Foreign Exchange, notably known as Forex (FX), is the largest, most liquid financial market worldwide with over $7.5 trillion traded daily. Initially, this vast market was only accessible to banks and financial institutions, but online forex brokers have now allowed individual investors to participate in currency trading.
What is Forex Trading?
Forex trading is where you buy one currency while simultaneously selling another. You start trading with the goal of making a profit when the buying and selling is completed at different prices at some point in the future. For example, if you thought the euro would appreciate against the U.S. dollar, you would be able to buy euros and sell dollars. When the euro price had increased and you decided to sell the euros back into dollars, you would have made a profit. Therefore, forex trading revolves around predicting and taking advantage of these variations in currency values, and in our guide, we will outline how to begin.
How Do Forex Markets Work?
- Decentralized Market: The forex market doesn’t utilize a single centralized market. Instead, it uses a vast global network of banks, brokers, hedge funds, corporations, and individual traders who are connected to the network through an electronic link.
- Global in Nature, Across Multiple Financial Centers: Trading occurs in major financial centers around the world such as London, New York, Tokyo and Sydney. The forex market never sleeps, as when one location starts closing, another location opens, which means the market is never inactive.
- 24 Hours a Day, 5 Days a Week: Forex is available to be traded 24 hours a day, five days a week. This means participants in the market can always react as per the current breaking news, economic data releases, or geopolitical events. Stock markets only operate during certain hours, while forex is always open, which creates defensive advantages for traders.
- Highly Liquid Market: The forex market is the most liquid market in the world with daily trading volumes in the trillions. The level of daily trading volume makes the forex market liquid because of the fast-moving nature of major currency pairs. The amount of activity with the “major” currency pairs such as EUR/USD, GBP/USD, USD/JPY means a lower amount of time and effort when entering and exiting trades.
- Tight Spreads and Minimal Slippage: Thanks to deep liquidity, transaction charges in the forex market are relatively low, the difference between bid and ask prices are small, and trades in the forex market are executed very quickly with limited slippage.
Currency Pairs and Pricing
Currency Trades and Currency Pairs: Every forex trade consists of two currencies. One is the base currency (the first currency in the pair) while the other is the quote currency (the second currency in the pair).
For example, in the EUR/USD currency pair, the euro (EUR) is the base currency while the U.S. dollar (USD) is the quote currency. The price of the pair shows how much of the quote currency is needed to buy one unit of the base currency.
Currency pairs can be categorized as follows:
- Majors – These are the most traded pairs and will always include the U.S. dollar. For example, other major pairs include EUR/USD, USD/JPY, and GBP/USD.
- Minors – A minor currency pair is one that does not include a U.S. dollar but does include other major currencies. Some examples of minor pairs are EUR/GBP and AUD/NZD.
- Exotics – An exotic currency pair involves a major currency paired with one from an emerging (or lesser-known) economy. For example, some exotic currency pairs include USD/TRY and EUR/THB.
Bid and Ask Prices:
- Bid: The price you can sell the base currency.
- Ask: The price you can buy the base currency.
- Bid-Ask Spread: The price difference between the bid and ask prices, which is the cost to trade.
Pips, Lots, Leverage and Margin
- Pip: The smallest change in price for a currency pair (similar to cents in dollar amounts). Generally, it is 0.0001, except for yen pairs where it is 0.01.
- Lot: The amount of a trade. A standard lot is 100,000 units, a mini lot is 10,000 units, and a micro lot is 1,000 units.
- Leverage: Allows you to trade larger amounts with a smaller investment. For instance, with a 100:1 leverage ratio, $1,000 can control $100,000.
- Margin: The funds you allocate (like a security deposit) to maintain an open trade.
What Moves Currency Prices?
- Economic Indicators: Currency demand is affected by factors such as GDP growth, inflation, employment data, and trade balance.
- Central Bank Policies: Changes in monetary policy and interest rates are key drivers of currency prices.
- Geopolitical Events: Factors that affect investor confidence such as elections, wars, and other forms of political instability affect currency demand.
- Market Sentiment: Currency demand moves based on risk-on and risk-off behavior that characterizes the mood of participants of the market.
- Carry Trade: Borrowing in low-interest currency and buying a higher interest currency will affect currency directional flows.
- Psychological Factors: Price change expectations, speculation, and herd behavior create and amplify price movement.
- Flexibility Required: The price of instruments will change continuously, and traders have to be aware of prices.
Getting Started: Accounts, Strategy and Tools
A beginner trader needs to choose an account type first. There are several options from demo accounts that are purely for practice to accounts designated as cent, micro, mini, and standard based on trading capital and risk level. As an aspiring trader, it is essential to select a regulated broker. You want the transparency of fees, “on-the-money” execution, and trading platforms such as MetaTrader, or cTrader.
Next, you will have to think about a trading plan. What are your goals? How much are you willing to risk in each trade? What are you going to do, scalping, swing trading, or investing for the long-term (trending)?
Just as you would not take a journey without an appropriately planned route, you need to prepare yourself with trading tools, indicators for technical analysis, a live news feed, and economic calendars to predict when news releases will affect markets moving forward. A strategy plus right tools provide the needed structure and discipline in making choices.
Risk Management Basics
Risk management is the bedrock of sustained success in forex trading. A key consideration in risk management is proper position sizing, limiting risk to 1–2% of account balance per trade or position. Using stop-loss orders allows you to protect your account against any surprises by executing pre-determined exit levels for you.
The other key piece to successful risk management is establishing a favorable risk-reward ratio for trades. A 2:1 risk-reward means you take $50 risk to potentially make $100. Of course, risk-reward and position sizing are just numbers.
The hardest part of risk management is the emotional discipline required from the trader. The trader must avoid revenge trading, be consistent with their plan, and have a detailed record of their trading history. They can then reflect on their successes and failures. Traders who succeed have consistent execution and emotional control. This is often the main differentiator between traders who excel and those who fail quickly.
Demo Trading: Learn Safely
Before traders can risk larger amounts of capital they will need to practice and then grow their comfort level and confidence with using demo accounts. These accounts allow traders to replicate live conditions in a simulated environment. Once a trader is comfortable, they can often move to cent accounts where they risk tiny amounts of real money. Using cent accounts allows them to practice real trading with the psychological feelings of using real money. This is a more secure means of becoming comfortable with trading while developing their confidence, skills and discipline without being subjected to irreversible losses as a new trader.
Forex trading is an unparalleled route into the international financial marketplace, but success in trading is more than just enthusiasm. Education, planning, and discipline are essential. By learning about market structure, understanding the terminology, putting risk management measures in place and practicing consistently, traders can responsibly manage this vast marketplace.