Saturday, February 18, 2012

Forex Basics - Forex Trading Basics Part 1 What is forex?

Part 1 - What is forex?
To describe Forex we must have at least a basic understanding of other markets.
Everyone in the world knows what trading stocks is but not everyone knows what trading forex is. Everyone knows that when you buy a stock you are buying a share of a corporation. Some even know what buying an option is.

Options Contracts - Similarities to Forex
An option represents the right to buy(long contract called a call) or sell(short contract called a put) a certain amount of shares of the traded instrument in question. In essence these are future contracts with expiration dates as to what the future price is speculated to be. Unlike actual commodity futures, options contracts do not require physical delivery of any goods.

Since no actual goods are exchanged options contracts are strictly speculative contracts. However an options trader can earn a huge reward if the trader gets the market right. With great reward often comes risk so if the futures trader gets it wrong it results in massive financial loss.

In an options trade a single options contract controls a much larger size of the asset in question (eg stock or commodity). For example 1 stock option controls 100 shares of the underlying asset. The cost of the options contract is called the premium based on what the going rate for that option is. The option will also have a strike price which is based on the actual price of the stock.

Origin of Futures
Aristotle described the story of Thales, a poor philosopher from Miletus who developed a "financial device, which involves a principle of universal application". Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or poor and because the olive press owners were willing to hedge against the possibility of a poor yield. When the harvest time came, and many presses were wanted concurrently and suddenly, he let them out at any rate he pleased, and made a large quantity of money.

The first futures exchange market was the Dōjima Rice Exchange in Japan in the 1730s, to meet the needs of samurai who—being paid in rice, and after a series of bad harvests—needed a stable conversion to coin.

The Chicago Board of Trade (CBOT) listed the first ever standardized 'exchange traded' forward contracts in 1864, which were called futures contracts. This contract was based on grain trading and started a trend that saw contracts created on a number of different commodities as well as a number of futures exchanges set up in countries around the world. By 1875 cotton futures were being traded in Mumbai in India and within a few years this had expanded to futures on edible oilseeds complex, raw jute and jute goods and bullion.

Forex trading is much like the highly speculative futures markets. The major difference is it involves currencies and it is what the exchange rate is based on. A currency can be traded like a future in which case it would be a single currency as in the USD (US dollar) or the EUR (EURO).

But usually they are trading in pairs which represent the exchange rate between the 2 countries. A pair looks like this AUD/USD (this is the Australian US Dollar Pair. I can trade FOREX without a broker. I can simply buy Australian dollars and hold on to them for a certain length of time and then turn them in at a bank that allows the exchange of foreign money. There is no mystery to FOREX - it is just an exchange rate based on various valuations of a currency that are mostly based on the current economic conditions of the perspective country and future expectations.

1 standard lot is equal to 100,000 units of the base currency, 10,000 units if it's a mini, or 1,000 units if it's a micro. The exception is the contracts don't expire unless the trade is closed. In that aspect (although the risk is still high) it is safer than an options contract that loses value based on time.

By Neal Vanderstelt
Forex Trader, Market Analyst, Trading System Designer
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