By Duane Gott, Senior Seminar Presenter, eSignal

This is the first of three posts that will explore the basics of currency trading, taking a look at the Forex market in detail and the world of currency arbitrage. In this weeks post, well be building some basic understanding of how the currency markets work, what happens when trades are placed and how the leverage of the Forex markets can literally make or break a traders career. Lets get startedWhat is Forex? The term Forex stands for the Foreign Exchange Market, also sometimes referred to as the FX market. The Forex market is the most liquid exchange in the world; it trades a cash turnover of nearly 1.9 trillion dollars per day. The Forex market liquidity is approximately 30 times larger than all of the U.S. domestic equity markets combined.

When we talk about trading, most lay people understand the idea of buying and selling a particular stock or commodity. The trader is placing a long or short speculation on a single trading instrument. When we begin working with the Forex market, we need to shift gears because we are now trading what is called a currency pair. The Forex market is speculation on the relationship between two countries respective currencies.

For example, a Forex trader can speculate on the relationship between the Eurodollar and the Japanese Yen (EUR/JPY) or the Swiss Franc versus the US Dollar (CHF/USD). Whenever we think about the Forex market, we need to think about sets of two instruments each (pairs) as opposed to a single stock, such as MSFT or DELL.

Currencies are traded for two primary reasons. Governments or companies that sell goods or services in countries other than their own must have a vehicle to convert any profits made from the other countries currencies back to their own. These types of transactions typically make up approximately 5% of the Forex market.

Currencies are also traded by institutions, companies and proprietary traders with speculation as the goal. This approach to the Forex market makes up approximately 95% of all transactions on the Forex market. Because such a large percentage is focused on the latter, well be turning our attention primarilty to that demographic.

The Forex market is unique in many ways. While U.S. markets are open for a set amount of time per day, the Forex market trades 24 hours a day, 5 1/2 days per week. Forex trading begins on Sunday morning and closes on Friday afternoon (Pacific Time). Trading begins in Sydney, Australia and moves around the globe as various financial markets open around the world.

Because this is a global market, there isnt a centralized exchange as there is with the NYSE or CME. With so many countries and respective currencies available, many traders narrow their focus to a few select currency pairs that offer the highest amount of liquidity. These pairs are called the Majors. The majors include currencies such as the US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar.

Now that we understand the concept of currency pairs, lets take a look at what happens when a trader places a trade in the Forex market. Because this transaction is purely electronic, lets use an example to convey the principle.

A trader with $10,000 walks into a bank speculating that the US dollar will weaken compared to the British Pound (also referred to as the British Cable or Sterling). The trader sells his / her US dollars to buy British Pounds. The trader then receives an equal amount of currency in the form of the British Pound (the amount received is dependent on the current exchange rate).

The trader leaves the bank with a pocket full of British Pounds. Over the next several days and weeks, the British Pound continues to gain strength against the weakening US Dollar. Once the trader feels that the British Pound may be topping out, he or she once again proceeds to the bank and sells the British Pounds and buys back US Dollars.

Because the British Pound has increased in strength and / or the US Dollar has continued to weaken, the trader now receives considerably more US Dollars in return. The trader has, thus, made a tidy profit simply by selling his or her US Dollars and buying another currency that has moved upward.

From a trading standpoint, there are several intricacies to this market that well informed FX traders should understand before putting their money on the line. One of these intricacies is the minimum tick increment of currency pairs. Stocks trade in pennies, futures trade in fractions and currencies trade in pips. A pip stands for Percentage In Point. Currency pairs in the Forex market trade out to four decimal places.

For example, if a bottle of shampoo were sold in a drugstore, it may sell for $3.50. If the bottle of shampoo were priced like a currency pair, the price would be $3.5000.

The exception to the four-decimal-place rule is the Japanese Yen. The Japanese Yen has not been revalued since World War II. Therefore, 1 Japanese Yen is approximately equivalent to $.08 in US Dollars. So, when we think about the USD/YEN currency pair, trading is only extended to the 1/100th rather than 1/1000th of other currencies.

One of the attractive aspects of the Forex market is the amount of currency that can be leveraged with a relatively small amount of money. With stocks, many pattern day traders enjoy the additional buying power of 4 to 1. This translates to traders being able to use margin to buy or sell shares they may not be able to otherwise afford.

If a pattern day trader of stocks has $100,000 in his or her account, the brokerage house will allow that trader to buy, sell and carry $400,000 worth of equities. This equates to a nice profit margin or a margin call depending on whether or not the trade moves in the traders favor. In the Forex market, this margin ability is magnified through 100-to-1 leverage. This means that a trader can control $1,000,000 in a foreign currency by leveraging a $10,000 account.

If a trader believes the British Pound is headed up against the US Dollar, the trader can leverage $1,000,000 with $10,000 of up-front capital, using the complete 100-to-1 ratio. This allows him or her to control the equivalent of $1,000,000 US Dollars of the British Pound. The trader purchases the British Pound at 1.6500.

Over the next two months, the British Pound continues to gain strength against the dollar, and the trader then sells the British Pound at 1.8500. With the power of 100-to-1 margin, the trader has made a profit of $121,212 (more than 1,200%) with an investment of $10,000.

Several economic and geopolitical components of this market can dramatically affect the trading of currencies. In the next article, well begin to illustrate some other examples of leverage and outline the life of a traditional Forex trade, as well as expand on some of these influencing forces.