Forex 101: Basic Concepts and Terms

Forex 101: Basic Concepts and Terms

We have quite a lot to cover here, and I want to make sure the information is presented in a

way that helps you absorb it quickly, while still getting a solid, 'big picture' view of how Forex

works for individual retail traders.

Therefore, I'm going to use a 'building-block' approach - starting from the simplest example

of currency exchange that most people are familiar with - then moving one step at a time to

paint a picture of a single retail trade.

So, let's begin with the transaction most people are familiar with - that of

currency for another when traveling overseas

Imagine that you're going on a trip to France. You have $1,000 U.S. dollars to spend on

food, transportation, souvenirs and tours. You're a smart traveler, though, so you don't want

to carry all of that $1,000 as cash in either currency.

Instead, you put $500 into traveler's checks for safe keeping, and convert the remaining

$500 into Euros (the Franc was replaced by the Euro at the formation of the European

Union, of which France is a member).

On the actual day that you go to get your money converted, the

set at

cash conversions.

After you do the math, you see that your $500 in U.S. Dollars turns into a mere $343.397

Euro. Ouch! You've just taken a hit to the tune of $156.60 right off the bat in term of buying

power, even though you haven't spent a cent.

What happened?

What's happened is that the Euro was stronger than the Dollar at the time you made the

exchange. Your Dollar wasn't worth as much as the Euro. Therefore, you could not purchase

500 Euro with 500 Dollars.

Keep in mind, however, that this wouldn't necessarily limit your buying power. How much

you have to spend while in France depends on the cost of living. For example, if the

equivalent of a $15 meal in the U.S. is only $12 in France, you may save enough to offset

the hit you took on the exchange rate.

Now, remember that you're a smart traveler. You keep up with the financial markets, and

check the exchange rate each day of your trip. On the third day, you notice that the Dollar is

continuing to weaken against the Euro.

You decide to go ahead and cash out your traveler's checks before things get any worse, at

a rate of

By the time your trip ends, you've spent most of the $343.39 you came with, but still have

the $333.39 you converted from traveler's checks. Let's say you've got an even 400 Euro

with you on the trip home, just to make things easy.

You put the money away when you get home, and keep watching the market. A few weeks

go by.

Suddenly, the news reports that a major mid-east oil deal has rallied and strengthened the

Dollar, bringing the exchange rate to:

those 400 Euros out of the sock drawer, and go buy back your Dollars.

After the exchange is done, you have $550.36. Don't forget - you started off with $1,000 and

lost $156.60 of it right off the bat, leaving you with the equivalent of $843.40. You spent

$449.64 of that on your trip, so you should technically only have 393.76 left.

You don't, though. You have $550.36 because the Euros you came home with

more dollars

This represents the simplest profit on an exchange of currencies, as well as the most

elemental idea behind the Forex concept:

Now, while this example is representative, it is not entirely

Forex market are often

serious profit.

Gains are made by trading far larger amounts of money, on far slimmer margins - and by

exchanging multiple currencies at a time.

1 US Dollar = 0.67679 Euro. This gives you $338.395 additional Euro.1 US Dollar = 0.72679 Euro. Bingo! It's time to digbought backthan you originally held.buy low and sell high.accurate. Real trades on themuch more complex than this for anyone who wants to turn a

Concept #1: Exchange Rates

As you saw from the example above, the

currency in relation to another.

A

official rate set by monetary authorities (and sometimes governments).

Fixed rates are typically set to a pre-determined value (e.g., the price of an ounce of gold),

and allowed only slight fluctuation.

A

type of rate is not set to any outside reference point.

Rather, the rate is determined by the market forces of supply and demand.

Although our earlier example used just two currencies, the Dollar and the Euro, it is

important to note that

transaction

Not if you want to make any real money, that is. Forex trading is not as easy as buying

$10,000 worth of U.S. Dollars with $5, 000 worth of Euros after a market correction.

This doesn't mean you can't achieve these kinds of gains, but you must understand that the

majority of successful trades on the retail level involve a well-planned

buying and selling

This brings us to our next concept:

Concept #2: Currency Pairs

you must NOT view Forex trades as a simple one-to-one.strategy based aroundmultiple currencies at a time - not just one or two.Currency Pairs

When you buy stocks on the Stock Exchange, you have the option of buying the stock of a

single company at a time, or multiple companies at a time. You may also choose to sell your

stock back right away, or hold it for an indefinite period of time.

The value of stock from a company like Microsoft, for example, is determined largely by that

company's

the performance of other corporations.

The foreign exchange market works a little bit differently.

The value of any currency on Forex is determined

currencies

comparing it to the Euro, the Australian dollar, the Japanese Yen and so on.

The buying and selling of any of these currencies is always done in what's known as

performance (profits, meeting quarterly goals, etc), and not directly affected byin relation to the value of all other. In other words, the value of 1 U.S. dollar changes based on whether you are

currency pairs

A currency pair consists of a

the currency you intended to purchase. The quote currency is the currency you intend to

use to purchase the base currency.

Together, the pair shows you how much of the quote currency is needed to buy one 'unit' of

the base currency.

To illustrate this, let's look at some exchange rates for

the U.S. Dollar against the Euro, Canadian Dollar and Japanese Yen:

.base currency and a quote currency. The base currency isDecember 15th, 2007. We'll compare

1 EUR

= 1.44245 USD / 1 USD = 0.693265 EUR1 CAD
1 JPY = 0.00882807 USD / 1 USD = 113.275 JPY= 0.9830391 USD / 1 USD = 1.01720 CADexchange rate can be defined as the price of onefixed exchange rate, like the one established in 1944 by the Bretton Woods Accord, is anfloating exchange rate is what is in effect on the foreign exchange market today. Thisexchanging one.foreign exchange rate is1 US Dollar = 0.68679 Euro. This rate is the official, interbank rate for strict cashto-

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