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Forex Trading 101: the Basics

January 18, 2016

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Last update: July 2021

The forex market is what we call a directional market, this is also known as a speculative or delta-based market as well. It is similar to that of the stock market where you either long or short the stock and make or lose money based on the entry price to the exit price. It is the largest, most liquid market in the world and one where everyone participates in it, even if they do not know.

For example, when James Bond travels from London to New York he will have to exchange his currency, the GBP, for the USD to buy goods and services in the United States. This is the same thing we all do when we travel from any country to a foreign country. The forex market is the exact same thing, we simply take one currency and exchange it for another currency. Profit or losses are made from the entry price to the exit price depending if the currency goes up or down. It is also important to note that you can buy or sell any currency.

Forex Trading 101: the Basics - James Bond Daniel Craig

One thing that is different is that currencies are not traded as a single currency but as a currency pair as you are exchanging one currency for the other currency. There are major pairs, cross pairs, and exotic pairs. We primarily focus on major pairs as those pairs include the USD as it is currently the reserve currency of the world. However, we will also trade cross pairs as there are some good carry trades involving the JPY due to its long-standing low-interest rates and current Abenomics policies, a popular carry trade is to sell the JPY and buy AUD as the Australians typically have higher interest rates than Japan.

The value of a currency is largely based on pure supply and demand, making it a true market with smaller manipulation than other markets such as the stock and bond markets. Typically, the value is based on the fundamental strength or weakness of the home nations economy, central bank monetary policy and in the case of Canada and Australia it can be based on the value of basic materials due to their nations strong reliance of producing raw materials.

Major Currencies

There are currently seven major currencies, these include USD, EUR, JPY, GBP, CHF, CAD, and AUD. These are listed in order of most widely used in international trade as reserve currencies. Let’s take a look at a few of the currencies a little closer.

Forex Trading 101: the Basics - $100 bill

USD: United States Dollar

The USD is the home currency of the United States but is also the world’s largest reserve currency as it is the most widely used currency in international trade. The USD was created along with the United States Central Bank, known as the FED, in 1913. It was named the world’s reserve currency in 1944 during the Bretton Woods act along with the IMF and World Bank. At this point, it was pegged to the value of gold, known as the Gold Standard. In 1971 the Nixon Administration and primarily Henry Kissinger removed the gold standard and replaced it with the Petrodollar in a deal first created with Saudi Arabia in 1973 and the rest of OPEC in 1975. This pegged the sell of oil, the world’s largest commodity, in USD which meant 90% of the world’s oil market was sold in USD. In 1999, led by Russia and China, nations started making separate international agreements with the middle eastern countries to sell oil in non-USD transactions. Currency, the USD has no complete commodity backing. However, as the world’s reserve currency the USD has substantial value in the international trade market. The USD is directly exchanged with other currencies in what is known as Major pairs, examples are the USD/JPY or the EUR/USD.

Forex Trading 101: the Basics - Euro banknotes

EUR: Euro

The EUR was established in 1995 and accepted as a traded currency in international markets in 1999. Currencies that are pegged to their value are the GBP and the CHF. It is the currency of the 17 member nation European Union or Euro Zone and is used by over 550 million people worldwide in the local communities including millions in Africa. For years, many in the world including China wanted the EUR to replace the USD as the worlds leading reserve currency. However, due to the economic problems in Europe, debt problems, and disagreements between member nations, many have moved away from this belief. The European Central Bank (ECB) is very similar to the United States Central Bank (FED) in that it is responsible for monetary policy in the issuing of banknotes as well as the determination of interest rates.

Forex Trading 101: the Basics - Japanese Yen banknote.

JPY: Japanese Yen

The JPY was established as far back as 1885 and it is widely used in international trade in Asian nations. Japan is home to the second-largest economy and third most liquid currency. However, due to 3 decades of economic stagnation, the JPY and economy are under tremendous pressure. The JPY is also widely used in carry trades as it traditionally has very low-interest rates in an attempt to spark inflation. This allows banks, institutions, and professional traders the ability to sell the JPY and buy other currencies in emerging markets or the AUD as they will have higher interest rates. This allows the market participants to make money on the declining JPY as well as carry the positive interest rate. The carry trade is by far the most popular trade in the world due to the ability to carry positive interest rates.

In the next segment of Forex Trading 101, we will look into the basic definitions of the currency market.

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Forex 101 - Carry Trade
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Forex Trading 101: Carry Trade

The Carry Trade is one of the most popular trades in the world. It is a trade where you sell a currency with a lower interest rate and buy one with a larger rate. You get to carry the positive interest.

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6 Replies to “Forex Trading 101: the Basics”

  1. David Miles says:
    November 15, 2014 at 10:34 am

    Option House automatically closed me out of a bear call spread on CMG on expiration Friday. Reason: I didn’t have enough in my account to cover the exercise of the short call. I did a long call at the next higher strike price to complete this spread. If the short call was exercised wouldn’t the long call have covered it. I had enough in my account to cover the spread. The share price never reached the short call strike price. It changed a winning trade into a loss.

    1. Tim Justice says:
      November 15, 2014 at 11:43 am

      If the short call was met and went ITM and the long call was OTM then you would be assigned Short shares at the short strike and the long strike would expire worthless. To avoid this risk, some brokers take action for their traders. It seems like optionhouse is fairly aggressive with this and does it automatically. I’ve had accounts a lot of places and if there was ever an issue they always called me first. But I’ve never traded with optionhouse so I don’t know their policy on this.

      1. David Miles says:
        November 15, 2014 at 1:41 pm

        Thanks! I would say that Options House is pretty aggressive. Their trigger seems to be 1% below the strike sold.

  2. Ali Tahta says:
    November 15, 2014 at 12:14 pm

    I read somewhere a couple of years ago that bond market investors will borrow as much money as possible from the Japanese as low as near 0% interest and turn around and invest in Brazilian/Australian bond market. brazil pays 12% of a year/Australia 2.5% 2 years bond versus Japan 0.025% for 2 years bond.
    Am i getting right? correct me if I’m wrong please.
    thank you.

  3. Ali Tahta says:
    November 15, 2014 at 4:38 pm

    being right-sorry.

  4. Matt Justice says:
    November 16, 2014 at 12:30 pm

    Yes Ali, they will borrow from Japan and U.S. either in bonds or forex and invest in emerging markets.

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