April 2007). This figure signifies an unprecedented three-year growth rate of 69% and far surpasses the trading volume in any other financial market globally.

Within this $3.2 trillion, approximately $1 trillion is attributed to spot foreign exchange trades, distinguishing them as trades involving the immediate delivery of the currency, as mentioned earlier.

The type of trading that garners the primary attention of most individual traders in the retail forex market is the spot foreign exchange. Although a few individual traders engage in currency futures and other derivative financial instruments, the substantial growth of the spot foreign exchange market has predominantly overshadowed these smaller markets.

5.  Operating Around the Clock, Five Days a Week

In addition to the substantial size and liquidity that can greatly benefit the average speculative trader, another distinctive feature of the foreign exchange market is its global and decentralized nature. Essentially functioning as an over-the-counter (OTC) market, it forms a unified, interconnected entity where various currency trading locations worldwide are electronically linked. One of the notable advantages arising from this structure is that all currencies can be traded electronically 24 hours a day as the major global markets open, overlap, and close successively.

From the perspective of New York time (U.S. Eastern Time), the market opening sequence unfolds as follows. The beginning of the trading week commences on Sunday afternoon in New York, with the opening of New Zealand banks at 2:00 pm. At 5:00 pm (still New York time), the financial markets in Sydney, Australia, become active. Tokyo follows at 7:00 pm, succeeded by the simultaneous opening of Hong Kong and Singapore at 9:00 pm. At this juncture, all five of these currency-trading financial markets are operational: New Zealand, Australia; Japan; Hong Kong; and Singapore.

During the early hours of Monday, Frankfurt, Germany, opens the primary euro market at 2:00 am, New York time. By this time, the global nature of the foreign exchange market ensures that trading is seamlessly handed over from one major financial center to another, creating a continuous and uninterrupted market environment.

After New Zealand and Australia have concluded their trading hours, and the East Asian markets of Tokyo, Hong Kong, and Singapore are nearing closure, the European time zone takes over with the commencement of the crucial London session. Traditionally recognized as the market with the highest liquidity, the London session opens an hour after Frankfurt, at 3:00 am NY time.

Subsequently, at 8:00 am on Monday morning, the New York financial markets become the last major global markets to open. Given the prominence of New York as a robust foreign exchange trading market, similar to London and Frankfurt, the overlap between these three