Nick McDonald: Forex markets demystified

About USD$4 trillion worth of currency exchanges hands on the forex market every day. Photo / Thinkstock

Forex has become the hot market for traders in the last decade and this has been especially true among traders in New Zealand. Many people who are new to the markets are picking currency trading over stocks, futures, options and other tradable securities and there are various reasons for this. This column will focus on forex in the coming weeks, starting here with some of the absolute basics, leading into a bit more advanced detail as we progress.

What is forex?

If you have never traded before and especially if you have never even been exposed to the markets in any great detail, something like the forex market can almost seem a bit mystical. I recall what it was like before I first started trading - the concept was intriguing to me but it was extremely foreign. I literally did not have a clue how you went about deciding on a trade let alone the mechanics of placing it. The good news is that, like anything, once you know a few basics the forex is not so mysterious after all.

Forex, FX, foreign exchange and currency trading are all the same thing although the names can be used interchangeably. The forex market place refers to the trading of money and is filled with participants simply trading or exchanging one currency for another. For example, a business or individual might be buying NZ dollars (NZD) and subsequently selling US dollars (USD) for a whole host of reasons such as:

1. An individual is coming to New Zealand on holiday from the USA. They are exchanging their US dollars (selling USD) for New Zealand dollars i.e. they are buying NZD.

2. A kiwi with assets in the US such as stock or property, might have sold up and decided to bring their USD back to NZD hence selling USD to buy NZD.

3. A New Zealand business with US income might be bringing that money back to NZ and therefore selling their USD in exchange for their local currency of NZD

4. A US business or individual might be investing money into New Zealand for a whole host of reasons and therefore need to buy NZD to spend here.

5. A trader might be speculating on the price movement of the NZDUSD currency pair. If they believe this is likely to go up, they will buy NZDUSD which means they are simultaneously buying NZD and selling USD at the same time. The trader's plan is to reverse that position at a higher price in the future in order to profit from the move higher. The trader in this case has also taken on the risk of losing money if he or she is wrong and the NZDUSD price in fact declines.

This is just a very small sample of why a currency trade might take place and as you can probably guess from this, the possibilities are endless. If you have ever bought a book on a foreign website or changed money at the airport for a trip overseas, you have participated in the currency market in some small way.

This sheer number of participants make the forex market VERY BIG! With around USD$4 trillion worth of currency exchanging hands on average every single day, the forex market is by far the largest market in the world. In fact, the forex market is bigger than every single other market in the world combined! That means that if you take every single tradable security (stocks, futures, bonds, options, etc) in every country of the world and add them all together, the forex market still dwarfs them all combined.

Personally I, like many individuals and business owners in NZ, have many reasons to transact in currency markets. I travel regularly and must buy local currency for spending. I also operate a business that earns income in foreign currency. But my main domain, the type of forex trading that I do virtually every single day is like the final point (point 5) in the list above - I speculate on movement in the currency markets.

The start point for this type of trading is that a trader needs a trading account and there are so many to choose from that it's mostly a case of picking which is best for them. For a new trader the best place to start is a demo account which means that you can experience what it is really like to trade the forex market but you do this as a paper transaction only with no real money at risk. This is a great way to learn and see if it is something that interests you or not. Companies like CMC Markets* and many others in New Zealand have demo accounts freely and easily available so have a look around, watch some of their 'how to' videos and place a few trades. There is no harm in it whatsoever!

There is only so much I can say in one short column and future columns will go into more detail on selecting forex trades and the mechanics of placing them. I will also look at why the forex market is so popular for NZ traders and also discuss the risks involved in this market.

For now though, anyone interested in forex just remember that on a demo account you cannot win or lose actual money, there is no risk and it is all just paper or pretend money. You can however gain some great experience and even have a little fun so if you are interested then get yourself a demo account and start seeing what it's all about.

*Disclaimer - Nick McDonald owns Trade With Precision which provides trading education services to CMC Markets clients. They do not however receive any financial benefit for individuals opening accounts, whether they be demo or live accounts.

Nick McDonald heads up www.tradewithprecision.com a global company teaching everyday people how to become a trader in the world's financial markets.