Chapter 1: What is Forex? The History of the Foreign Exchange (Forex or FX) Market
Before we jump into modern Forex trading, it's important to understand a very brief history of money and the exchange of money because the same basic principles apply to all types of currency.
Although online Forex trading is a fairly new invention, as a Foreign Exchange Trader, you are participating in an activity that has gone on for thousands of years and is necessary for the world to run (relatively) smoothly.
Ancient History of Currency
The cowrie shell is the longest running and most used type of currency in history. In fact, shell money was used as legal tender in parts of Africa until the mid 1800s and it's still legal tender in parts of Papua New Guinea.
Here are some examples of cowrie shells. They are beautiful and you can see why they were used as currency.
As civilizations evolved, they moved away from shell money and other primitive forms of currency. Some of the earliest metal money was produced in China, in the shape of cowrie shells.
These shell shapes were then flattened and became more like the coins we know today. Some of the first coins made out of precious metals came from Lydia (modern day Turkey).
The Chinese are credited with developing the first paper currency in around 806 AD. Paper money did not become popular in Europe until many centuries later.
Regardless of what type of object was used as currency, there has always been the need to exchange one type of currency for another.
Until the entire world starts using the same currency, there will continue to be Foreign Exchange.
The Need for Money Exchange Centers
Societies naturally interacted and there became the need to exchange a foreign currency for the local currency.
For example, in medieval Europe, many towns would issue their own coins. So if an outsider came into town and wanted to buy goods and services, they would have to visit a local money exchanger first.
This still goes on today and you have probably had to do this when visiting another country. Forex Traders help make this a smooth process by providing liquidity to the market.
When currencies can float (or are not tied to another currency), Traders profit by buying currencies that are increasing in value or lending currencies that are dropping in value.
The Birth of Modern Retail Forex Trading
Fast forward to more modern times and the invention of computers and the internet. Online Forex brokers started popping up in the late 1990s and gave the public the opportunity to trade currencies online.
This was the start of retail Forex trading.
Retail Forex traders are traders who trade independently and do not trade for an institution such as a bank or hedge fund.
This allowed even more traders to make a living from anywhere in the world. Traders could finally easily execute trades, without needing to call a broker or have expensive technology like dedicated data lines or satellite phones.
With the invention of cryptocurrencies, we have stepped into a whole new age of currency trading. Since many of these currencies have specific use cases, there will continue to be many combinations of tradable digital and fiat currencies.
Primary Benefits of Forex Trading
Why trade Forex? These are the highlights…
- Free demo trading accounts can help you develop your skills, without risking any money
- Get started with a small amount of money, sometimes a little as $100…while still taking only 1% risk per trade
- Forex is the largest market in the world, meaning that you can usually trade at the price you want
- Trade from anywhere in the world that has a good internet connection
- You have the equal opportunity to profit from both rising and falling markets
- The Forex markets have enough volatility to provide trading opportunities
- Trade 24 hours a day, 5 days a week
Basic Forex Trading Terms
There is a long list of terms that traders use, but we don't want to bore you with the details. Here are the main ones that you need to know to get started:
- Currency pair: The two currencies that you trade against each other in Forex trading. For example, the EUR/USD (Euro vs US Dollar) is a currency pair. The first currency (EUR in this example), is the base currency. The second currency (USD) is the quote currency.
- Bid: The price that a buyer is willing to pay for a trade.
- Ask: The price that a seller is willing to accept for a trade.
- Spread: The difference between the bid and the ask price. This difference goes to your Forex broker and is their fee for facilitating the trade.
- Going long: You make money with the price of a currency pair goes up.
- Going short: You make money with the price of a currency pair goes down.
- Stop loss: An order to close your trade at a certain price, to limit your loss on a trade.
- Take profit: An order to close your trade at a certain price, to make a certain amount of profit.
- Rollover: This is the amount of interest that you get paid or you have to pay, based on the difference in interest rates of the currencies in each currency pair.
- Liquidity: The amount of trading activity in a market. High liquidity makes it easy to execute a trade at the price you want. Low liquidity can cause you to get a bad price or not be able to trade at all.
- Lot size: The amount of currency you trade on each trade.
- Leverage: Your broker allows you to borrow money to trade, based on the money in your account. For example, if your broker allows 50:1 leverage, you can use $10 in your account to control $500 worth of currency.
- Bearish: When a trader believes that the price of a currency pair will go down.
- Bullish: When a trader believes that the price of a currency pair will go up.
- Slippage: This happens when there isn't enough liquidity in the market and price jumps around a lot. The difference between the price you wanted and the price you actually get executed at is called slippage.
- Technical analysis: Trading decisions are primarily made based on chart patterns. These patterns repeat themselves because of how markets work and the basic human nature of traders.
- Fundamental analysis: Trading decisions are primarily made based on news and economic factors.
- Trading sessions: Forex trades in sessions, based on when trading markets open and close around the world, because Forex trades 24 hours a day, 5 days a week. To learn more about trading sessions, read this blog post.
- Volatility: The amount the market moves. Volatility is necessary to make money, but too much volatility can be hard to trade because it's too unpredictable.
You may hear certain currencies called by their nicknames. Here's a list of the major currencies, so you know what other traders are talking about:
- Australian Dollar (AUD): Aussie
- British Pound (GBP): Sterling
- Canadian Dollar (CAD): Loonie
- Japanese Yen (JPY): Yen
- New Zealand Dollar (NZD): Kiwi
- Swiss Franc (CHF): Swissy
- US Dollar (USD): Greenback
Benefits of Forex vs Other Markets
We love all trading markets, but Forex does provide some very distinct benefits over the other markets out there. It can be a great way to learn to trade the markets, before jumping into other trading arenas.
Forex vs Futures
Futures trading has very high capital requirements. You should generally have at least $25,000 in your account to be properly capitalized and even that could be considered not enough capital to trade safely, in some futures markets.
In addition, some contract months in futures are not heavily traded, so it can be hard to find someone to take the other side of your trade.
Forex vs Options
You will also need a lot of money to start trading options. Options can be less liquid than other markets because they are traded at different strike prices, which are in themselves mini markets, within each market.
Forex vs Stocks
If you start a stock trading account with $100, your commissions will usually be at least $14 per trade, which is already 14% of your total risk capital. That means that you will have to make 14% per trade, just to break even. That's difficult, even for the best traders in the world.
Small cap stocks may not have enough shares available for you to execute a trade that the price you want. So you will either have to pay a lot, or you may not be able to get the shares at all.
Finally, it can be hard to make money when a stock goes down. Some stocks simply don't have shares available to short (borrow). Forex provides equal access to long and short trades.
Now that you understand the basics, let's move on to the next chapter on fundamental and technical analysis…