Since the end of the Second World War, it has become commonplace for British people to holiday abroad. A foreign holiday is often most people’s first experience of dealing with “foreign exchange” as they get their holiday money converted into the currency of the land that they’ll be visiting.
Invariably, this first experience is often a negative one since the rate at which the commercial broker sells you a currency is always higher than the rate at which they will buy back any unspent money from you at the end of your trip. This simple example shows you that there is money to be made in trading foreign exchange, or Forex, as it is universally known.
If your travels have taken you into some of the seventeen lands that share the common European currency, the Euro, you can’t fail to be impressed with the fact that the same money is accepted throughout the block. This means that you can travel without having to hold a bewildering array of foreign banknotes and coins with you and you are spared the feeling of being “ripped off” at a succession of Bureau de Change outlets as your cash dwindles from country to country merely for the privilege of being able to use it in each country you visit. Given the ease of a single currency, you could be forgiven for wondering why we have such a dazzling array of currencies in the first place.
The Origins of Foreign Currencies
If you consider Britain as an example, few people travelled abroad before the second half of the twentieth century and the only currency they used was Sterling. For such people, there was already a single currency: their own.
However, long before the advent of popular foreign travel, international trade had flourished; particularly in the aftermath of the industrial revolution. Trading nations needed to be able to buy and sell goods in a currency that was relevant to them – a de facto single currency. For many years, gold (and the gold standard) served this purpose and debts between nations were settled by the transfer of gold between bank vaults. The value of gold had been set by Sir Isaac Newton in 1700 AD and remained unchanged for 200 years.
The transfer of gold became impracticable as global trade increased (its supply also became an issue). The gold standard was agreed whereby US Dollars could be accepted for all international debt and the US government promised to redeem them for gold, on demand.
The gold standard collapsed when the London spot price for gold surpassed the value of the gold standard. Speculators could exchange Dollars for gold and then sell it at a higher price on the precious metals market. The USA declared that it would no longer exchange Dollar bills for gold in 1971 (this was known as the “Nixon shock”). As a consequence of the Nixon shock, nations were required to float their own currencies against each other and Forex as we know it today was born.
In September 2010, the daily volume of foreign exchange trading on the world’s markets surpassed the $4 trillion mark for the first time. With a market of that enormity, it is possible to make (or lose) a fortune by trading in foreign exchange.
In essence, a Forex trade is a gamble. You decide that a particular currency pair (e.g. GBP:USD or EUR:JPY) will either strengthen or weaken (i.e. the first currency in the pair rises compares to the second or vice versa) and you invest accordingly. If the currency moves in your favour, a point will come when you decide to sell the currency to lock in your profit and you will have completed your first trade.
Whilst Forex investment is a gamble since nobody can predict what will happen with certainty, the movement of currencies are predictable in a general way. For instance, if you look at GBP:USD over the past four months of trading history, you can see that Sterling has strengthened from $1.60 to $1.66. On a short-term basis, the trend is not so clear; there are multiple peaks and troughs in the course of any trading day, but the general trend has been inexorably upwards. If you could predict what a currency pair will do, you have the possibility to make a tidy profit.
Reading The Tealeaves
In order to maximise your chances at making money through investing in Forex, there are two basic tools at your disposal: Fundamental Analysis and Technical Analysis.
Fundamental analysis looks at economic factors, political issues, natural disasters and so on, to form an overview of where a currency is likely to head. For instance, a general election will often cause economic instability (in the short-term) and a currency may dip lower; a central bank’s decision to increase interest rates is likely to cause the currency involved to strengthen.
However, fundamental analysis can only provide a probability that a currency will move in a particular way. Japan has many economic problems and an enormous debt burden. The March 11th 2011 earthquake and tsunami which followed it, should have led to a weakening of the Yen against other major trading partners, but it is currently stronger now against the US Dollar than it was before disaster struck. Fundamental analysis predicts that this situation will change in the longer term and, indeed, the Yen has depreciated slightly against Sterling and the Euro recently.
Technical analysis is based purely on the history of what a currency pair has actually done and the belief that careful analysis of the data will reveal pattern that can predict how a currency will trade in the (near) future. For instance, during a certain time frame, a currency pair will trade between “support” and “resistance” levels. At a support level, the market believes that a given currency pair is undervalued, so traders, sensing a profit, buy it, pushing it higher. At a resistance level, the converse is true; brokers believe that a pair is over-priced and so they sell it. If you can identify where these levels are, you can use the information to make a profit. Would that it were quite so simple! Unfortunately, resistance and support levels are not set in stone and may be broken through before new support and resistance levels become established.
Technical data patterns can be used to identify “buy” and “sell” opportunities and also to generate signals to either take profits or to exit from a losing position – stop loss signals.
Taken in conjunction with fundamental analysis, technical analysis can help you to derive winning strategies for trading foreign exchange. However, the best advise to any would-be Forex trader is get to learn as much as you can about the subject before putting your hard earned cash at risk. All of the prominent online forex trading houses have the facility to let you set up a demonstration account to let you develop your skills and stratagems without risking any money.
The King Of Forex
George Soros is probably the most famous name associated with trading Forex. In 1992, Soros interpreted the fundamental and technical indicators to successfully predict that the UK government would be forced into a devaluation of the Pound. He went “short” on Sterling (meaning that he took positions that assumed the value of Sterling would fall relative to other major currencies) and in the process reaped a reputed $1 billion profit.
The wave of speculation that he led, forced the UK to withdraw from the European Exchange Rate Mechanism (a precursor system to nations joining the Euro) which was designed to keep European currencies within certain bands through concerted action by central banks.