Wouldn’t it be great if you could trade your money for someone else’s money today, trade back the next day, and add a few extra bucks to your pocket?
Believe it or not, this kind of transaction happens every day, countless times per day. In fact, by daily trading volume, foreign exchange (forex) represents the largest financial market in the world, with more currency trading than stocks on the stock market.
Successful traders make millions of dollars in the process, leading countless newcomers to try their hand. But what exactly is the forex market, or FX market, and what is FX trading?
What Is Forex Trading?
Forex trading gets its name from the foreign exchange market, or the forex market, on which currency exchange trades occur. In this marketplace, currencies from around the world are exchanged for one another in currency pairs, also called forex pairs.
Some of the most active forex traders are businesses that deal in foreign currencies and use currency forwards, futures, and swaps — we’ll define these in a bit — to lock in exchange rates and protect their businesses from price volatility.
Wherever there’s volatility, there are individual traders ready to speculate on future price movements. Similar to day trading stocks, forex speculators look for patterns in the charts of currency price movements and attempt to buy when values are low and sell when they’re high, profiting on the difference.
Anatomy of Currency Pairs
When trading forex, all assets are displayed as pairs that provide abbreviations of two currencies separated by a backslash. The first currency in the pair is known as the base currency and the second currency is called the quote currency.
In the pair, the value of the base currency is always 1 while the value of the quote fluctuates based on the rate of exchange between the two currencies.
One of the most commonly traded pairs on the market is the EUR/USD pair. For example’s sake, let’s say the pair is currently trading at 1.16.
In this example, the base currency is the euro (EUR) and the quote currency is the United States dollar (USD). If the value of the pair is 1.16, then 1 euro can purchase 1.16 U.S. dollars.
Basic Forex Terms You Need to Know
It’s important to get to know the lingo before you get involved in any trading activities, forex or otherwise. In forex, a spread isn’t something you enjoy on the top of a bagel, and snipping has nothing to do with scissors. Below, you’ll find seven terms that are absolutely crucial to know before you get started:
Contracts for Difference (CFDs)
Contracts for Difference, or CFDs, are derivative trading instruments, meaning traders who use them don’t actually own the underlying asset. Instead, they own a contract that will either produce a profit or a loss based on the direction of price movement the contract is based upon.
Those that believe a specific pair is going to rise in value will buy CFDs, while those that believe the value will fall sell them.
CFDs pay the difference in the closing price and opening price for a currency pair. For example, if a CFD on the EUR/USD pair opened at 1.16 and closed at 1.20, the contract would pay $0.04 — the difference between the opening price and closing price of the contract, minus any fees involved in the trade.
Unlike other contracts traded in financial markets, like futures and options, CFDs don’t have an expiration date. Instead, they trade like other securities with constant price movements for buyers and sellers.
Changes in currency prices happen fast but tend to be relatively small. Because of this, forex traders use leverage to expand their gains. Using leverage is the act of borrowing money from your broker for a trade, the same way businesses often borrow a percentage of the funds they need to fulfill large orders.
For example, say you want to bet that the euro will gain against the Japanese yen. Because neither currency is likely to fluctuate all that much — we’re talking pennies or fractions of pennies per day — you might need to invest $10,000 in the trade to see any meaningful returns from the price movements.
But you won’t have to put the entire $10,000 into the trade yourself. With most forex brokers, you’ll be able to borrow a large percentage of your position—say $9,000, in this example, meaning that you’ll only have $1,000 worth of skin in the game.
The caveat to this deal is that when leverage is used, both profits and losses are greatly magnified. Should a highly leveraged trade go awry, you’ll need to be prepared to accept painful losses.
Trading currency requires traders to be willing to make relatively large trades, most of which fall into one of three lot sizes. The standard lot size is 100,000 units, meaning that if you’re trading the EUR/USD based on the example above, the total trade would have a value of $116,000.
Fortunately, smaller lot sizes have been created to allow forex access to traders who don’t have or want to risk large amounts of money on single trades. The two other most popular lot sizes are minis, which consist of 10,000 units, and micros, which consist of 1,000 units.
Forex trades take place in margin accounts, which allow for the use of leverage. Margins are the money held aside to assure the broker that when the trade ends, they won’t lose money on the loan they provided to make the trade possible.
Using the example above of a $10,000 trade being made with $1,000 of your upfront capital, the $1,000 you contribute is the margin, with the remaining $9,000 being leverage, or a loan from the broker. If the price of the pair you’re trading falls below the margin requirement, your account will be subject to a margin call, meaning you’ll either have to sell some of the leveraged assets in your account or add additional capital to avoid solvency issues.
The term pip is an acronym meaning “Percentage In Point” or “Price Interest in Point,” and represents the minimum price change possible in a currency. One pip is four decimal places back, or 0.0001, with 100 pips representing one cent.
When trading a standard lot size, or 100,000 units of currency, one pip would be multiplied by the number of units, bringing the minimum price change on the trade to $10. On mini lot sizes, the minimum price movement is $1, while micro lot sizes can move in increments of $0.10.
When using a forex trading platform, you don’t pay a commission on your trades. Instead, the broker makes their money by baking fees into the spread, or the difference between the bid and ask price. The size of the spread paid on a trade will vary based on several factors, the most important of which are lot size, demand for the currency being traded, and volatility.
How Does Forex Trading Work?
Forex is an interesting market because there’s no single major currency market that’s globally accepted. As a result, trading happens electronically over the counter, the same type of trading you would expect when buying an OTC stock.
There are two basic ways that you can go about trading — either trade in the now (on the spot), or execute contracts for the future purchase and delivery of currency.
What Is the Spot Market?
The spot market got its name from the fact that deals on this market take place on the spot based on the current exchange rate between the currencies.
For example, if you believe there will be a large spike in the value of the euro compared to the U.S. dollar, you could purchase USD/EUR on the spot at the current exchange rate.
Should the value of the euro climb as you predicted, you can sell your holdings on the spot, earning a profit based on the difference between your buying and selling price. Of course, if the value of the euro falls after the trade, the difference between the buying and selling price becomes the loss on the trade.
What Is the Forwards and Futures Market?
Trades that happen in the forwards and futures market are derivative trades where deals are made for the future, rather than the immediate exchange of currency. As the name of the market suggests, there are two different types of deals that happen on the forwards and futures market:
- Forwards Contracts. Forwards are privately negotiated contracts that settle just once at the time of expiration. With forward contracts, two parties agree on a future price of a currency that will be purchased in the OTC market at the expiration of the agreement. These contracts are most commonly used for currencies that aren’t commonly traded or are otherwise inconvertible.
- Futures Contracts. Futures contracts are exchange-traded assets that are readily available to traders on the open market. They are standardized contracts originally created to stabilize prices on future exchanges of commodities. Under currency futures contracts, a predetermined amount of currency is contracted to be traded at a later date for a specific price.
What Causes Movement in Currency Exchange Rates?
What exactly causes price movements in different currencies? Some of the most significant factors that help determine future movements in the prices of currencies include:
- Central Bank Activities. Central banks are charged with making monetary policies in developed economies. These banks set interest rates, purchase bonds, and take other actions to help balance the economies they represent. As this balance takes place, the value of the currencies controlled by central banks will fluctuate.
- Economic Conditions. A currency is only as strong as the economy it represents. After all, how much money would you want to sink into a currency that represents a failing economy? When economic conditions are positive, currencies tend to climb in value in relation to others. Conversely, poor economic conditions result in declines in a currency’s value.
- Geopolitical Conditions. The global economy is a robust system that makes trade possible between countries. Peaceful, mutually beneficial global trade has become crucially important to modern economies. When geopolitical conditions support continued amicable trade between countries, the currencies from those countries tend to see growth. On the other hand, when geopolitical conditions threaten trade or governments become unstable, the currencies involved tend to take a nosedive.
The Most Traded Currency Pairs
If you’re a beginner to the forex space, it’s important to choose the pairs you trade wisely. Most beginners should stick with the most popular pairs for a couple of reasons:
- Liquidity. The most popular pairs are traded millions of times every day. So, when you decide it’s time to exit your position, you’ll have no issues getting out of the trade.
- Knowledge. The most commonly traded currency pairs represent countries that you likely know a bit about, making the research associated with trading these pairs less daunting.
The five most commonly traded currency pairs are:
- EUR/USD: Euro to U.S. dollar.
- USD/JPY: U.S. dollar to Japanese yen.
- GBP/USD: British pound to U.S. dollar.
- AUD/USD: Australian dollar to U.S. dollar.
- USD/CHF: U.S. dollar to Swiss franc.
Common Forex Trading Strategies
Your trading strategy will play a crucial role in whether you’re successful when trading currencies. Some of the most commonly used strategies include:
A strategy used on the most liquid assets, scalping is the fastest-paced strategy used by traders in currency markets. Scalpers only hold assets for seconds or minutes at most, hoping to make small profits on each trade.
The idea is that the trader will be able to make several trades each session by trading highly liquid assets and using technical analysis to confirm direction. This allows small profits to add up to meaningful gains.
Day trading forex is the process of using technical and sometimes fundamental analysis to determine where the price of a currency pair is headed in the near term.
As the name of the strategy suggests, day traders don’t hold onto assets for longer than a single day. This helps to alleviate the risk of an asset held over night losing significant value from one session to the next.
Swing trading is a great strategy for those who aren’t interested in constantly monitoring markets throughout the trading day. These trades are held for days or even weeks, in an attempt to capitalize on a current or coming swing in value.
Swing traders often make their trades just before or just after major economic reports, central bank announcements, or geopolitical events. Once the trade is made, the trader waits for the swing in value to take place, cashing in on mid-term profits.
Position trading is a strategy used by long-term minded forex traders. Position traders might hold both long and short positions, purchasing long positions when they expect the value of a currency to rise and short positions when they expect its value to fall.
As with any long-term trading or investing strategy, position traders rely heavily on fundamental analysis when making their trades.
Pros & Cons to Consider
There are plenty of pros and cons to consider before getting involved in forex trading.
Forex is the most popular financial market in the world. Some of the most exciting reasons to get involved include:
1. High Liquidity
Currency is the most liquid asset in the world. That’s important because it means that there’s likely to be a buyer ready to take over your position when it’s time to exit, alleviating the risk of you finding yourself stuck in a trade. Of course, there are some exceptions to the rule, and major currencies enjoy higher levels of liquidity than lesser-traded ones.
2. Extreme Profit Potential
There are plenty of traders who have made, and continue to make, millions of dollars in the forex space. Any time such significant profits can be achieved, there’s going to be excitement around the concept.
3. 24-Hour Trading
Most markets in which financial assets are traded have limited hours, making it difficult for the average person to have the time to get involved. Conversely, markets centered around forex are open 24 hours per day, five days per week, making it possible for anyone to make the time to participate.
4. Low Capital Requirements
Because leverage is commonplace where forex trades are concerned, a relatively small amount of capital is needed to get started.
5. A Decentralized Market
here is no single exchange, or even small group of major exchanges, on which the majority of currency trades take place. As a result of the decentralized nature of the market, there’s less potential for manipulation than there is in more traditional markets like the stock market.
Reading the pros above makes forex sound like a wonderland filled with sunshine, rainbows, and ice cream, but things aren’t always as they seem. There are a few significant drawbacks to consider before diving in:
1. Heavy Volatility
With currency being the most heavily traded asset in the world, the level of volatility in the market is higher than any other market you may consider working in. This volatility makes predicting movements in price more difficult and has the potential to lead to extreme losses.
2. Leverage Increases Risk
Leverage is a great way to expand profits, but it’s a double-edged sword. If trades go the wrong way, leverage could result in you losing more than the initial capital you put on the table for the trade. The risk of loss must be considered before getting started.
3. Time- and Research-Intensive
Trading currency is a research-intensive process that requires the trader to have a detailed understanding of economic reports, the activities of central banks, and geopolitical conditions. If you don’t have the time or desire to do the research required, forex isn’t for you.
Consider the Following When Choosing a Forex Broker
So you’ve decided that you’re ready to try your hand as a forex trader. Great! Before you dive in head first, it’s important to choose the right broker. Here are a few things to consider:
- Trading Tools. A quality forex trading account will come with all the tools you need for quality technical analysis. Look into the charting capabilities and indicators offered before deciding to work with one broker or another.
- Demo Account. Forex is a risky industry, and beginners should practice before they get started. Brokers that have a vested interest in their traders tend to offer demo accounts in which virtual currency can be traded to test your trading strategy before employing it in the real world. Before signing up with a broker, find out whether they offer a trade simulator.
- Spreads. Forex brokers don’t charge commissions, but they make money off the spread between the bid and ask price when each trade takes place. Compare the spreads offered between various forex brokers to ensure you’re not overpaying when you trade.
- Customer Support. Finally, when working with a broker, you’re forming a financial relationship. When you have questions about your hard-earned money, you’ll want to make sure that someone is both willing and able to answer your questions. Before choosing a broker, read consumer reviews about the service and support they offer. If other customers have had a good experience with the broker, chances are you will too.
The world of forex trading is an exciting one in which money is literally used to buy money. With so many people making massive profits in the space, you might be itching to get started.
Before you do, consider the risk associated with leverage and the high levels of volatility in the currency markets. Moreover, take the time to find a quality broker to work with, and test your strategies in a virtual environment before risking your hard-earned money.
As always, research and preparation are the foundation on which profitability is built in the forex space.