How Forex Market Works

The Forex market, just like every other market in the world, is driven by supply and demand. In fact, understanding the concept of supply and demand is so important in the Forex market that we are going to take a step back into Economics 101 for a moment to make sure we’re all on the same page. Having a good grasp of supply and demand will make all of the difference in your Forex investing career because it will give you the ability to sift through the mountain of news that is produced every day and find those messages that are most important. So how do supply and demand affect the Forex market?

       Supply is the measure of how much of a particular commodity is available at any one time. The value of a commodity—a currency in this case—is directly linked to its supply. As the supply of a currency increases, the currency becomes less valuable. Conversely, as the supply of a currency decreases, the currency becomes more valuable. Think about rocks and diamonds. Rocks aren’t very valuable because they are everywhere. You can take a walk down a country road and have your choice of hundreds or even thousands of different rocks. Diamonds, on the other hand, are expensive because there aren’t that many of them in circulation. There is a small supply of diamonds in the world, and you have to pay a premium if you want one.

       On the other side of the economic equation, we find demand. Demand is the measure of how much of a particular commodity people want at any one time. Demand for a currency has the opposite effect on the value of a currency than does supply. As the demand for a currency increases, the currency becomes more valuable. Conversely, as the demand for a currency decreases, the currency becomes less valuable. To get a good idea of the effects demand can have on something’s value, you have to look no further than Tickle Me Elmo. When Tickle Me Elmo was first released, there was an insanely high demand for the toy. Mothers and fathers were trampling each other to grab and pay for Elmo before someone else could wrestle it from their arms so they could make sure they had everything on their kid’s holiday list. For those who weren’t fast or aggressive enough to get Tickle Me Elmo at the store, paying outrageously high prices on eBay was their last resort. Huge demand had made this red, giggling doll much more valuable than it would have been if nobody’s child had wanted it.

       To illustrate how supply and demand interact to determine an ideal exchange rate in the Forex market, we use a standard supply and demand graph (see illustration below). Supply is represented by a solid diagonal line that is directed up from a low point at the left to a high point at the right. Demand is represented by a dotted diagonal line that is directed down from a high point at the left to a low point at the right. The y, or vertical, axis represents price. The x, or horizontal, axis represents the quantity of supply and demand. Finally, the ideal exchange rate is represented by the point at which the two diagonal

lines intersect. In this case, the supply and demand graph indicates that the ideal exchange rate for the EUR/USD pair is $1.2100.

       To illustrate an increase in either supply or demand, all you have to do is move the corresponding line to the right along the x axis. So if supply is increasing, you move the diagonal supply line farther to the right. If demand is increasing, you move the diagonal demand line farther to the right. To illustrate a decrease in either supply or demand, you simply do the opposite. All you have to do is move the corresponding line to the left along the x axis. If supply is decreasing, you move the diagonal supply line farther to the left. If demand is decreasing, you move the diagonal demand line farther to the left.

       As we discussed, as supply increases, the ideal price decreases. You can see in illustration below that as the diagonal supply line moves farther and farther right—illustrating an increase in supply—the intersection of the two lines moves lower and lower on the y axis. This tells us that the ideal exchange rate is getting lower and lower.

       Conversely, as shown in illustration below, as the diagonal supply line moves farther and farther left—illustrating a decrease in supply—the intersection of the two lines moves higher and higher on the y axis. This tells us that the ideal exchange rate is getting higher and higher.

       Moving the diagonal demand line left and right will have similar effects on the exchange rate. As demand increases, the ideal price increases. So when you move the diagonal demand line farther and

farther right—illustrating an increase in demand—the intersection of the two diagonal lines moves higher and higher. (See Illustration above.)

       You can also see (in Illustration below ) how when you move the diagonal demand line farther and farther left—illustrating a decrease in demand—the intersection of the two diagonal lines moves lower and lower.

       The instances in which you see a dramatic shift in the ideal price level come when both the supply and demand lines are moving. For instance, if demand for a currency suddenly increases while supply is decreasing, the ideal price level will climb very quickly. (See Illustration below.)

On the flip side, if demand for a currency suddenly falls off while supply is increasing, the ideal price level will fall just as quickly. (See Illustration below.) Supply and demand work efficiently in tandem.

       Take a moment to make sure you feel comfortable with the concept of supply and demand and how these graphs represent the interaction between the two because we use these graphs to explain why the Forex market does what it does and how you can profit from it.

       Understanding the movement of the Forex market is relatively simple because the same forces of supply and demand you experience in your life every day play a significant role in determining the exchange rates in the Forex market. Take oil prices, for example. When demand for oil goes up or the supply of oil drops off, oil prices go up. As oil prices go up, gasoline and natural gas prices go up. As gasoline and natural gas prices go up, you end up spending more to drive around town and to heat your home. And as you spend more and more on oil-based products, your budget gets leaner and leaner. The same factors that affect your budget affect the budgets of the world’s largest corporations and governments.

       One country that suffers from rising oil prices just the way you do is Japan. Japan imports nearly 100 percent of its oil. It’s not known for its booming oil reserves, so it doesn’t have much of a choice. Therefore, any oil Japan wants to use to produce electronics, cars, and other goods must be bought at whatever the going rate is. But that’s just the beginning. Japan’s economy relies on its ability to export the goods it creates to other countries, like the United States. As you’ve noticed driving around town, it costs a lot of money to transport your groceries, your kids, and yourself from one place to another. It costs even more when you have to ship your goods across the Pacific Ocean. Every car, DVD player, and computer Japan produces is becoming more and more expensive to ship to consumers. So when you look at it, Japan is getting hit on both sides. It has to import all its oil at inflated prices to create its goods, and then it has to pay inflated prices to ship all the goods it creates.

       So what impact does all this have on Japanese goods? It makes them more expensive. If Japanese companies have to pay more to produce their products and then have to pay more to distribute their products, they are going to have to charge more for their products so that they can cover their expenses and make a profit. As products become more and more expensive, consumers are able to buy less and less. And as consumers buy less, companies make less money, which leads to all sorts of economically negative outcomes. Now, let’s take a step back and look at what all this has to do with the exchange rate of the Japanese yen.

       Looking through the lens of supply and demand, you can see how an increase in the price of oil would affect the value of the Japanese yen. Oil is priced and sold in U.S. dollars. As oil becomes more expensive, purchasers in Japan have to convert more and more of their Japanese yen into U.S. dollars so they can pay for their oil. This increases the supply of Japanese yen in the Forex market and subsequently lowers the value of the Japanese yen. To compound the problem, as Japanese goods become more expensive and fewer and fewer people can afford to buy them, the demand for Japanese yen falls. Since you must purchase Japanese products in Japanese yen, you have to sell whatever currency you have to buy Japanese yen. The fewer products you buy, the fewer Japanese yen you need. And when you don’t need something, you stop demanding it. Rising supply plus falling demand equals a decrease in the value of the Japanese yen.

       The price of oil and its effect on the Japanese yen is just one example of how supply and demand affects the Forex market. We look at many other fundamental factors that influence the Forex market in the coming chapters. The important thing now is that you feel comfortable with the concept of supply and demand. Once you are comfortable with this most basic and most important concept of economics, you will be unstoppable in the Forex market.

       So, every time you analyze the Forex market, all you have to do is ask yourself how supply and demand are going to be affected by what is going on.