Introduction to Currency Trading

The foreign exchange market (forex or FX for short) is one of the most exciting, fast-paced markets around.
Until recently, forex trading in the currency market had been the domain of large financial institutions,
corporations, central banks, hedge funds and extremely wealthy individuals. The emergence of the internet
has changed all of this, and now it is possible for average investors to buy and sell currencies easily with the
click of a mouse through online brokerage accounts.

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. Therefore, many 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 250:1. Higher leverage can be extremely risky, but because of 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.

Extreme liquidity and the availability of high leverage have helped to spur the market's rapid growth and
made it the ideal place for many traders. Positions can be opened and closed within minutes or can be held
for months. Currency prices are based on objective considerations of supply and demand and cannot be
manipulated easily because the size of the market does not allow even the largest players, such as central
banks, to move prices at will.

The forex market provides plenty of opportunity for investors. However, in order to be successful, a currency
trader has to understand the basics behind
currency movements.

The goal of this forex tutorial is to provide a foundation for investors or traders who are new to the foreign
currency markets. We'll cover the basics of  exchange rates, the market's history and the key concepts you
need to understand in order to be able to participate in this market. We'll also venture into how to start
trading foreign currencies and the different types of strategies that can be employed.
What Is Forex?
The foreign exchange market is the "place" where currencies are traded. Currencies are important to most
people around the world, whether they realize it or not, because currencies need to be exchanged in order
to conduct foreign trade and business. If you are living in the U.S. and want to buy cheese from France,
either you or the company that you buy the cheese from has to pay the French for the cheese in euros
(EUR). This means that the U.S. importer would have to exchange the equivalent value of U.S. dollars
(USD) into euros. The same goes for traveling. A French tourist in Egypt can't pay in euros to see the
pyramids because it's not the locally accepted currency. As such, the tourist has to exchange the euros for
the local currency, in this case the Egyptian pound, at the current exchange rate.

The need to exchange currencies is the primary reason why the forex market is the largest, most liquid
financial market in the world. It dwarfs other markets in size, even the stock market, with an average traded
value of around U.S. $2,000 billion per day. (The total volume changes all the time, but as of April 2004, the
Bank for International Settlements (BIS) reported that the forex market traded U.S. $1,900 billion per day.)

One unique aspect of this international market is that there is no central marketplace for foreign exchange.
Rather, currency trading is conducted electronically over-the-counter (OTC), which means that all
transactions occur via computer networks between traders around the world, rather than on one centralized
exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded
worldwide in the major financial centers of London,
New York, Tokyo, Zurich, Frankfurt, Hong Kong,
Singapore, Paris and Sydney - across almost every time zone. This means that when the trading day in the
U.S. ends, the forex market begins anew in Tokyo and Hong Kong. As such, the forex market can be
extremely active any time of the day, with price quotes changing constantly.

Spot Market and the Forwards and Futures Markets

There are actually three ways that institutions, corporations and individuals trade forex: the spot market, the
forwards market and the futures market. The forex trading in the spot market always has been the largest
market because it is the "underlying" real asset that the forwards and futures markets are based on. In the
past, the futures market was the most popular venue for traders because it was available to individual
investors for a longer period of time. However, with the advent of electronic trading, the spot market has
witnessed a huge surge in activity and now surpasses the futures market as the preferred trading market for
individual investors and speculators. When people refer to the forex market, they usually are referring to the
spot market. The forwards and futures markets tend to be more popular with companies that need to hedge
their foreign exchange risks out to a specific date in the future.

What is the spot market?

More specifically, the spot market is where currencies are bought and sold according to the current price.
That price, determined by supply and demand, is a reflection of many things, including current interest rates,
economic performance, sentiment towards ongoing political situations (both locally and internationally), as
well as the perception of the future performance of one currency against another. When a deal is finalized,
this is known as a "spot deal". It is a bilateral transaction by which one party delivers an agreed-upon
currency amount to the counter party and receives a specified amount of another currency at the agreed-
upon exchange rate value. After a position is closed, the settlement is in cash. Although the spot market is
commonly known as one that deals with transactions in the present (rather than the future), these trades
actually take two days for settlement.

What are the forwards and futures markets?

Unlike the spot market, the forwards and futures markets do not trade actual currencies. Instead they deal in
contracts that represent claims to a certain currency type, a specific price per unit and a future date for
settlement.

In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of
the agreement between themselves.

In the futures market, futures contracts are bought and sold based upon a standard size and settlement date
on public commodities markets, such as the Chicago Mercantile Exchange. In the U.S., the National Futures
Association regulates the futures market. Futures contracts have specific details, including the number of
units being traded, delivery and settlement dates, and minimum price increments that cannot be customized.
The exchange acts as a counterpart to the trader, providing clearance and settlement.

Both types of contracts are binding and are typically settled for cash for the exchange in question upon
expiry, although contracts can also be bought and sold before they expire. The forwards and futures markets
can offer protection against risk when trading currencies. Usually, big international corporations use these
markets in order to hedge against future exchange rate fluctuations, but speculators take part in these
markets as well. (For a more in-depth introduction to futures, see Futures Fundamentals.)

Note that you'll see the terms: FX, forex, foreign-exchange market and currency market. These terms are
synonymous and all refer to the forex
market.
Reading a Forex
Quote and
Understanding the
Jargon
One of the biggest sources of confusion for
those new to the currency market is the
standard for quoting currencies. In this
section, we'll go over currency quotations
and how they work in currency pair trades.

Reading a Quote
When a currency is quoted, it is done in
relation to another currency, so that the
value of one is reflected through the value of another. Therefore, if you are trying to determine the exchange
rate between the U.S. dollar (USD) and the Japanese yen (JPY), the forex quote would look like this:
 USD/JPY = 119.50

This is referred to as a currency pair. The currency to the left of the slash is the base currency, while the
currency on the right is called the quote or counter currency. The base currency (in this case, the U.S.
dollar) is always equal to one unit (in this case, US$1), and the quoted currency (in this case, the Japanese
yen) is what that one base unit is equivalent to in the other currency. The quote means that US$1 = 119.50
Japanese yen. In other words, US$1 can buy 119.50 Japanese yen. The forex quote includes the currency
abbreviations for the currencies in question.

Direct Currency Quote vs. Indirect Currency Quote

There are two ways to quote a currency pair, either directly or indirectly. A direct currencyquote is simply a
currency pair in which the domestic currency is the base currency; while an indirect quote, is a currency pair
where the domestic currency is the quoted currency. So if you were looking at the Canadian dollar as the
domestic currency and U.S. dollar as the foreign currency, a direct quote would be CAD/USD, while an
indirect quote would be USD/CAD. The direct quote varies the foreign currency, and the quoted, or domestic
currency, remains fixed at one unit. In the indirect quote, on the other hand, the domestic currency is
variable and the foreign currency is fixed at one unit.

For example, if Canada is the domestic currency, a direct quote would be 0.85 CAD/USD, which means with
C$1, you can purchase US$0.85. The indirect quote for this would be the inverse (1/0.85), which is 1.18
USD/CAD and means that USD$1 will purchase C$1.18.

In the forex spot market, most currencies are traded against the U.S. dollar, and the U.S. dollar is frequently
the base currency in the currency pair. In these cases, it is called a direct quote. This would apply to the
above USD/JPY currency pair, which indicates that US$1 is equal to 119.50 Japanese yen.

However, not all currencies have the U.S. dollar as the base. The Queen's currencies - those currencies that
historically have had a tie with Britain, such as the British pound, Australian Dollar and New Zealand dollar -
are all quoted as the base currency against the U.S. dollar. The euro, which is relatively new, is quoted the
same way as well. In these cases, the U.S. dollar is the counter currency, and the exchange rate is referred
to as an indirect quote. This is why the EUR/USD quote is given as 1.25, for example, because it means that
one euro is the equivalent of 1.25 U.S. dollars.

Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of the
Japanese yen (JPY), which is quoted out to two decimal places.

Cross Currency
When a currency quote is given without the U.S. dollar as one of its components, this is called a cross
currency. The most common cross currency pairs are the EUR/GBP, EUR/CHF and EUR/JPY. These
currency pairs expand the trading possibilities in the forex market, but it is important to note that they do not
have as much of a following (for example, not as actively traded) as pairs that include the U.S. dollar, which
also are called the majors. (For more on cross currency, see Make The Currency Cross Your Boss.)

Bid and Ask

As with most trading in the financial markets, when you are trading a currency pair there is a bid price (buy)
and an ask price (sell). Again, these are in relation to the base currency. When buying a currency pair (going
long), the ask price refers to the amount of quoted currency that has to be paid in order to buy one unit of
the base currency, or how much the market will sell one unit of the base currency for in relation to the
quoted currency.

The bid price is used when selling a currency pair (going short) and reflects how much of the quoted
currency will be obtained when selling one unit of the base currency, or how much the market will pay for the
quoted currency in relation to the base currency.

The quote before the slash is the bid price, and the two digits after the slash represent the ask price (only
the last two digits of the full price are typically quoted). Note that the bid price is always smaller than the ask
price. Let's look at an example:

USD/CAD = 1.2000/05
Bid = 1.2000
 Ask= 1.2005

If you want to buy this currency pair, this means that you intend to buy the base
currency and are therefore looking at the ask price to see how much (in Canadian
dollars) the market will charge for U.S. dollars. According to the ask price, you can
buy one U.S. dollar with 1.2005 Canadian dollars.

However, in order to sell this currency pair, or sell the base currency in exchange
for the quoted currency, you would look at the bid price. It tells you that the market
will buy US$1 base currency (you will be selling the market the base currency) for a
price equivalent to 1.2000 Canadian dollars, which is the quoted currency.

Whichever currency is quoted first (the base currency) is always the one in which
the transaction is being conducted. You either buy or sell the base currency.
Depending on what currency you want to use to buy or sell the base with, you refer
to the corresponding currency pair spot exchange rate to determine the price.

Spreads and Pips

The difference between the bid price and the ask price is called a spread. If we were
to look at the following quote: EUR/USD = 1.2500/03, the spread would be 0.0003 or
3 pips, also known as points. Although these movements may seem insignificant,
even the smallest point change can result in thousands of dollars being made or lost
due to leverage. Again, this is one of the reasons that speculators are so attracted to the
forex market; even the tiniest price movement can result in huge profit.

The pip is the smallest amount a price can move in any currency quote. In the case
of the U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With
the Japanese yen, one pip would be 0.01, because this currency is quoted to two
decimal places. So, in a forex quote of USD/CHF, the pip would be 0.0001 Swiss
francs. Most currencies trade within a range of 100 to 150 pips a day.

Currency Quote Overview

USD/CAD = 1.2232/37
Base Currency Currency to the left (USD)
Quote/Counter
Currency to the right (CAD)
Currency
Price for which the market maker will buy
Bid Price 1.2232 the base currency. Bid is always smaller
than ask.
Price for which the market maker will sell
Ask Price 1.2237
the base currency.
One point move, in USD/CAD it is .0001 and
The pip/point is the smallest movement a
Pip 1 point change would be from 1.2231 to
price can make.
1.2232
Spread Spread in this case is 5 pips/points;
difference between bid and ask price
 (1.2237-1.2232).

Currency Pairs in the Forwards and Futures Markets

One of the key technical differences between the forex markets is the way currencies are quoted. In the
forwards or futures markets, foreign exchange always is quoted against the U.S. dollar. This means that
pricing is done in terms of how many U.S. dollars are needed to buy one unit of the other currency.
Remember that in the spot market some currencies are quoted against the U.S. dollar, while for others, the
U.S. dollar is being quoted against them. As such, the forwards/futures market and the spot market quotes
will not always be parallel one another.

For example, in the spot market, the British pound is quoted against the U.S. dollar as GBP/USD. This is the
same way it would be quoted in the forwards and futures markets. Thus, when the British pound strengthens
against the U.S. dollar in the spot market, it will also rise in the forwards and futures markets.

On the other hand, when looking at the exchange rate for the U.S. dollar and the Japanese yen, the former
is quoted against the latter. In the spot market, the quote would be 115 for example, which means that one
U.S. dollar would buy 115 Japanese yen. In the futures market, it would be quoted as (1/115) or .0087,
which means that 1 Japanese yen would buy .0087 U.S. dollars. As such, a rise in the USD/JPY spot rate
would equate to a decline in the JPY futures rate because the U.S. dollar would have strengthened against
the Japanese yen and therefore one Japanese yen would buy less U.S. dollars.

Now that you know a little bit about how currencies are quoted, let's move on to the benefits and risks
involved with trading forex.
Foreign Exchange Risk and Benefits
In this section, we'll take a look at some of the benefits and risks associated with the forex market. We'll also
discuss how it differs from the equity market in order to get a greater understanding of how the forex market
works.

The Good and the Bad

We already have mentioned that factors
such as the size, volatility and global
structure of the foreign exchange market
have all contributed to its rapid success.
Given the highly liquid nature of this
market, investors are able to place
extremely large trades without affecting
any given exchange rate. These large
positions are made available to
forex traders because of the low margin
requirements used by the majority of the
industry's brokers. For example, it is
possible for a trader to control a position of
US$100,000 by putting down as little as
US$1,000 up front and borrowing the
remainder from his or her forex broker.
This amount of leverage acts as a double-
edged sword because investors can
realize large gains when rates make a small favorable change, but they also run the risk of a massive loss
when the rates move against them. Despite the foreign exchange risks, the amount of leverage available in
the forex market is what makes it attractive for many speculators.

The currency market is also the only market that is truly open 24 hours a day with decent liquidity throughout
the day. For traders who may have a day job or just a busy schedule, it is an optimal market to trade in. As
you can see from the chart below, the major trading hubs are spread throughout many different time zones,
eliminating the need to wait for an opening or closing bell. As the U.S. trading closes, other markets in the
East are opening, making it possible to trade at any time during the day.

Time Zone Time (ET)

 Tokyo Open 7:00 pm
Tokyo Close 4:00 am
London Open 3:00 am
London Close 12:00 pm
New York Open 8:00 am
New York Close 5:00 pm

While the forex market may offer more excitement to the investor, the risks are also higher in comparison to
trading equities. The ultra-high leverage of the forex market means that huge gains can quickly turn to
damaging losses and can wipe out the majority of your account in a matter of minutes. This is important for
all new traders to understand, because in the forex market - due to the large amount of money involved and
the number of players - traders will react quickly to information released into the market, leading to sharp
moves in the price of the currency pair.

Though currencies don't tend to move as sharply as equities on a percentage basis (where a company's
stock can lose a large portion of its value in a matter of minutes after a bad announcement), it is the
leverage in the spot market that creates the volatility. For example, if you are using 100:1 leverage on
$1,000 invested, you control $100,000 in capital. If you put $100,000 into a currency and the currency's
price moves 1% against you, the value of the capital will have decreased to $99,000 - a loss of $1,000, or all
of your invested capital, representing a 100% loss. In the equities market, most traders do not use leverage,
therefore a 1% loss in the stock's value on a $1,000 investment, would only mean a loss of $10. Therefore, it
is important to take into account the risks involved in the forex market before diving in.

Differences Between Forex and Equities

A major difference between the forex and equities markets is the number of traded instruments: the forex
market has very few compared to the thousands found in the equities market. The majority of forex traders
focus their efforts on seven different currency pairs: the four majors, which include (EUR/USD, USD/JPY,
GBP/USD, USD/CHF); and the three commodity pairs (USD/CAD, AUD/USD, NZD/USD). All other pairs are
just different combinations of the same currencies, otherwise known as cross currencies. This makes
currency trading easier to follow because rather than having to cherry-pick between 10,000 stocks to find the
best value, all that FX traders need to do is “keep up” on the economic and political news of eight countries.

The equity markets often can hit a lull, resulting in shrinking volumes and activity. As a result, it may be hard
to open and close positions when desired. Furthermore, in a declining market, it is only with extreme
ingenuity that an equities investor can make a profit. It is difficult to short-sell in the U.S. equities market
because of strict rules and regulations regarding the process. On the other hand, forex offers the opportunity
to profit in both rising and declining markets because with each trade, you are buying and selling
simultaneously, and short-selling is, therefore, inherent in every transaction. In addition, since the forex
market is so liquid, traders are not required to wait for an uptick before they are allowed to enter into a short
position - as they are in the equities market.

Due to the extreme liquidity of the forex market, margins are low and leverage is high. It just is not possible
to find such low margin rates in the equities markets; most margin traders in the equities markets need at
least 50% of the value of the investment available as margin, whereas forex traders need as little as 1%.
Furthermore, commissions in the equities market are much higher than in the forex market. Traditional
brokers ask for commission fees on top of the spread, plus the fees that have to be paid to the exchange.
Spot forex brokers take only the spread as their fee for the transaction. (For a more in-depth introduction to
currency trading, see Getting Started in Forex and A Primer On The Forex Market.)

By now you should have a basic understanding of what the forex market is and how it works. In the next
section, we'll examine the evolution of the current foreign exchange system.
Forex History and Market ParticipantsGiven the global nature of the
forex exchange market, it is important to first examine and learn some of the important historical events
relating to currencies and currency exchange before entering any trades. In this section we’ll review the
international monetary system and how it has evolved to its current state. We will then take a look at the
major players that occupy the forex market - something that is important for all potential forex traders to
understand.
The History of the Forex
Gold Standard System
The creation of the gold standard monetary system in 1875 marks one of the most important events in the
history of the forex market. Before the gold standard was implemented, countries would commonly use gold
and silver as means of international payment. The main issue with using gold and silver for payment is that
their value is affected by external supply and demand. For example, the discovery of a new gold mine would
drive gold prices down.

The underlying idea behind the gold

standard was that governments
guaranteed the conversion of currency into
a specific amount of gold, and vice versa.
In other words, a currency would be
backed by gold. Obviously, governments
needed a fairly substantial gold reserve in
order to meet the demand for currency
exchanges. During the late nineteenth
century, all of the major economic
countries had defined an amount of
currency to an ounce of gold. Over time,
the difference in price of an ounce of gold
between two currencies became the
exchange rate for those two currencies.
This represented the first standardized
means of currency exchange in history.

The gold standard eventually broke down

during the beginning of World War I. Due to the political tension with Germany, the major European powers
felt a need to complete large military projects. The financial burden of these projects was so substantial that
there was not enough gold at the time to exchange for all the excess currency that the governments were
printing off.

Although the gold standard would make a small comeback during the inter-war years, most countries had
dropped it again by the onset of World War II. However, gold never ceased being the ultimate form of
monetary value. (For more on this, read The Gold Standard Revisited, What Is Wrong With Gold? and Using
Technical Analysis In The Gold Markets.)

Bretton Woods System

Before the end of World War II, the Allied nations believed that there would be a need to set up a monetary
system in order to fill the void that was left behind when the gold standard system was abandoned. In July
1944, more than 700 representatives from the Allies convened at Bretton Woods, New Hampshire, to
deliberate over what would be called the Bretton Woods system of international monetary management.

To simplify, Bretton Woods led to the formation of the following:

1. A method of fixed exchange rates;

2. The U.S. dollar replacing the gold standard to become a primary reserve currency; and
3. The creation of three international agencies to oversee economic activity: the International
Monetary Fund (IMF), International Bank for Reconstruction and Development, and the General
Agreement on Tariffs and Trade (GATT).

One of the main features of Bretton Woods is that the U.S. dollar replaced gold as the main standard of
convertibility for the world’s currencies; and furthermore, the U.S. dollar became the only currency that
would be backed by gold. (This turned out to be the primary reason that Bretton Woods eventually failed.)

Over the next 25 or so years, the U.S. had to run a series of balance of payment deficits in order to be the
world’s reserved currency. By the early 1970s, U.S. gold reserves were so depleted that the U.S. treasury
did not have enough gold to cover all the U.S. dollars that foreign central banks had in reserve.
Finally, on August 15, 1971, U.S. President Richard Nixon closed the gold window, and the U.S. announced
to the world that it would no longer exchange gold for the U.S. dollars that were held in foreign reserves.
This event marked the end of Bretton Woods.

Even though Bretton Woods didn’t last, it left an important legacy that still has a significant effect on today’s
international economic climate. This legacy exists in the form of the three international agencies created in
the 1940s: the IMF, the International Bank for Reconstruction and Development (now part of the World
Bank) and GATT, the precursor to the World Trade Organization. (To learn more about Bretton Wood, read
What Is The International Monetary Fund? and Floating And Fixed Exchange Rates.)

Current Exchange Rates

After the Bretton Woods system broke down, the world finally accepted the use of floating foreign exchange
rates during the Jamaica agreement of 1976. This meant that the use of the gold standard would be
permanently abolished. However, this is not to say that governments adopted a pure free-floating exchange
rate system. Most governments employ one of the following three exchange rate systems that are still used
today:

1. Dollarization;
2. Pegged rate; and
3. Managed floating rate.

Dollarization
This event occurs when a country decides not to issue its own currency and adopts a foreign currency as its
national currency. Although dollarization usually enables a country to be seen as a more stable place for
investment, the drawback is that the country’s central bank can no longer print money or make any sort of
monetary policy. An example of dollarization is El Salvador's use of the U.S. dollar. (To read more, see
Dollarization Explained.)

Pegged Rates
Pegging occurs when one country directly fixes its exchange rate to a foreign currency so that the country
will have somewhat more stability than a normal float. More specifically, pegging allows a country’s currency
to be exchanged at a fixed rate with a single or a specific basket of foreign currencies. The currency will only
fluctuate when the pegged currencies change.

For example, China pegged its yuan to the U.S. dollar at a rate of 8.28 yuan to US$1, between 1997 and
July 21, 2005. The downside to pegging would be that a currency’s value is at the mercy of the pegged
currency’s economic situation. For example, if the U.S. dollar appreciates substantially against all other
currencies, the yuan would also appreciate, which may not be what the Chinese central bank wants.

Managed Floating Rates

This type of system is created when a currency’s exchange rate is allowed to freely change in value subject
to the market forces of supply and demand. However, the government or central bank may intervene to
stabilize extreme fluctuations in exchange rates. For example, if a country’s currency is depreciating far
beyond an acceptable level, the government can raise short-term interest rates. Raising rates should cause
the currency to appreciate slightly; but understand that this is a very simplified example. Central banks
typically employ a number of tools to manage currency.

Market Participants
Unlike the equity market - where investors often only trade with institutional investors (such as mutual funds)
or other individual investors - there are additional participants that trade on the forex market for entirely
different reasons than those on the equity market. Therefore, it is important to identify and understand the
functions and motivations of the main players of the forex market.

Governments and Central Banks

Arguably, some of the most influential participants involved with currency exchange are the central banks
and federal governments. In most countries, the central bank is an extension of the government and
conducts its policy in tandem with the government. However, some governments feel that a more
independent central bank would be more effective in balancing the goals of curbing inflation and keeping
interest rates low, which tends to increase economic growth. Regardless of the degree of independence that
a central bank possesses, government representatives typically have regular consultations with central bank
representatives to discuss monetary policy. Thus, central banks and governments are usually on the same
page when it comes to monetary policy.

Central banks are often involved in manipulating reserve volumes in order to meet certain economic goals.
For example, ever since pegging its currency (the yuan) to the U.S. dollar, China has been buying up
millions of dollars worth of U.S. treasury bills in order to keep the yuan at its target exchange rate. Central
banks use the foreign exchange market to adjust their reserve volumes. With extremely deep pockets, they
yield significant influence on the currency markets.

Banks and Other Financial Institutions

In addition to central banks and governments, some of the largest participants involved with forex
transactions are banks. Most individuals who need foreign currency for small-scale transactions deal with
neighborhood banks. However, individual transactions pale in comparison to the volumes that are traded in
the interbank market.

The interbank market is the market through which large banks transact with each other and determine the
currency price that individual traders see on their trading platforms. These banks transact with each other on
electronic brokering systems that are based upon credit. Only banks that have credit relationships with each
other can engage in transactions. The larger the bank, the more credit relationships it has and the better the
pricing it can access for its customers. The smaller the bank, the less credit relationships it has and the
lower the priority it has on the pricing scale.

Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the bid/ask price.
One way that banks make money on the forex market is by exchanging currency at a premium to the price
they paid to obtain it. Since the forex market is a decentralized market, it is common to see different banks
with slightly different exchange rates for the same currency.

Hedgers
Some of the biggest clients of these banks are businesses that deal with international transactions. Whether
a business is selling to an international client or buying from an international supplier, it will need to deal with
the volatility of fluctuating currencies.

If there is one thing that management (and shareholders) detest, it is uncertainty. Having to deal with
foreign-exchange risk is a big problem for many multinationals. For example, suppose that a German
company orders some equipment from a Japanese manufacturer to be paid in yen one year from now. Since
the exchange rate can fluctuate wildly over an entire year, the German company has no way of knowing
whether it will end up paying more euros at the time of delivery.

One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go into the
spot market and make an immediate transaction for the foreign currency that they need.

Unfortunately, businesses may not have enough cash on hand to make spot transactions or may not want to
hold massive amounts of foreign currency for long periods of time. Therefore, businesses quite frequently
employ hedging strategies in order to lock in a specific exchange rate for the future or to remove all sources
of exchange-rate risk for that transaction.

For example, if a European company wants to import steel from the U.S., it would have to pay in U.S.
dollars. If the price of the euro falls against the dollar before payment is made, the European company will
realize a financial loss. As such, it could enter into a contract that locked in the current exchange rate to
eliminate the risk of dealing in U.S. dollars. These contracts could be either forwards or futures contracts.

Speculators
Another class of market participants involved with foreign exchange-related transactions is speculators.
Rather than hedging against movement in exchange rates or exchanging currency to fund international
transactions, speculators attempt to make money by taking advantage of fluctuating exchange-rate levels.

The most famous of all currency speculators is probably George Soros. The billionaire hedge fund manager
is most famous for speculating on the decline of the British pound, a move that earned $1.1 billion in less
than a month. On the other hand, Nick Leeson, a derivatives trader with England’s Barings Bank, took
speculative positions on futures contracts in yen that resulted in losses amounting to more than $1.4 billion,
which led to the collapse of the company.

Some of the largest and most controversial speculators on the forex market are hedge funds, which are
essentially unregulated funds that employ unconventional investment strategies in order to reap large
returns. Think of them as mutual funds on steroids. Hedge funds are the favorite whipping boys of many a
central banker. Given that they can place such massive bets, they can have a major effect on a country’s
currency and economy. Some critics blamed hedge funds for the Asian currency crisis of the late 1990s, but
others have pointed out that the real problem was the ineptness of Asian central bankers. (For more on
hedge funds, see Introduction To Hedge Funds - Part One and Part Two.)Either way, speculators can have
a big sway on the currency markets, particularly big ones.

Now that you have a basic understanding of the forex market, its participants and its history, we can move
on to some of the more advanced concepts that will bring you closer to being able to trade within this
massive market. The next section will look at the main economic theories that underlie the forex market.
Economic Theories, Models, Feeds & Data
There is a great deal of academic theory revolving around currencies. While often not applicable directly to
day-to-day trading, it is helpful to understand the overarching ideas behind the academic research.

The main economic theories found in the

foreign exchange deal with parity
conditions. A parity condition is an
economic explanation of the price at which
two currencies should be exchanged,
based on factors such as inflation and
interest rates. The economic theories
suggest that when the parity condition
does not hold, an arbitrage opportunity
exists for market participants. However,
arbitrage opportunities, as in many other
markets, are quickly discovered and
eliminated before even giving the
individual investor an opportunity to
capitalize on them. Other theories are
based on economic factors such as trade,
capital flows and the way a country runs its
operations. We review each of them briefly
below.

Major Theories: Purchasing Power Parity

Purchasing Power Parity (PPP) is the economic theory that price levels between two countries should be
equivalent to one another after exchange-rate adjustment. The basis of this theory is the law of one price,
where the cost of an identical good should be the same around the world. Based on the theory, if there is a
large difference in price between two countries for the same product after exchange rate adjustment, an
arbitrage opportunity is created, because the product can be obtained from the country that sells it for the
lowest price.

The relative version of PPP is as follows:

Where 'e' represents the rate of change in the exchange rate and 'π1' and 'π2'represent the rates of inflation
for country 1 and country 2, respectively.

For example, if the inflation rate for country XYZ is 10% and the inflation for country ABC is 5%, then ABC's
currency should appreciate 4.76% against that of XYZ.
  

Interest Rate Parity

The concept of Interest Rate Parity (IRP) is similar to PPP, in that it suggests that for there to be no
arbitrage opportunities, two assets in two different countries should have similar interest rates, as long as
the risk for each is the same. The basis for this parity is also the law of one price, in that the purchase of one
investment asset in one country should yield the same return as the exact same asset in another country;
otherwise exchange rates would have to adjust to make up for the difference.

The formula for determining IRP can be found by:

Where 'F' represents the forward exchange rate; 'S' represents the spot exchange rate; 'i1' represents the
interest rate in country 1; and 'i2' represents the interest rate in country 2.

International Fisher Effect

The International Fisher Effect (IFE) theory suggests that the exchange rate between two countries should
change by an amount similar to the difference between their nominal interest rates. If the nominal rate in one
country is lower than another, the currency of the country with the lower nominal rate should appreciate
against the higher rate country by the same amount.

The formula for IFE is as follows:

Where 'e' represents the rate of change in the exchange rate and 'i1' and 'i2'represent the rates of inflation for
country 1 and country 2, respectively.

Balance of Payments Theory

A country's balance of payments is comprised of two segments - the current account and the capital account
- which measure the inflows and outflows of goods and capital for a country. The balance of payments
theory looks at the current account, which is the account dealing with trade of tangible goods, to get an idea
of exchange-rate directions.

If a country is running a large current account surplus or deficit, it is a sign that a country's exchange rate is
out of equilibrium. To bring the current account back into equilibrium, the exchange rate will need to adjust
over time. If a country is running a large deficit (more imports than exports), the domestic currency will
depreciate. On the other hand, a surplus would lead to currency appreciation.

The balance of payments identity is found by:

 
Where BCA represents the current account balance; BKA represents the capital account balance; and BRA
represents the reserves account balance.

Real Interest Rate Differentiation Model

The Real Interest Rate Differential Model simply suggests that countries with higher real interest rates will
see their currencies appreciate against countries with lower interest rates. The reason for this is that
investors around the world will move their money to countries with higher real rates to earn higher returns,
which bids up the price of the higher real rate currency.

Asset Market Model

The Asset Market Model looks at the inflow of money into a country by foreign investors for the purpose of
purchasing assets such as stocks, bonds and other financial instruments. If a country is seeing large inflows
by foreign investors, the price of its currency is expected to increase, as the domestic currency needs to be
purchased by these foreign investors. This theory considers the capital account of the balance of trade
compared to the current account in the prior theory. This model has gained more acceptance as the capital
accounts of countries are starting to greatly outpace the current account as international money flow
increases.

Monetary Model
The Monetary Model focuses on a country's monetary policy to help determine the exchange rate. A
country's monetary policy deals with the money supply of that country, which is determined by both the
interest rate set by central banks and the amount of money printed by the treasury. Countries that adopt a
monetary policy that rapidly grows its monetary supply will see inflationary pressure due to the increased
amount of money in circulation. This leads to a devaluation of the currency.

These economic theories, which are based on assumptions and perfect situations, help to illustrate the basic
fundamentals of currencies and how they are impacted by economic factors. However, the fact that there
are so many conflicting theories indicates the difficulty in any one of them being 100% accurate in predicting
currency fluctuations. Their importance will likely vary by the different market environment, but it is still
important to know the fundamental basis behind each of the theories.

Economic Data
Economic theories may move currencies in the long term, but on a shorter-term, day-to-day or week-to-week
basis, economic data has a more significant impact. It is often said the biggest companies in the world are
actually countries and that their currency is essentially shares in that country. Economic data, such as the
latest gross domestic product (GDP) numbers, are often considered to be like a company's latest earnings
data. In the same way that financial news and current events can affect a company's stock price, news and
information about a country can have a major impact on the direction of that country's currency. Changes in
interest rates, inflation, unemployment, consumer confidence, GDP, political stability etc. can all lead to
extremely large gains/losses depending on the nature of the announcement and the current state of the
country.

The number of economic announcements made each day from around the world can be intimidating, but as
one spends more time learning about the forex market it becomes clear which announcements have the
greatest influence. Listed below are a number of economic indicators that are generally considered to have
the greatest influence - regardless of which country the announcement comes from.

Employment Data
Most countries release data about the number of people that currently are employed within that economy. In
the U.S., this data is known as non-farm payrolls and is released the first Friday of the month by the Bureau
of Labor Statistics. In most cases, strong increases in employment signal that a country enjoys a prosperous
economy, while decreases are a sign of potential contraction. If a country has gone recently through
economic troubles, strong employment data could send the currency higher because it is a sign of economic
health and recovery. On the other hand, high employment can also lead to inflation, so this data could send
the currency downward. In other words, economic data and the movement of currency will often depend on
the circumstances that exist when the data is released.

Interest Rates
As was seen with some of the economic theories, interest rates are a major focus in the forex market. The
most focus by market participants, in terms of interest rates, is placed on the country's central bank changes
of its bank rate, which is used to adjust monetary supply and institute the country's monetary policy. In the
U.S., the Federal Open Market Committee (FOMC) determines the bank rate, or the rate at which
commercial banks can borrow and lend to the U.S. Treasury. The FOMC meets eight times a year to make
decisions on whether to raise, lower or leave the bank rate the same; and each meeting, along with the
minutes, is a point of focus. (For more on central banks read Get to Know the Major Central Banks.)

Inflation
Inflation data measures the increases and decreases of price levels over a period of time. Due to the sheer
amount of goods and services within an economy, a basket of goods and services is used to measure
changes in prices. Price increases are a sign of inflation, which suggests that the country will see its
currency depreciate. In the U.S., inflation data is shown in the Consumer Price Index, which is released on a
monthly basis by the Bureau of Labor Statistics.
Gross Domestic Product
The gross domestic product of a country is a measure of all of the finished goods and services that a country
generated during a given period. The GDP calculation is split into four categories: private consumption,
government spending, business spending and total net exports. GDP is considered the best overall measure
of the health of a country's economy, with GDP increases signaling economic growth. The healthier a
country's economy is, the more attractive it is to foreign investors, which in turn can often lead to increases
in the value of its currency, as money moves into the country. In the U.S., this data is released by the
Bureau of Economic Analysis once a month in the third or fourth quarter of the month.

Retail Sales
Retail sales data measures the amount of sales that retailers make during the period, reflecting consumer
spending. The measure itself doesn't look at all stores, but, similar to GDP, uses a group of stores of varying
types to get an idea of consumer spending. This measure also gives market participants an idea of the
strength of the economy, where increased spending signals a strong economy. In the U.S., the Department
of Commerce releases data on retail sales around the middle of the month.

Durable Goods
The data for durable goods (those with a lifespan of more than three years) measures the amount of
manufactured goods that are ordered, shipped and unfilled for the time period. These goods include such
things as cars and appliances, giving economists an idea of the amount of individual spending on these
longer-term goods, along with an idea of the health of the factory sector. This measure again gives market
participants insight into the health of the economy, with data being released around the 26th of the month by
the Department of Commerce.

Trade and Capital Flows

Interactions between countries create huge monetary flows that can have a substantial impact on the value
of currencies. As was mentioned before, a country that imports far more than it exports could see its
currency decline due to its need to sell its own currency to purchase the currency of the exporting nation.
Furthermore, increased investments in a country can lead to substantial increases in the value of its
currency.

Trade flow data looks at the difference between a country's imports and exports, with a trade deficit
occurring when imports are greater than exports. In the U.S., the Commerce Department releases balance
of trade data on a monthly basis, which shows the amount of goods and services that the U.S. exported and
imported during the past month. Capital flow data looks at the difference in the amount of currency being
brought in through investment and/or exports to currency being sold for foreign investments and/or imports.
A country that is seeing a lot of foreign investment, where outsiders are purchasing domestic assets such as
stocks or real estate, will generally have a capital flow surplus.

Balance of payments data is the combined total of a country's trade and capital flow over a period of time.
The balance of payments is split into three categories: the current account, the capital account and the
financial account. The current account looks at the flow of goods and services between countries. The
capital account looks at the exchange of money between countries for the purpose of purchasing capital
assets. The financial account looks at the monetary flow between countries for investment purposes.

Macroeconomic and Geopolitical Events

The biggest changes in the forex often come from macroeconomic and geopolitical events such as wars,
elections, monetary policy changes and financial crises. These events have the ability to change or reshape
the country, including its fundamentals. For example, wars can put a huge economic strain on a country and
greatly increase the volatility in a region, which could impact the value of its currency. It is important to keep
up to date on these macroeconomic and geopolitical events.

There is so much data that is released in the forex market that it can be very difficult for the average
individual to know which data to follow. Despite this, it is important to know what news releases will affect
the currencies you trade. (For more insight, check out Trading On News Releases and Economic Indicators
To Know.)

Now that you know a little more about what drives the market, we will look next at the two main trading
strategies used by traders in the forex market – fundamental and technical analysis.
Fundamental Analysis & Fundamentals Trading
Strategies
In the equities market, fundamental analysis looks to measure a company's true value and to base
investments upon this type of calculation. To some extent, the same is done in the retail forex market, where
forex fundamental traders evaluate currencies, and their countries, like companies and use economic
announcements to gain an idea of the currency’s true value.

All of the news reports, economic data and political events that come out about a country are similar to news
that comes out about a stock in that it is used by investors to gain an idea of value. This value changes over
time due to many factors, including economic growth and financial strength. Fundamental traders look at all
of this information to evaluate a country's currency.

Given that there are practically unlimited forex fundamentals trading strategies based on fundamental data,
one could write a book on this subject. To give you a better idea of a tangible trading opportunity, let’s go
over one of the most well-known situations, the forex carry trade. (To read some frequently asked questions
about currency trading, see Common Questions About Currency Trading.)

A Breakdown of the Forex Carry Trade

The currency carry trade is a strategy in which a trader sells a currency that is offering lower interest rates
and purchases a currency that offers a higher interest rate. In other words, you borrow at a low rate, and
then lend at a higher rate. The trader using the strategy captures the difference between the two rates.
When highly leveraging the trade, even a small difference between two rates can make the trade highly
profitable. Along with capturing the rate difference, investors also will often see the value of the higher
currency rise as money flows into the
higher-yielding currency, which bids up its
value.

Real-life examples of a yen carry trade can

be found starting in 1999, when Japan
decreased its interest rates to almost zero.
Investors would capitalize upon these
lower interest rates and borrow a large
sum of Japanese yen. The borrowed yen
is then converted into U.S. dollars, which
are used to buy U.S. Treasury bonds with
yields and coupons at around 4.5-5%.
Since the Japanese interest rate was
essentially zero, the investor would be
paying next to nothing to borrow the
Japanese yen and earn almost all the yield
on his or her U.S. Treasury bonds. But
with leverage, you can greatly increase the
return.

For example, 10 times leverage would create a return of 30% on a 3% yield. If you have $1,000 in your
account and have access to 10 times leverage, you will control $10,000. If you implement the currency carry
trade from the example above, you will earn 3% per year. At the end of the year, your $10,000 investment
would equal $10,300, or a $300 gain. Because you only invested $1,000 of your own money, your real
return would be 30% ($300/$1,000). However this strategy only works if the currency pair’s value remains
unchanged or appreciates. Therefore, most forex carry traders look not only to earn the interest rate
differential, but also capital appreciation. While we’ve greatly simplified this transaction, the key thing to
remember here is that a small difference in interest rates can result in huge gains when leverage is applied.
Most currency brokers require a minimum margin to earn interest for carry trades.

However, this transaction is complicated by changes to the exchange rate between the two countries. If the
lower-yielding currency appreciates against the higher-yielding currency, the gain earned between the two
yields could be eliminated. The major reason that this can happen is that the risks of the higher-yielding
currency are too much for investors, so they choose to invest in the lower-yielding, safer currency. Because
carry trades are longer term in nature, they are susceptible to a variety of changes over time, such as rising
rates in the lower-yielding currency, which attracts more investors and can lead to currency appreciation,
diminishing the returns of the carry trade. This makes the future direction of the currency pair just as
important as the interest rate differential itself. (To read more about currency pairs, see Using Currency
Correlations To Your Advantage, Making Sense Of The Euro/Swiss Franc Relationship and Forces Behind
Exchange Rates.)

To clarify this further, imagine that the interest rate in the U.S. was 5%, while the same interest rate in
Russia was 10%, providing a carry trade opportunity for traders to short the U.S. dollar and to long the
Russian ruble. Assume the trader borrows $1,000 US at 5% for a year and converts it into Russian rubles at
a rate of 25 USD/RUB (25,000 rubles), investing the proceeds for a year. Assuming no currency changes,
the 25,000 rubles grows to 27,500 and, if converted back to U.S. dollars, will be worth $1,100 US. But
because the trader borrowed $1,000 US at 5%, he or she owes $1,050 US, making the net proceeds of the
trade only $50.

However, imagine that there was another crisis in Russia, such as the one that was seen in 1998 when the
Russian government defaulted on its debt and there was large currency devaluation in Russia as market
participants sold off their Russian currency positions. If, at the end of the year the exchange rate was 50
USD/RUB, your 27,500 rubles would now convert into only $550 US (27,500 RUB x 0.02 RUB/USD).
Because the trader owes $1,050 US, he or she will have lost a significant percentage of the original
investment on this carry trade because of the currency’s fluctuation - even though the interest rates in
Russia were higher than the U.S.

Another good example of forex fundamental analysis is based on commodity prices. (To read more about
this, see Commodity Prices And Currency Movements.)

You should now have an idea of some of the basic economic and fundamental ideas that underlie the forex
and impact the movement of currencies. The most important thing that should be taken away from this
section is that currencies and countries, like companies, are constantly changing in value based on
fundamental factors such as economic growth and interest rates. You should also, based on the economic
theories mentioned above, have an idea how certain economic factors impact a country's currency. We will
now move on to technical analysis, the other school of analysis that can be used to pick trades in the forex
market.
Technical Analysis & TechnicaI Indicators
One of the underlying tenets of technical analysis is that historical price action predicts future price action.
Since the forex is a 24-hour market, there tends to be a large amount of data that can be used to gauge
future price activity, thereby increasing the statistical significance of the forecast. This makes it the perfect
market for traders that use technical tools, such as trends, charts and indicators. (To learn more, see
Introduction to Technical Analysis and Charting Your Way To Better Returns.)

It is important to note that, in general, the

interpretation of technical analysis remains
the same regardless of the asset being
monitored. There are literally hundreds of
books dedicated to this field of study, but
in this tutorial we will only touch on the
basics of why technical analysis is such a
popular tool in the forex market.

As the specific techniques of technical

analysis are discussed in other tutorials,
we will focus on the more forex-specific
aspects of technical analysis.

Technical Analysis Discounts Everything;

Especially in Forex
Minimal Rate Inconsistency
There are many large players in the forex
market, such as hedge funds and large
banks, that all have advanced computer systems to constantly monitor any inconsistencies between the
different currency pairs. Given these programs, it is rare to see any major inconsistency last longer than a
matter of seconds. Many traders turn to forex technical analysis because it presumes that all the factors that
influence a price - economic, political, social and psychological - have already been factored into the current
exchange rate by the market. With so many investors and so much money exchanging hands each day, the
trend and flow of capital is what becomes important, rather than attempting to identify a mispriced rate.

Trend or Range
One of the greatest goals of technical traders in the FX market is to determine whether a given pair will trend
in a certain direction, or if it will travel sideways and remain range-bound. The most common method to
determine these characteristics is to draw trend lines that connect historical levels that have prevented a
rate from heading higher or lower. These levels of support and resistance are used by technical traders to
determine whether or not the given trend, or lack of trend, will continue.

Generally, the major currency pairs - such as the EUR/USD, USD/JPY, USD/CHF and GBP/USD - have
shown the greatest characteristics of trend, while the currency pairs that have historically shown a higher
probability of becoming range-bound have been the currency crosses (pairs not involving the U.S. dollar).
The two charts below show the strong trending nature of USD/JPY in contrast to the range-bound nature of
EUR/CHF. It is important for every trader to be aware of the characteristics of trend and range, because they
will not only affect what pairs are traded, but also what type of strategy should be used. (To learn more
about this subject, see Trading Trend Or Range?)

Graph created by E-Signal.

Figure 1
 Graph created by E-Signal.
Figure 2

Common Indicators
Technical traders use many different indicators in combination with support and resistance to aid them in
predicting the future direction of exchange rates. Again, learning how to interpret various forex technical
indicators is a study unto itself and goes beyond the scope of this forex tutorial. If you wish to learn more
about this subject, we suggest you read our technical analysis tutorial.

A few indicators that we feel we should mention, due to their popularity, are: Bollinger bands, Fibonacci
retracement, moving averages, moving average convergence divergence (MACD) and stochastics. These
technical tools are rarely used by themselves to generate signals, but rather in conjunction with other
indicators and chart patterns.

For more on technical analysis and the forex, take a look at the following articles: Using Bollinger Band
"Bands" To Gauge Trends, Trading Double Tops And Double Bottoms, Introducing The Bearish Diamond
Formation, Keep An Eye On Momentum and Consolidation - Trade The Calm, Profit From The Storm.
How To Trade & Open A Forex Account
So, you think you are ready to trade? Make sure you read this section to learn how you can go about setting
up a forex account so that you can start trading currencies. We'll also mention other factors that you should
be aware of before you take this step. We will then discuss how to trade forex and the different types of
orders that can be placed.

Opening A Forex Brokerage Account

Trading forex is similar to the equity
market because individuals interested in
trading need to open up a trading account.
Like the equity market, each forex account
and the services it provides differ, so it is
important that you find the right one. Below
we will talk about some of the factors that
should be considered when selecting a
forex account.

Leverage
Leverage is basically the ability to control large amounts of capital, using very little of your own capital; the
higher the leverage, the higher the level of risk. The amount of leverage on an account differs depending on
the account itself, but most use a factor of at least 50:1, with some being as high as 250:1. A leverage factor
of 50:1 means that for every dollar you have in your account you control up to $50. For example, if a trader
has $1,000 in his or her account, the broker will lend that person $50,000 to trade in the market. This
leverage also makes your margin, or the amount you have to have in the account to trade a certain amount,
very low. In equities, margin is usually at least 50%, while the leverage of 50:1 is equivalent to 2%.

Leverage is seen as a major benefit of forex trading, as it allows you to make large gains with a small
investment. However, leverage can also be an extreme negative if a trade moves against you because your
losses also are amplified by the leverage. With this kind of leverage, there is the real possibility that you can
lose more than you invested - although most firms have protective stops preventing an account from going
negative. For this reason, it is vital that you remember this when opening an account and that when you
determine your desired leverage you understand the risks involved.

Commissions and Fees

Another major benefit of forex accounts is that trading within them is done on a commission-free basis. This
is unlike equity accounts, in which you pay the broker a fee for each trade. The reason for this is that you are
dealing directly with market makers and do not have to go through other parties like brokers.

This may sound too good to be true, but rest assured that market makers are still making money each time
you trade. Remember the bid and ask from the previous section? Each time a trade is made, it is the market
makers that capture the spread between these two. Therefore, if the bid/ask for a foreign currency is
1.5200/50, the market maker captures the difference (50 basis points).

If you are planning on opening a forex account, it is important to know that each firm has different spreads
on foreign currency pairs traded through them. While they will often differ by only a few pips (0.0001), this
can be meaningful if you trade a lot over time. So when opening an account make sure to find out the pip
spread that it has on foreign currency pairs you are looking to trade.

Other Factors
There are a lot of differences between each forex firm and the accounts they offer, so it is important to
review each before making a commitment. Each company will offer different levels of services and programs
along with fees above and beyond actual trading costs. Also, due to the less regulated nature of the forex
market, it is important to go with a reputable company. (For more information on what to look for when
opening an account, read Wading Into The Currency Market. If you are not ready to open a "real money"
account but want to try your hand at forex trading, read Demo Before You Dive In.)

How to Trade Forex

Now that you know some important factors to be aware of when opening a forex account, we will take a look
at what exactly you can trade within that account. The two main ways to trade in the foreign currency market
is the simple buying and selling of currency pairs, where you go long one currency and short another. The
second way is through the purchasing of derivatives that track the movements of a specific currency pair.
Both of these techniques are highly similar to techniques in the equities market.The most common way is to
simply buy and sell currency pairs, much in the same way most individuals buy and sell stocks. In this case,
you are hoping the value of the pair itself changes in a favorable manner. If you go long a currency pair, you
are hoping that the value of the pair increases. For example, let's say that you took a long position in the
USD/CAD pair - you will make money if the value of this pair goes up, and lose money if it falls. This pair
rises when the U.S. dollar increases in value against the Canadian dollar, so it is a bet on the U.S. dollar.

The other option is to use derivative products, such as options and futures, to profit from changes in the
value of currencies. If you buy an option on a currency pair, you are gaining the right to purchase a currency
pair at a set rate before a set point in time. A futures contract, on the other hand, creates the obligation to
buy the currency at a set point in time. Both of these trading techniques are usually only used by more
advanced traders, but it is important to at least be familiar with them. (For more on this, try Getting Started in
Forex Options and our tutorials, Option Spread Strategies and Options Basics Tutorial.)

Types of Orders
A trader looking to open a new position will likely use either a market order or a limit order. The incorporation
of these order types remains the same as when they are used in the equity markets. A market order gives a
forex trader the ability to obtain the currency at whatever exchange rate it is currently trading at in the
market, while a limit order allows the trader to specify a certain entry price. (For a brief refresher of these
orders, see The Basics of Order Entry.)

Forex traders who already hold an open position may want to consider using a take-profit order to lock in a
profit. Say, for example, that a trader is confident that the GBP/USD rate will reach 1.7800, but is not as sure
that the rate could climb any higher. A trader could use a take-profit order, which would automatically close
his or her position when the rate reaches 1.7800, locking in their profits.

Another tool that can be used when traders hold open positions is the stop-loss order. This order allows
traders to determine how much the rate can decline before the position is closed and further losses are
accumulated. Therefore, if the GBP/USD rate begins to drop, an investor can place a stop-loss that will
close the position (for example at 1.7787), in order to prevent any further losses.

As you can see, the type of orders that you can enter in your forex trading account are similar to those found
in equity accounts. Having a good understanding of these orders is critical before placing your first trade.

If you want to read more, see these frequently asked questions How does the forex market trade 24 hours a
day?, Why is currency always quoted in pairs? and What is the value of one pip and why are they different
between currency pairs?
Currency Trading Summary
While this online forex tutorial only represents a fraction of all there is to know about forex trading, we hope
that you've gained some insight into this topic. We also encourage those of you who are interested in
potentially trading in the online forex market to learn more about the complexities and intricacies that make
this market unique.

Let's recap: 
 The forex market represents the electronic over-the-counter markets where currencies are traded
worldwide 24 hours a day, five and a half days a week. The typical means of trading forex are on
the spot, futures and forwards markets.
 Currencies are "priced" in currency pairs and are quoted either directly or indirectly.
 Currencies typically have two prices: bid (the amount that the market will buy the quote currency for
in relation to the base currency); and ask (the amount the market will sell one unit of the base
currency for in relation to the quote currency). The bid price is always smaller than the ask price.
 Unlike conventional equity and debt markets, forex investors have access to large amounts of
leverage, which allows substantial positions to be taken without making a large initial investment.
 The adoption and elimination of several global currency systems over time led to the formation of
the present currency exchange system, in which most countries use some measure of floating
exchange rates.
 Governments, central banks, banks and other financial institutions, hedgers, and speculators are
the main players in the forex market.
 The main economic theories found in the foreign exchange deal with parity conditions such as
those involving interest rates and inflation. Overall, a country's qualitative and quantitative factors
are seen as large influences on its currency in the forex market.
 Forex traders use fundamental analysis to view currencies and their countries like companies,
thereby using economic announcements to gain an idea of the currency's true value.
 Forex traders use technical analysis to look at currencies the same way they would any other asset
and, therefore, use technical tools such as trends, charts and indicators in their trading strategies.
 Unlike stock trades, forex trades have minimal commissions and related fees. But new forex
traders should take a conservative approach and use orders, such as the take-profit or stop-loss, to
minimize losses.

While this online forex tutorial only represents a fraction of all there is to know about forex trading, we hope
that you've gained some insight into this topic. We also encourage those of you who are interested in
potentially trading in the online forex market to learn more about the complexities and intricacies that make
this market unique.

Let's recap: 
  The forex market represents the electronic over-the-counter markets where currencies are traded
worldwide 24 hours a day, five and a half days a week. The typical means of trading forex are on
the spot, futures and forwards markets.
 Currencies are "priced" in currency pairs and are quoted either directly or indirectly.
 Currencies typically have two prices: bid (the amount that the market will buy the quote currency for
in relation to the base currency); and ask (the amount the market will sell one unit of the base
currency for in relation to the quote currency). The bid price is always smaller than the ask price.
 Unlike conventional equity and debt markets, forex investors have access to large amounts of
leverage, which allows substantial positions to be taken without making a large initial investment.
 The adoption and elimination of several global currency systems over time led to the formation of
the present currency exchange system, in which most countries use some measure of floating
exchange rates.
 Governments, central banks, banks and other financial institutions, hedgers, and speculators are
the main players in the forex market.
 The main economic theories found in the foreign exchange deal with parity conditions such as
those involving interest rates and inflation. Overall, a country's qualitative and quantitative factors
are seen as large influences on its currency in the forex market.
 Forex traders use fundamental analysis to view currencies and their countries like companies,
thereby using economic announcements to gain an idea of the currency's true value.
 Forex traders use technical analysis to look at currencies the same way they would any other asset
and, therefore, use technical tools such as trends, charts and indicators in their trading strategies.
 Unlike stock trades, forex trades have minimal commissions and related fees. But new forex
traders should take a conservative approach and use orders, such as the take-profit or stop-loss, to
minimize losses.

The Federal Reserve: Introduction

Most people are aware that there is a government body that acts as the guardian of the economy - an
economic sentinel who implements policies designed to keep the country operating smoothly. Unfortunately,
most investors do not understand how or why the government involves itself in the economy.

In the U.S., the answer lies in the role of the Federal Reserve, or simply, the Fed. The Fed is the gatekeeper
of the U.S. economy. It is the bank of the U.S. government and, as such, it regulates the nation's financial
institutions. The Fed watches over the world's largest economy and is, therefore, one of the most powerful
organizations on earth.

As an investor, it is essential to acquire a basic

knowledge of the Federal Reserve System. The Fed dictates economic and monetary policies that have
profound impacts on individuals in the U.S. and around the world. In this tutorial, we'll learn about how the
Fed is structured, find out who Alan Greenspan and Ben Bernanke are and talk about monetary policy and
the Federal Open Market Committee (FOMC) rate meeting
Most people are aware that there is a government body that acts as the guardian of the economy - an
economic sentinel who implements policies designed to keep the country operating smoothly. Unfortunately,
most investors do not understand how or why the government involves itself in the economy.

In the U.S., the answer lies in the role of the Federal Reserve, or simply, the Fed. The Fed is the gatekeeper
of the U.S. economy. It is the bank of the U.S. government and, as such, it regulates the nation's financial
institutions. The Fed watches over the world's largest economy and is, therefore, one of the most powerful
organizations on earth.

As an investor, it is essential to acquire a basic

knowledge of the Federal Reserve System. The Fed dictates economic and monetary policies that have
profound impacts on individuals in the U.S. and around the world. In this tutorial, we'll learn about how the
Fed is structured, find out who Alan Greenspan and Ben Bernanke are and talk about monetary policy and
the Federal Open Market Committee (FOMC) rate meeting
What Is The Fed
The Federal Reserve was created by the U.S. Congress in 1913. Before that, the U.S. lacked any formal
organization for studying and implementing monetary policy. Consequently markets were often unstable and
the public had very little faith in the banking system. The Fed is an independent entity, but is subject to
oversight from Congress. Basically, this
means that decisions do not have to be
ratified by the President or anyone else in
the government, but Congress periodically
reviews the Fed's activities.  

The Fed is headed by a government

agency in Washington known as the Board
of Governors of the Federal Reserve. The
Board of Governors consists of seven
presidential appointees, each of
whom serves 14 year terms. All members
must be confirmed by the Senate and can
be reappointed. The board is led by a
chairman and a vice chairman, each
appointed by the President and approved
by the Senate for four-year terms. The
current chair is Ben Bernanke, who took
over for Alan Greenspan on February 1, 2006. Greenspan had been chairman since 1987.

There are 12 regional Federal Reserve Banks located in major cities around the country that operate under
the supervision of the Board of Governors. Reserve Banks act as the operating arm of the central bank and
do most of the work of the Fed. The banks generate their own income from four main sources:

 Services provided to banks

 Interest earned on government securities acquired while carrying out the work of the Federal
Reserve
 Income from foreign currency held
 Interest on loans to depository institutions

The income gathered from these activities is used to finance day to day operations, including information
gathering and economic research. Any excess income is funneled back into the U.S. Treasury.

The system also includes the Federal Open Market Committee, better known as the FOMC. This is the
policy-making branch of the Federal Reserve. Traditionally, the chair of the board is also selected as the
chair of the FOMC. The voting members of the FOMC are the seven members of the Board of Governors,
the president of the Federal Reserve Bank of New York and presidents of four other Reserve Banks who
serve on a one-year rotating basis. All Reserve Bank presidents participate in FOMC policy discussions
whether they are voting members or not. The FOMC makes the important decisions on interest rates and
other monetary policies. This is the reason why they get most of the attention in the media. We'll talk about
the FOMC in detail later.

Finally, all national banks and some state-chartered banks are part of the Federal Reserve System. They
are referred to as member banks.
The Fed's mandate is "to promote sustainable growth, high levels of employment, stability of prices to help
preserve the purchasing power of the dollar and moderate long-term interest rates."

In other words, the Fed's job is to foster a sound banking system and a healthy economy. To accomplish its
mission, the Fed serves as the banker's bank, the
government's bank, the regulator of financial
institutions and as the nation's money manager.

Banker's Bank
Each of the 12 Fed Banks provide services to
financial institutions in the same way that regular banks provide services to individuals. This helps to assure
the safety and efficiency of the nation's payments system. For example, when you cash a check or have
money electronically transferred, there is a good chance that a Fed Bank will handle the transfer of money
from one bank to another.

The Government's Bank

The biggest customer of the Federal Reserve is one of the largest spenders in the world - the U.S.
government. Similar to how you have a checking account at your local bank, the U.S. Treasury has a
checking account with the Federal Reserve. All revenue generated by taxes and all outgoing government
payments are handled through this account. Included in this service, the Fed sells and redeems government
securities such as savings bonds and Treasury bills, notes and bonds.

The Fed also issues all coin and paper currency. The U.S. Treasury actually produces the cash, but the Fed
Banks distributes it to financial institutions. It's also the Fed's responsibility to check bills for wear and tear
and to take damaged currency out of circulation.

Regulator and Supervisor

The Federal Reserve Board has regulatory and supervisory responsibilities over banks. This includes
monitoring banks that are members of the system, the international banking facilities in the U.S., the foreign
activities of member banks and the U.S. activities of foreign-owned banks. The Fed also helps to ensure that
banks act in the public's interest by helping to develop federal laws governing consumer credit. Examples
are the Truth in Lending Act, the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act and the
Truth in Savings Act. In short, the Federal Reserve Board acts as the policeman for banking activities within
the U.S. and abroad.

The FRB also sets margin requirements for investors. This limits the amount of money that an investor can
borrow to purchase securities. Currently, the requirement is set at 50%, meaning that with $500, you have
the opportunity to purchase up to $1000 worth of securities.

Money Manager
While all the previously mentioned duties are important, the primary responsibility of the Fed is devising and
implementing monetary policy. This function is so important, in fact, that we'll talk about it in detail in the next
section.
The Federal Reserve: Monetary Policy
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The term monetary policy refers to the actions that the Federal Reserve undertakes to influence the amount
of money and credit in the U.S. economy. Changes to the amount of money and credit affect interest rates
(the cost of credit) and the performance of the U.S. economy. To state this concept simply, if the cost of
credit is reduced, more people and firms will borrow money and the economy will heat up.

The Toolbox
The Fed has three main tools at its
disposal to influence monetary policy:

Open-Market Operations - The Fed

constantly buys and sells U.S. government
securities in the financial markets, which in
turn influences the level of reserves in the
banking system. These decisions also
affect the volume and the price of credit
(interest rates). The term open market
means that the Fed doesn't independently
decide which securities dealers it will do
business with on a particular day. Rather,
the choice emerges from an open market
where the various primary securities
dealers compete. Open market operations
are the most frequently employed tool of
monetary policy.

Setting the Discount Rate - This is the interest rate that banks pay on short-term loans from a Federal
Reserve Bank. The discount rate is usually lower than the federal funds rate, although they are closely
related. The discount rate is important because it is a visible announcement of change in the Fed's monetary
policy and it gives the rest of the market insight into the Fed's plans.

Setting Reserve Requirements - This is the amount of physical funds that depository institutions are required
to hold in reserve against deposits in bank accounts. It determines how much money banks can create
through loans and investments. Set by the Board of Governors, the reserve requirement is usually around
10%. This means that although a bank might hold $10 billion in deposits for all of its customers, the bank
lends most of this money out and, therefore, doesn't have that $10 billion on hand. Furthermore, it would be
too costly to hold $10 billion in coin and bills within the bank. Excess reserves are, therefore, held either as
vault cash or in accounts with the district Federal Reserve Bank Therefore, the reserve requirements ensure
that depository institutions maintain a minimum amount of physical funds in their reserves.

The Federal Funds Rate

The use of open-market operations is the most important tool that used to manipulate monetary policy. The
Fed's goal in trading the securities is to affect the federal funds rate - the rate at which banks borrow
reserves from each other. The Federal Open Market Committee (FOMC) sets a target for this rate, but not
the actual rate itself (because it is determined by the open market). This is what news reports are referring to
when they talk about the Fed lowering or raising interest rates.

All banks are subject to reserve requirements, but they frequently fall below requirements in carrying out of
day-to-day business. To meet requirements they have to borrow from each other's reserves. This creates a
market in reserve funds, with banks borrowing and lending as needed at the federal funds rate. Therefore,
the federal funds rate is important because by increasing or decreasing it, over time, the Fed can impact
practically every other interest rate charged by U.S. banks.

Remember, the end goals of monetary policy are sustainable economic growth, full employment and stable
prices. Through monetary policy, therefore, the Fed attempts to tweak the economy to the right levels.

The Federal
Reserve: The
FOMC Rate Meeting
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So far we've learned about the
structure of the Federal Reserve and
its duties, the Federal Open Market
Committee (FOMC), the tools of
monetary policy and the federal funds
rate. Now we're going to put it all
together to see how the Fed uses the
tools at its disposal to influence the
economy.

The FOMC Decision

The FOMC typically meets eight
times each year. At these meetings,
the FOMC members decide
whether monetary policy should be
changed. Before each meeting, FOMC
members receive the "Green Book,"
which contains the Federal Reserve
Board (FRB) staff forecasts of the U.S.
economy, the "Blue Book," which presents the Board staff’s monetary policy analysis and the "Beige Book,"
which includes a discussion of regional economic conditions prepared by each Reserve Bank.

When the FOMC meets, it decides whether to lower, raise or maintain its target for the federal funds rate.
The FOMC also decides on the discount rate. The reason we say that the FOMC sets the target for the rate
is because the rate is actually determined by market forces. The Fed will do its best to influence open-
market operations, but many other factors contribute to what the actual rate ends up being. A good example
of this phenomenon occurs during the holiday season. At Christmas, consumers have an increased demand
for cash, and banks will draw down on their reserves, placing a higher demand on the overnight reserve
market; this increases the federal funds rate. So when the media says there is a change in the federal funds
rate (in basis points), don't let it confuse you; what they are, in fact, referring to is a change in the Fed's
target. 
If the FOMC wants to increase economic growth, it will reduce the target fed funds rate. Conversely, if it
wants to slow down the economy, it will increase the target rate.

The Fed tries to sustain steady growth, without the economy overheating. When talking about economic
growth, extremes are always bad. If the economy is growing too fast, we end up with inflation. If the
economy slows down too much, we end up in recession.

Sometimes the FOMC maintains rates at current levels but warns that a possible policy change could
occur in the near future. This warning is referred to as the bias. The means that the Fed might think that
rates are fine for now, but that there is a considerable threat that economic conditions could warrant a rate
change soon. The Fed will issue an easing bias if it thinks the lowering of rates is imminent.
Conversely, the Fed will adopt a bias towards tightening if it feels that rates might rise in the future.

Why It Works
If the target rate has been increased, the FOMC sells securities. If the FOMC reduces the target rate, it buys
securities.

For example, when the Fed buys securities, it essentially creates new money to do so. This increases the
supply of reserves in the market. Think of it this way, if the Fed buys a government security, it issues the
seller a check, which the seller deposits in his or her bank. This check is then credited against the bank's
reserve requirement. As a result, the bank has a greater supply of reserves, and doesn't need to borrow
money overnight in the reserves market. Therefore, federal funds rate is reduced. Of course, when the Fed
sells securities, it reduces reserves at the banks of purchasers, which makes it more likely that the bank will
engage in overnight borrowing, and increase the federal funds rate.

To put it all together, reducing the target rate means the fed is putting more money into the economy. This
makes it cheaper to get a mortgage or buy a car, which helps to boost the economy. Furthermore, interest
rates are related, so if banks have to pay less to borrow money themselves, the cost of a loan is reduced.

Why is Everybody Always Talking About Alan Greenspan?

Many investors have watched Alan Greenspan with the utmost attention. As the former chairman of the Fed,
he guided U.S. monetary policy between 1987 and 2006, making him an extremely powerful man. Few had
the power to make the markets move like Greenspan. When he spoke, he carried the weight of the Federal
Reserve, forcing professional investors to analyze his every word. He was  designated chairman by
presidents Reagan, George H.W. Bush, Bill Clinton and President George W. Bush. He was succeeded
by Ben Bernanke on February 1, 2006.

The Federal Reserve: Conclusion

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The Fed has more power and influence on financial markets than any legislative entity. Its monetary
decisions are intensely observed and often lead the way for other countries to take the same policy
changes. We hope that this tutorial has helped to shed some light on how the Fed affects the markets.
Let's recap

 The Federal Reserve Board was created

to in 1913 to provide the nation with a
safer, more flexible and more stable monetary and financial system.
 The Board of Governors of the Federal Reserve heads up the Fed.
 Twelve Regional Federal Reserve Banks are the operating arms of the Fed.
 The Federal Open Market Committee (FOMC) is the policy-making branch of the Federal Reserve.
 The Fed's mandate is "to promote sustainable growth, high levels of employment, stability of prices
to help preserve the purchasing power of the dollar and moderate long-term interest rates."
 The Fed serves as the banker's bank, the government's bank, the regulator of financial institutions
and as the nation's money manager.
 Monetary policy is influenced through open-market operations, the discount rate and reserve
requirements.
 The FOMC sets a target for the federal funds rate and attempts to reach that rate primarily through
the use of open market operations.
 The FOMC typically meets eight times per year to make decisions on monetary policy.
 If the FOMC wants to increase economic growth, it will reduce the target federal funds rate (and
vice versa).
 If the target rate has been increased, the FOMC sells securities. If the FOMC reduces the target
rate, they buy securities.
 Reducing the target rate means that the fed is putting more money into the economy (and vice
versa).
 Chairman of the Fed, Ben Bernanke took over the position from Alan Greenspan on February 1,
2006. Greenspan had held the position since 1987