Forex: The world’s largest market

Today we’re looking at the foreign exchange market, with a guest post by first-time contributor Jon Morgan.

If you’re unfamiliar with Forex trading, or find it confusing, then this issue is for you.

The foreign exchange market (also called Forex, or just FX) is the single largest market in the world.

Normally, this market gets little attention from everyday retail investors. But this week was different.

If you’re an investor and you start hearing about rumblings in the forex market, it’s rarely good news. Case in point: the Japanese Yen, which has spiked 10%+ in the past month, and rattled global markets this week.

In this issue, I’ll break down how the Forex market works, and show you exactly what’s happening in Japan.

Let’s go 👇

Jon Morgan is the Lead Crypto Analyst at Stocktwits and the author of ​The Litepaper​. Jon has contributed to TipRanks, FXStreet, and Cointelegraph. He has been recognized as one of Quora’s Most Viewed Writers in finance.

What is Forex?

The foreign exchange market is where currencies are traded. It is by far the world’s largest financial market (valued at ​$2.4 quadrillion​), simply unmatched in size and scope.

An astounding ​$7.4 trillion is traded daily​, making Forex the most liquid market. This high liquidity ensures you can enter and exit trades with ease.

With trading hubs in major financial centers like London, NYC, and Tokyo, Forex operates around the clock. It reflects global economic shifts and news events in real time.

Forex is the perfect market for those who genuinely love to trade. But it’s often ignored, for a few reasons.

First, it’s a market retail investors don’t generally invest in.

Central banks trade to control inflation or stabilize the currency. Financial institutions and corporations trade to hedge against foreign exchange risk.

Retail investors might trade for speculative purposes, hoping to profit from currency movements. But many just stay away. You may know a currency trader or two, but odds are you don’t do it yourself.

Second, forex is designed specifically for trading, and is what is known as a range-bound market. In the long run, stocks trend in one direction: up. Whereas Forex markets mostly move sideways.

At its core, Forex involves buying one currency while selling another, always in pairs.

Examples of pairs include EUR/USD, GBP/JPY, and AUD/CAD. (No idea what JPY or CAD mean? That’s fine — we’ll get to that.)

How the Forex market is designed for trading

Forex is uniquely structured to facilitate trading. Unlike stock markets, Forex allows you to easily trade both long and short positions. You can profit whether the market is rising or falling.

Going long means buying a currency pair, expecting that the base currency will rise.

• For example, say you think the European Central Bank will raise interest rates faster than the US Federal Reserve, which would cause the euro to strengthen against the dollar.
• In that case, you might buy EUR/USD at 1.2000, expecting the Euro to Strengthen against the US Dollar.
• If the Euro rises to 1.2500, you profit from the increase.

Going short means selling a currency pair, expecting the base currency to fall.

• For example, you might sell GBP/USD at 1.4000, expecting the British Pound to weaken against the US Dollar.
• If the Pound drops to 1.3500, you profit from the decrease.

How to read + interpret a Forex pair

When you look at a stock price, it’s easy to know what it represents.

If Tesla stock is trading at $200, each share of TSLA is worth $200.

Forex trading looks way different than a stock quote:

At first glance, it’s normal to go, ‘WTF is this?’. It’s almost a put-off, something you don’t even want to look at.

Without getting into the definition of what each number is called (something no one uses anyway), let’s make this simple:

The numbers 1.0854 and 1.0856 show the price of how much in USD you’d need to buy one Euro. In this example, you’d need $1.0856 dollars to purchase one USD.

Trading the EUR/USD means you’re speculating on whether the Euro will outperform or underperform the U.S. Dollar.

If you want to sell (short) the EUR/USD, that means you’re betting on the Euro weakening against the U.S. Dollar. If you think the Euro will beat the USD, you’d buy it.

That little ‘1.5’ is called the spread — the difference between your buy and sell price. (It’s how your broker makes money.)

How does Forex compare to other markets?

Forex vs stock market

Stock markets have set hours and are influenced by recent opening and closing sessions. Forex’s insane liquidity means tighter bid/ask spreads and less slippage.

A tight spread means the difference between your buying and selling price is smaller, leading to lower trading costs.

Slippage occurs when the spread changes between the time a market order is requested, and the time an exchange executes your order.

Forex offers more volatility due to its vast, decentralized nature. Unlike the stock market, which has central exchanges, Forex is an over-the-counter (OTC) market.

This decentralization means it’s influenced by many factors from all over the world, leading to more trading opportunities.

Forex vs commodities

Commodities often require significant knowledge about the goods being traded, and are heavily influenced by weather. (A single bad drought can affect agricultural sectors like crazy).

Forex, however, is driven by economic indicators, interest rates, and political stability. For instance, higher interest rates in a country can attract foreign capital, boosting the currency’s value.

Forex vs futures

Forex trading is more accessible than trading futures, with fewer barriers to entry.

Futures trading involves a lengthy application process, different margin and leverage rates depending on the time of day, and you have to pay for the data.

Additionally, opening a Forex account is simple and can be done in minutes. Data in FX is free.

What causes currencies to rise and fall?

Fundamental analysis involves evaluating a country’s economic health to gauge currency strength:

• Central banks set interest rates
• Higher interest rates typically attract foreign capital
• This typically causes a currency to rise

Now, notice the word typically.

Let’s say the nation “Madeupistan” is having some internal issues. They need to raise cash to make things better, so they boost interest rates to 20%.

A 20% yield?! Who wouldn’t want to get some of that?

A 20% yield on a nation’s cash sounds like a good deal — but the risks could be high. Madeupistan might be undergoing a military coup, and they could nationalize industries, or even remove the currency from the open market. In that case, you’d be up shite creek.

Economic data like GDP, employment figures, and retail sales numbers give insights into economic performance.

Strong GDP growth can signal a strong economy, which can boost the currency. Political stability also plays a role.

Uncertainty and instability can weaken a currency. Think Brexit and the pound.

In June 2016, the United Kingdom voted on whether to stay or leave the EU. After the exit vote, the GBP/USD tanked -15% over six-months.

With no fixed trade agreements between the UK and the EU upon the exit, there were very real fears about how the UK’s economy would react.

There’s a common misunderstanding that buying a country’s currency is placing a bet on the country itself. While this is partially true, it’s not that simple.

Plenty of countries are doing well but have weak currencies! A currency’s value is influenced by a complex mix of factors, including economic policies, market speculation, and international trade dynamics (exports, imports, tariffs, etc).

Additionally, some currencies are heavily correlated to a nation’s major exports. The Canadian Dollar, for example, is heavily influenced by oil prices. Similarly, the Australian dollar can be heavily influenced by iron ore and precious metal events.

What happened to the Japanese Yen? 💴

Something I’ve been preaching about over the past few years is the Japanese Yen and how much it should freak everyone out.

People talk a lot about the US Dollar and the Euro. However, after the dollar, the Yen is the most important currency for banks and income strategists.

If you take anything away from this article, I want you to understand this: the closest and nearest threat to another global financial crisis isn’t inflation, war, the US Dollar, oil, or aliens. It’s the Japanese Yen.

Why? Because of the carry trade.

What is the Yen carry trade?

The carry trade is a classic financial arbitrage game, where savvy investors borrow in a currency with dirt-cheap interest rates, park the cash into a currency with higher interest rates, and pocket the difference. Easy money.

The Japanese yen is the go-to funding currency because of its perpetually low rates. It’s like borrowing a neighbor’s cheap lawnmower to mow lawns in a posh neighborhood and charging premium rates.

But watch out — if the Yen suddenly becomes more valuable, your debt to Japan gets more expensive, this easy money-making machine can turn into a loss very fast.

And that is exactly what happened this week.

Party’s over for the Yen surge

For years, the yen was the go-to currency for investors looking to borrow cheaply. Japan kept interest rates at rock-bottom levels, while other countries hiked theirs to combat inflation.

The plan was simple: borrow yen, invest in higher-yielding assets like US Treasuries, the Aussie Dollar, and Mexican Pesos, and pocket the difference.

Easy money, right?

Not anymore.

The Bank of Japan finally decided to play hardball, hinting at interest rate hikes and pushing the yen into overdrive. In weeks, the Yen spiked over 10% against the US dollar, flipping the carry trade on its head.

Investors who borrowed yen are now scrambling as their so-called “low-risk” strategy is turning into a financial dumpster fire.

Margin calls are coming in hot, forcing them to buy Yen to cover their losses, which only makes things worse. It’s like trying to put out a fire with a flamethrower.

Why did the Bank of Japan decide to play hardball and raise interest rates? Because the Yen has fallen to levels not seen since the 1990s — a creepy and scary situation.

But Japan raising interest rates is problematic too. Why? Because Japan’s national debt is 1.3 quadrillion Yen, or 265% of the Japan’s GDP!

Sharp rises in borrowing rates would be disruptive for Japan’s heavily indebted government and economy.

1.3 quadrillion. A huge number with lots of zeros. Fifteen zeroes.

How do you even begin to tackle a number this big?

No one knows, and that’s the problem! If Japan’s currency breaks, the world bond market and global financial system aren’t far behind.

It’s not just too big to fail; it’s to big to fix.

The Yen is a “Dirty Float”

Here’s another thing you need to understand about the Japanese Yen – it’s a managed currency.

FX traders call currencies like the Yen a “Dirty Float,” as opposed to “Free Floating” currencies like the US Dollar, Aussie Dollar, Euro, British Pound, etc.

The yen is a Dirty Float because the Japanese government and/or the Bank of Japan can intervene at will, anytime, for any reason.

A vicious feedback loop has begun

This mess is just getting started.

There are an estimated 6 to 14 trillion dollars involved in the Yen carry trade worldwide. The more hedge funds, prop shops, trading firms, and other professional speculators have to sell assets to get out of the yen, the more the Yen strengthens, creating a brutal cycle.

Experts say the yen carry trade unwinding is only about ​halfway through​, which means more chaos could be on the horizon. The Yen could keep climbing, forcing even more selling and amplifying the market turmoil.

Unless the Fed decides to cut rates (which is not a foregone conclusion) this will get a lot uglier.

What’s next?

But while there’s no exit in sight, there may be a pause.

If you’re wondering why markets suddenly did a 180, it’s because fears of the BoJ hiking rates again appear to have faded.

The Japanese government & BoJ are active in the media; making public comments and basically playing chicken with traders and investors (playing a game of “F- around & find out.”)

So, if you want to know what the Bank of Japan may or may not do here in the near future with the Yen, pay attention to what they say, and how they say what they say.

Earlier this week, Bank of Japan Deputy Governor Shinichi Uchida ​said​ the BoJ won’t raise rates again unless necessary.

Forex trading tips

If there’s one thing I’ve learned in this world, it’s that trading without a strategy is like sailing without a GPS.

Without proper risk management, you’ll lose your shirt. Ignoring risk management is a common mistake that can lead to significant losses.

How to manage your risk

Always set a stop-loss to limit potential losses. A stop-loss order automatically closes your trade if the market moves against you by a certain amount..

Stop-loss is your insurance. Not using a stop-loss is like skydiving without a parachute. It’s dumb and dangerous.

Once you set a stop-loss, do not move it further from your entry — ever. If you do move your stop loss, it should only move closer to your entry, not further away.

Set your risk management rules. Decide on your position size, stop-loss levels, and maximum risk per trade.

Never risk more than 1-2% of your trading capital on a single trade. This way you won’t wipe out your account if you have a few losing trades.

Diversify your trades. Don’t put all your eggs in one basket. Trade different pairs and use different strategies to spread your risk.

Experiment with trading styles

Each trader has a particular style or timeframe they like to trade. Choose your strategy based on your goals and risk tolerance.

This could be day trading, swing trading, scalping, or position trading.

• Scalping involves making small profits on numerous trades throughout the day. This requires quick decision-making and a lot of focus.
• Swing trading involves holding positions for days or weeks to capitalize on expected price moves. This style is less stressful than scalping and can be more profitable if you catch a strong trend.
• Position trading is long-term trading based on fundamental analysis and long-term trends. Position traders hold their trades for weeks, months, or even years, aiming to profit from major market moves.

Have a clear plan and stick to it.

Choose the right broker

Choosing the right broker is crucial. Ensure your broker is regulated by a reputable authority like the CFTC, NFA, or FCA. Regulation protects you from fraud and ensures the broker operates fairly.

Look for brokers offering low spreads to minimize trading costs.

A low spread means the difference between the buying and selling price is small, leading to lower costs. Fast execution ensures you get the price you want, especially in volatile markets. Reliable customer support can be a lifesaver when you encounter issues.

I’m based in the US, and I use both ​Oanda​ and ​FOREX.com​ — I’ve been using them for 10+ years and haven’t had an issue with either.

Now, would I rather use a broker outside the US that offers higher leverage, and access to other derivatives like CFDs and the like? Yes.

But in the ‘Land of the Free’, the mighty regulators on their lofty perches believe that the little guy doesn’t know what they’re doing and can’t be allowed to risk their money without the government saying it’s OK. (Land of free markets, my ass!)

Tools of the trade

To trade forex effectively, you need the right tools.

• MetaTrader 4 (MT4) and ​MetaTrader 5​ (MT5) are industry standards. They offer a range of tools and indicators, making it easier to analyze the market and execute trades.
• ​Babypips.com​ isn’t just free, it’s probably the best FX educational resource that you’ll find anywhere. If you really want to get into the nitty gritty of Forex — there is no better place to start.
• ​TradingView​ — for the beginner and retail trader — is the best and easiest charting and technical analysis service out there. They also have a boatload of integrations with FX brokers so you can trade right off the platform.

Develop a plan and stick to it

A solid trading plan is essential for success in the forex market. Define your goals. What do you want to achieve with your trading? Be specific and realistic.

Keep a trading journal to record your trades, strategies, and outcomes. This helps you learn from your mistakes and refine your approach.

Trading based on fear or greed leads to losses. Avoid making rash decisions based on short-term market movements. Keep your emotions in check and stick to your trading plan.

Not every day will be a trading day. Sometimes, the best trade is no trade.

Every trader faces setbacks. Learn from losses. What matters is how you bounce back.

Above all, success in Forex is as much about mindset as it is about strategy. 💱

That’s all for today.

Reply to this email with comments. We read everything.

See you next time,
Jon

Disclosures

• This issue was written by Jon Morgan and edited by Stefan von Imhof.
• This issue was sponsored by Avawatz
• Neither the ALTS 1 Fund nor Altea have any foreign currency holdings.
• This issue contains an affiliate link to TradingView. If you sign up we get a few bucks.