What is forex trading? A definition
Forex comes from the term foreign exchange trading. Apart from being called forex, it is also referred to as FX by broker comparison sites and traders alike. Forex is exchanged through a global network of businesses, banks and individuals. Due to the way the market operates, currency prices constantly fluctuate. As the largest market in the world, the value of the forex market exceeds US$ 4 trillion each day. One of the reasons forex trading is so popular is that it allows part-time traders to make trades outside of their usual work hours as it is a 24 hour market, it does not close except at weekends. This market is global in scope, meaning that you can trade major currency pairs such as EUR/GBP or USD/JPY.
So, what is forex trading and how does it work? No matter how simple it sounds, there is a need for you to truly master the fundamentals for you to become a successful trader. Selling your Euros to buy US Dollars, for example, is exactly what forex trading is and how it works by definition, but as mentioned above, there is more to it than exchanging one currency for another. Forex traders look to profit from their trades, and like any other type of trading, it involves risks. Historically, the forex market was the domain of the large institutions in the finance world, such as corporations, central banks, large financial firms and hedge funds. Today, anyone with a bit of capital can start buying and selling currencies through their brokerage accounts.
Forex trading guide: the basics
Currencies are important. They are not only used to buy goods and services around the world but they are exchanged to make foreign trade possible. If you live in Mexico and would like to buy Champagne from the Champagne region of France, you can buy it in Euros or purchase it from a company that imports the product. This means that either you or the importer will have to exchange Mexican Pesos to the value of the bottle of champagne in Euros. This kind of transaction also happens when you travel. If you are an international tourist visiting the Philippines, you would need to exchange your currency to get the local currency for you to pay for your stay. These examples illustrate why the foreign exchange market is both huge and extremely liquid. In fact, it dwarfs even the stock market in terms of size. One thing that every new trader should know is that the forex market does not have a central marketplace for exchanging or trading currencies. The exchange is all done Over the Counter (or OTC). This means that all transactions are done online between traders around the world. You already know that the market is open the entire day for five and a half days every week. Once financial centres open, traders can start buying or selling currencies.
Choosing a currency pair – which currencies traders choose and why
Prior to beginning trading and performing your research, you must choose the currency pair that you wish to trade. There are a many pairs to choose from, including major pairs such as GBP/USD (British Pound/ US Dollar) and USD/JPY (US Dollar/ Japanese Yen), exotic pairs such as USD/ZAR (US Dollar/ South African Rand) and USD/HKD (US Dollar/ Hong Kong Dollar), and minor pairs such as EUR/GBP (Euro/ British Pound) and CHF/JPY (Swiss Franc/ Japanese Yen).
Not all brokers offer the same selection, with many of them offering major pairs only, so if you are primarily interested in trading forex, you will need to consider what pairs you require access to and perform a broker comparison. This will allow you to evaluate the services offered by the broker as well as their fee structure.
Both technical and fundamental research can be used to help determine possible trading opportunities. It is recommended that you take your time to fully analyse potential currency pairs to help you manage your own risk. The more you know about a specific country, its politics, and current news, the better prepared you will be to predict changes in the market.
During times of uncertainty, it is not uncommon for traders to focus their trading efforts on currencies which are considered low risk. These currencies have issuing governments which tend to have stable, strong economies. Popular safe haven currencies have traditionally included the Japanese Yen, the US dollar and the British Pound.
Institutional Forex markets
There are three ways forex is traded on an institutional level:
- Spot market – The most basic type of trading in the forex market is through the spot market. This is where currencies are sold or bought based on their current price. The current price is determined by the amount of supply that a certain currency has and the demand for it. It is also a reflection of what is happening in the market. This includes economic performance, current interest rates, the sentiments of people regarding certain political situations both at home and abroad, and the perception on how said currency will perform against another. The British pound has fallen a number of times in the past few weeks due to Brexit negotiations, but on good days when headlines are more hopeful than the day before, its value goes up. This is because the perception of its future performance is factored in by analysis.
- Forwards market – This involves contracts being bought or sold over the counter between two entities. The parties determine the terms of said contract for a delivery price in the future.
- Futures market – Similar to the forwards market, the futures market does not involve trading actual currencies but deals in contracts representing claims to a particular currency, its price per unit and its settlement date in the future.
Forex trading for beginners
The most common way for individuals to trade the forex market is via a CFD – a CFD is a Contract For Difference and is commonly used as a method for CFD trading. CFDs in forex trading allow you to speculate on whether a currency pair will rise or fall without actually owning the currency. When trading in CFDs, you would trade a number of CFDs in the unit of the base currency (or the currency on the left of the pair).
Opening a trading account means looking for a reputable brokerage firm that offers the service. To ensure that you only deal with legitimate companies, you can ask your bank if it has a brokerage for forex trading. While looking for a brokerage firm, you must take note of the considerations below. The single most important detail that every new trader must remember is
understanding the risks involved. While the forex market is less volatile than others, there are still risks that you should be aware of. Risk depends on leverage. The higher the leverage you choose for a particular currency pair, the higher the risks are. A leverage of 50:1, for example, translates to every pound controlling up to £50. With this leverage and with an account containing £1,000, your broker will lend you £50,000 so that you can trade in the market. This is one of the advantages of forex trading because you can make a lot of profit with very little cash, but as mentioned, this can have extremely difficult results as a trade can move in the other direction, effectively amplifying the leverage you have chosen. You already know that brokers make money through the spread between the bid and the ask. To ensure that you get the most out of your earnings, you can compare the spread offered by the brokerage firm you are looking at.
Plenty of opportunities
Trading currencies is not a get rich quick scheme. With daily currency fluctuations often rather small, traders often need to have leverage for them to make meaningful trades. This means that your leverage may be as high (as high as 250:1), but this all depends on the currency and the situation. High leverage is industry standard when it comes to trading currencies. Due to the availability of high leverage and the extremely liquid market, it is an ideal place to trade. Traders can open or close trades within a few hours or even minutes and can also opt to hold position for a number of months. The most basic lessons that an FX trader needs to learn are the law of supply and demand and the fundamentals of currency movements to get plenty of opportunities to profit. When you are ready, you can start trading with as little $500 with a broker.
Making money out of currency trading involves a deep appreciation of the market and the goings-on in the world. It also requires basic trading skills and an understanding of all the trading concepts used by brokers. To be able to trade successfully and to ensure that you do not lose money as a beginner, you will need to master the fundamentals of forex trading first. You can do this by taking advantage of demo accounts to get a feel of how it works. Reading an introductory book can be beneficial, while learning from a successful trader is another way for you to get in-depth insights about the market. Successful traders usually use tools to help them make trading decisions. This can be through manual or automated trading signals or by trading the news. It also involves studying different trading strategies and choosing which one you are most comfortable with. While this particular market can be exhilarating and may even conjure daydreams of earning a huge windfall, you must have realistic expectations and a thorough understanding of the risks involved in forex trading.