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Forex guide

All trading involves risk. Losses can exceed deposits.

What is FX?

FX, also known as foreign exchange, forex or the currency market, is the decentralised international market for buying and selling currencies. It is the largest financial market in the world.

The FX market helps companies and individuals convert one currency into another. At the simplest level, we all participate in it when we travel overseas and sell our home currency in exchange for the cash we need to spend abroad.

As well as being traded by individuals and businesses, forex is important for financial institutions, central banks, and governments. It facilitates international trade and investment by allowing companies that earn money in one currency to pay for goods and services in another.

Why trade forex?

Forex trading enables you to speculate on the relative strength of one currency against another.

Trading FX Markets

The appeal of trading currencies over other asset classes includes excellent market liquidity and 24-hour markets for five days a week. But it’s important that you understand the product and the market, and ensure you have a stringent risk and money management strategy in place.

Currency trading essentially means playing one currency against another. If you feel the Australian dollar will appreciate against the US dollar (for example, you think the AUD/USD exchange rate will go from $0.7100 to $0.7200) you buy the pair. That’s known as ‘going long’. The directional bias is expressed through the first named currency (in this case AUD), but your profit and loss is derived in the second named pair (in this case USD).

The role of technical analysis in FX trading

Technical analysis plays a key role in FX trading, and is an important risk management tool even if you predominately trade using fundamental analysis. Technical analysis is an integral part of identifying trends, momentum, risk/reward and entry and exit points.

Essentially a chart is a road map of supply and demand, and amalgamates the activity of every single market participant at any given time. Markets are highly effective aggregators of news and therefore charts can show how markets view current issues such as politics, potential monetary policy changes by a central bank, the underlying economy or overall sentiment at a macro level.

The key players in the forex market

There are many players in the forex market at any one time, but the key players include exporters, leveraged funds, macro-focused funds, real money accounts (insurance and life funds), retail traders and reserve managers (who transact on behalf of central banks).

This diverse range of participants ultimately means there are many opinions and varying thought processes in the market at any given time, all with different time frames and tolerance to risk. A good way to rationalise this flow and bring it all together is through price action and technical analysis.

What drives a currency?

Each currency is more sensitive to different influences, and what drives the Australian dollar, for example, will often be different to that of the British pound, Japanese yen, US dollar or the euro. Timeframe is especially important as the different influences will change over a short-, medium- and longer-term perspective.

Short-term considerations: risk appetite, volatility, moves in commodity prices, interest rate pricing and positioning.

Medium-term considerations: current account surplus/deficit, fiscal policy, political risk, bond yield spreads (or differentials) and relative economic growth.

Longer-term considerations: purchasing power parity, net foreign assets and terms of trade.

Of these, the single most important trader variable is volatility. This is because volatility directly affects risk and money management, as greater volatility will generally mean you have to place a stop further from your entry point. Increased volatility will also often see demand for currencies of countries whose economies run a current account surplus, such as the Japanese yen, euro or Swiss franc. These nations are global net creditors and in times of stress, funds will repatriate to their currencies.

In times of lower volatility, tighter price ranges and heightened risk appetite, it is advisable to buy currencies where yields in their bond market are higher – the Australian and New Zealand dollars and many emerging market currencies for example. This is known as the ‘carry trade’ and you can fund a position by borrowing (funding) in a lower yielding currency.

There are many other trading strategies used by currency traders. While this may all sound daunting, you need to find a strategy and trading plan that is right for your individual circumstance. Find a plan that provides an edge, whether that is trading currencies using fundamentals, technicals or a combination of both.

Points

The movements of a currency are measured in terms of points. A point is generally the fourth digit to the right of the decimal point. So for EUR/USD, a movement from 1.43551 to 1.43561 is one point.