What Is Forex Trading? A Beginner’s Guide

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What Is Forex Trading? A Beginner’s Guide

Forex (FX) is a combination of the words foreign currency and exchange. Foreign exchange is the process of converting one currency into another for a number of purposes, most notably business, trade, or tourism. According to the Bank for International Settlements’ 2019 triennial report (a worldwide bank for national central banks), daily forex trading volume surpassed $6.6 trillion in 2019.

Currency trading may be dangerous and complicated. Because the system has such enormous trading volumes, it is impossible for rogue traders to affect currency prices. This technique contributes to market transparency for investors who have access to interbank trading.

Retail investors should spend time studying about the forex market before deciding on a forex broker and determining if it is licensed in the United States or the United Kingdom (U.S. and U.K. dealers have greater monitoring) or in a nation with laxer laws and oversight. It’s also a good idea to find out what type of account safeguards are available in the event of a market downturn or if a dealer goes bankrupt.

Continue reading to understand what the forex markets, what they are used for, and how to get started trading.

Key Takeaways

  • The foreign exchange (commonly known as forex or FX) market is a worldwide marketplace where national currencies are exchanged.
  • Because of the global scope of trade, business, and finance, FX markets are the world’s biggest and most liquid asset markets.
  • Currencies are traded in pairs called exchange rate pairings. EUR/USD, for example, is a currency pair used to trade the euro against the US dollar.
  • Forex markets operate as both spot (cash) markets and derivatives markets, with forwards, futures, options, and currency swaps available.
  • Forex is used by market players to hedge against international currency and interest rate risk, speculate on geopolitical events, and diversify portfolios, among other things.

Forex Trading: A Beginner’s Guide

What Is the Forex Market?

Currency is exchanged on the foreign exchange market. Currency is significant because it allows us to buy goods and services both locally and across borders. To undertake overseas commerce and business, international currencies must be exchanged.

If you live in the United States and wish to purchase cheese from France, you or the firm from whom you buy the cheese must pay the French in euros (EUR).This implies that the importer in the United States would have to convert the equal amount of US dollars (USD) for euros.

The same is true for traveling. A French visitor visiting Egypt cannot pay in euros since the currency is not accepted locally. The traveler must convert his or her euros for local money, in this instance the Egyptian pound, at the current exchange rate.

One distinguishing feature of this international market is the absence of a central marketplace for foreign currency. Rather, currency trading is done over the counter (OTC), which implies that all transactions take place over computer networks among traders all over the globe, rather than on a single controlled exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded in practically every time zone in the main financial capitals of Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich. This implies that when the trading day in the United States finishes, the currency market in Tokyo and Hong Kong starts afresh. As a result, the currency market may be quite busy at any moment, with price quotations changing on a regular basis.

It’s worth noting that the phrases FX, forex, foreign exchange market, and currency market are often used. These concepts are interchangeable and all pertain to the currency market.

A Brief History of Forex

The FX market has been around for millennia in its most basic form. To acquire products and services, people have long swapped or bartered items and money. However, as we know it today, the currency market is a very new creation.

Following the breakdown of the Bretton Woods Agreement in 1971, additional currencies were permitted to float freely against one another. Individual currency values fluctuate depending on demand and circulation, and are monitored by foreign exchange trading services.

The majority of forex trading is done on behalf of customers by commercial and investment banks, but there are also speculative possibilities for trading one currency against another for professional and individual investors.

Currency as an asset class has two unique characteristics:

An investor may benefit from the difference between two interest rates in two separate economies by purchasing the higher interest rate currency and selling the lower interest rate currency. Prior to the 2008 financial crisis, shorting the Japanese yen (JPY) and buying British pounds (GBP) was quite widespread due to the significant interest rate disparity. This method is also known as a carry trade.

Prior to the Internet, currency trading was very difficult for ordinary investors. Because forex trading needed a huge amount of cash, most currency traders were major multinational organizations, hedge funds, or high-net-worth individuals (HNWIs). With the assistance of the Internet, a retail market geared at individual traders has evolved, offering simple access to the foreign currency markets through banks or brokers operating a secondary market. Most online brokers or dealers provide individual traders with extremely high leverage, allowing them to manage a huge transaction with a tiny account balance.

An Overview of Forex Markets

The foreign exchange market is where currencies are exchanged. It is the world’s first fully continuous and ongoing trading market. Historically, the forex market was controlled by institutional corporations and major banks acting on behalf of their customers. However, it has grown increasingly retail-oriented in recent years, and traders and investors of all sizes have started to participate.

One intriguing characteristic of global forex markets is that there are no physical structures that serve as trading venues for the markets. It is instead a series of linkages formed through trade terminals and computer networks. Institutions, investment banks, commercial banks, and individual investors all participate in this market.

Foreign exchange markets are seen to be more opaque than other financial markets. OTC markets are where currencies are exchanged, and disclosures are not required. Large liquidity pools from institutional corporations are a common occurrence in the market. One would think that the most essential factor for determining a country’s pricing would be its economic metrics. That, however, is not the case. According to a 2019 poll, the motivations of huge financial organizations had the most crucial effect in influencing currency values.

Forex is typically traded via three venues: spot markets, forward markets, and futures markets. Because it is the “underlying” asset on which forward and futures markets are based, the spot market is the biggest of the three. When individuals talk about the forex market, they typically mean the spot market. Forwards and futures markets are more common among enterprises or financial institutions who need to hedge their foreign currency risks out to a certain future date.

Spot Market

Because it trades in the largest underlying real asset for the forwards and futures markets, forex trading in the spot market has traditionally been the largest. Previously, volumes in forward and futures markets outnumbered those in spot markets. However, the introduction of computerized trading and the proliferation of forex brokers increased trading volumes in forex spot markets.

Currency is purchased and sold on the spot market depending on their trading price. That price is established by supply and demand and is computed based on a number of variables, including current interest rates, economic performance, feeling toward ongoing political circumstances (both locally and globally), and the perception of one currency’s future performance versus another. A spot deal is a completed transaction. It is a bilateral transaction in which one party provides an agreed-upon quantity of one currency to the counterparty and gets an agreed-upon amount of another currency at the agreed-upon exchange rate value. When a position is closed, it is settled in cash. Although the spot market is well recognized for dealing with transactions in the now (rather than the future), these trades actually take two days to settle.

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Forwards and Futures Markets

A forward contract is a private agreement between two parties in the OTC markets to acquire a currency at a future date and at a fixed price. A futures contract is a standardized agreement between two parties to take delivery of a currency at a defined price and date in the future. Futures are traded on exchanges rather than over the counter.

Contracts in the forwards market are purchased and sold OTC between two parties who agree on the parameters of the transaction. Futures contracts are purchased and sold on public commodity exchanges such as the Chicago Mercantile Exchange based on a defined size and settlement date (CME).

The National Futures Association (NFA) controls the futures market in the United States. Futures contracts include particular characteristics such as the quantity of units exchanged, delivery and settlement dates, and minimum price increments that cannot be changed. The exchange functions as the trader’s counterparty, offering clearing and settlement services.

Both forms of contracts are legally binding and are usually resolved for cash at the exchange in issue when they expire, however contracts may be purchased and sold before they expire. Currency forwards and futures markets may provide risk protection when trading currencies. These markets are often used by large multinational firms to hedge against future currency rate volatility, although speculators also participate.

Options contracts are traded on specific currency pairings in addition to forwards and futures. Before the option expires, holders have the right, but not the responsibility, to engage into a forex deal at a future date and at a predetermined exchange rate.

Forwards, futures, and options markets, unlike the spot market, do not exchange real currencies. They instead engage in contracts that indicate claims to a given currency type, a specified price per unit, and a future settlement date. That is why they are referred to as derivatives markets.

Uses of the Forex Markets

Forex for Hedging

Companies conducting business in other nations are vulnerable to currency swings when they acquire or sell products and services outside of their native market. Foreign exchange markets allow you to hedge currency risk by establishing a fixed rate at which the transaction will be executed.

To do this, a trader may purchase or sell currencies in advance in the forwardor swap markets, so locking in an exchange rate. Assume a corporation intends to sell American-made blenders in Europe when the euro/dollar exchange rate (EUR/USD) is €1 to $1 at parity.

The blender costs $100 to produce, and the company aims to sell it for €150, which is comparable with other European-made blenders. If this strategy is effective, the corporation will benefit $50 every sale since the EUR/USD exchange rate is even. Unfortunately, the US dollar proceeds to appreciate against the euro until the EUR/USD exchange rate reaches 0.80, implying that it now costs $0.80 to acquire €1.00.

The company’s dilemma is that, although it still costs $100 to build the blender, it can only sell it at a competitive price of €150—which, when converted back into dollars, is only $120 (€150 0.80 = $120). Because of the rising currency, the profit was substantially lower than planned.

The blender firm might have mitigated this risk by selling the euro short and purchasing the US currency at parity. In this approach, if the value of the US dollar grew, the gains from the transaction would compensate for the lower profit from the sale of blenders. If the value of the US dollar falls, the more favorable exchange rate increases the profit from the sale of blenders, which covers the trade losses.

This kind of hedging is possible in the currency futures market. The trader benefits from the fact that futures contracts are standardized and cleared by a central authority. Currency futures, on the other hand, may be less liquid than forwards markets, which are decentralized and operate inside the global interbank system.

Forex for Speculation

Interest rates, trade flows, tourism, economic strength, and geopolitical risk all influence currency supply and demand, resulting in daily volatility in the FX markets. There is a potential to benefit from fluctuations in the value of one currency in relation to another. Because currencies are traded in pairs, predicting one currency would weaken is practically the same as predicting the other currency in the pair will rise.

Consider a trader who believes interest rates in the United States would grow in comparison to Australia, but the exchange rate between the two currencies (AUD/USD) is 0.71 (i.e., it costs $0.71 USD to purchase $1.00 AUD). The trader thinks that rising US interest rates will boost demand for USD, causing the AUD/USD exchange rate to decline as fewer, stronger USDs are required to purchase one AUD.

Assume the trader is accurate and interest rates increase, causing the AUD/USD exchange rate to fall to 0.50. This indicates that it costs $0.50 USD to purchase $1.00 AUD. The investor would have gained from the value move if they had shorted the AUD and gone long on the USD.

How to Start Trading Forex

Trading FX is comparable to trading stocks. Here are some methods to help you get started in FX trading.

1.Learn about forex: While not difficult, forex trading is a project in and of itself that needs specialized expertise. Forex transactions, for example, have a larger leverage ratio than stocks, and the determinants of currency price movement vary from those of equity markets. For novices, there are various online courses available that educate the ins and outs of forex trading.

2.Open a brokerage account: To begin forex trading, you will need to open a brokerage account. Commissions are not charged by forex brokers. Instead, they profit on the spreads (also known as pips) that exist between the purchasing and selling prices.

Setting up a micro forex trading account with minimum capital requirements is a smart option for new traders. These accounts feature flexible trading restrictions and enable brokers to limit transactions to as little as 1,000 units of a currency. A regular account lot is equivalent to 100,000 cash units. A micro forex account will assist you in becoming more familiar with forex trading and determining your trading style.

3.Develop a trading plan: While it is not always feasible to foresee and timing market movement, having a trading strategy will assist you in establishing broad principles and a trading road map. A solid trading strategy is based on your current circumstances and money. It takes into consideration the amount of money you are prepared to put up for trading as well as the level of risk you can accept before losing your position. Remember that forex trading is generally done with huge leverage. However, it also provides greater benefits to those who are prepared to accept the risk.

4.Always keep track of your numbers: Once you start trading, review your positions at the conclusion of each day. Most trading software already includes a daily trade accounting. Check to see whether you have any pending positions to fill and that you have enough funds in your account to execute future transactions.

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5.Cultivate emotional equilibrium: The emotional roller coaster that is beginner forex trading is filled with unresolved issues. Should you have hung on to your position for a little longer to make more money? How did you miss the article about poor GDP statistics, which resulted in a drop in the total worth of your portfolio? Obsessing over such unsolved topics might lead to perplexity. That is why it is critical to maintain emotional stability despite winnings and losses in your trading situations. Be strict about closing out positions as required.

Forex Terminology

The best approach to begin your forex adventure is to learn the language. To help you started, here are a few terms:

  • A forex account is a kind of currency trading account. There are three kinds of FX accounts based on the lot size:

  1. Micro forex accounts: These accounts enable you to trade up to $1,000 in currency in a single lot.
  2. Mini forex accounts: These accounts enable you to trade up to $10,000 in currency in a single lot.
  3. Standard forex accounts: These accounts enable you to trade up to $100,000 in currency in a single lot.

Remember that the trading limit for each lot includes leveraged margin money. This implies that the broker may lend you money in a predefined percentage. For example, they may put up $100 for every $1 you put up for trading, implying that you will only need to invest $10 of your own money to exchange $1,000 in currencies.

  • The lowest price at which you are prepared to acquire a currency is known as the ask (or offer). For example, if you post an ask price of $1.3891 for GBP, that value represents the lowest amount you are ready to pay in USD for a pound. In general, the ask price is higher than the bid price.
  • A bid is the price you are willing to sell a currency for. A market maker in a specific currency is in charge of constantly putting out bids in response to buyer inquiries. While bid prices are normally lower than ask prices, when demand is strong, bid prices might be higher than ask prices.
  • Bear market: A bear market is one in which currency values fall. Bear markets are the consequence of a market decline caused by dismal economic fundamentals or catastrophic events such as a financial crisis or a natural catastrophe.
  • Bull market: A bull market is one in which all currency values rise. Bull markets indicate a market rise and are caused by positive news regarding the global economy.
  • Contract for difference (CFD): A contract for difference (CFD) is a kind of derivative that allows traders to speculate on currency price changes without actually owning the underlying asset. A trader who believes the price of a currency pair will rise will purchase CFDs on that pair, while those who anticipate the price will fall will sell CFDs on that currency pair. Because leverage is used in forex trading, a CFD deal gone wrong may result in significant losses.
  • Leverage is the use of borrowed money to increase returns. The forex market is known for its high leverage, and traders often employ these leverages to raise their holdings.
  • For example, in a trade against the JPY, a trader would put up $1,000 of their own money and borrow $9,000 from their broker. Because they have spent relatively little of their own money, the trader stands to benefit significantly if the deal goes in the right way. A high-leverage situation, on the other hand, increases downside risks and may result in severe losses. In the above scenario, if the deal goes in the other way, the trader’s losses will increase.
  • Lot size: Currency is exchanged in conventional increments known as lots. Standard, mini, micro, and nano are the four most prevalent lot sizes. The standard lot size is 100,000 units of the currency. Mini lot sizes are 10,000 units, while micro lot sizes are 1,000 units of the currency. Some brokers also provide traders with nano lot sizes of currencies, which are worth 100 units of the currency. The lot size chosen has a considerable impact on the ultimate profits or losses of the deal. The greater the lot size, the greater the profit (or loss), and vice versa.
  • Margin: The money placed aside in an account for a currency exchange is known as margin. Margin money assures the broker that the trader will stay solvent and able to satisfy financial commitments even if the deal does not go as planned. The margin amount is determined by the trader and customer balance over time. For forex trading, margin is utilized in conjunction with leverage (described above).
  • A pip is an abbreviation for “percentage in point” or “price interest point.” It is the smallest price change in currency markets, equivalent to four decimal points. One pip equals 0.0001. One pip equals one penny, and 10,000 pip equals one dollar. The pip value varies according on the typical lot size provided by a broker. Each pip in a normal $100,000 lot will be worth $10. Because currency markets utilize high leverage in their operations, modest price movements (measured in pips) may have a large impact on the trade.
  • A spread is the difference between a currency’s bid (sell) and ask (buy) prices. Forex traders do not charge fees; instead, they profit on spreads. Many variables determine the magnitude of the spread. Some of these include the magnitude of your deal, currency demand, and volatility.
  • Sniping and hunting is the practice of buying and selling currencies around predefined positions in order to maximize earnings. Brokers engage in this behavior, and the only method to detect them is to network with other traders and look for patterns of such conduct.

Basic Forex Trading Strategies

A long trade and a short trade are the two most fundamental types of forex transactions. A long trader is wagering that the currency price will rise in the future and that they will benefit from it. A short trade is a wager that the price of a currency pair will fall in the future. Traders may also fine-tune their trading method by using technical analysis tools such as breakout and moving average.

Trading strategies are classified into four groups based on their length and number of trades:

  • A scalp trade consists of positions maintained for seconds or minutes at most, with profit amounts limited in terms of pips. Such deals are meant to be cumulative, which means that tiny gains generated in each individual trade build up to a tidy sum at the end of the day or time period. They depend on price swing prediction and cannot withstand high volatility. As a result, traders prefer to limit such transactions to the most liquid pairings and during the busiest trading hours of the day.
  • Day trades are short-term positions that are held and liquidated on the same day. A day trade might last for hours or minutes. To enhance their profit gains, day traders must have technical analysis abilities and awareness of significant technical indicators. Day trades, like scalp trades, depend on incremental profits throughout the day to trade.
  • In a swing trade, the trader keeps the position for a longer length of time than a day, such as days or weeks. Swing trading may be advantageous during important government announcements or times of economic turmoil. Swing trades, since they have a larger time horizon, do not need regular market monitoring throughout the day. Swing traders should be able to judge economic and political changes and their influence on currency movement in addition to technical research.
  • In a position transaction, the trader keeps the currency for an extended length of time, which might be months or even years. Because it gives a reasoned foundation for the trade, this form of trading requires greater basic analytical abilities.
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Charts Used in Forex Trading

Three types of charts are used in forex trading. They are:

Line Charts

Line charts are used to detect a currency’s long-term patterns. They are the most basic and often used sort of chart among forex traders. They show the currency’s closing trading price for the time periods provided by the user. A line chart’s trend lines may be utilized to develop trading strategies. For example, you may utilize trend line information to spot breakouts or changes in trend for increasing or falling prices.

A line chart, although informative, is often utilized as a starting point for additional trading research.

Bar Charts

Bar charts, like other types of charts, are used to illustrate certain time periods for trading. They include more pricing data than line charts. Each bar chart represents one trading day and includes the opening, highest, lowest, and closing prices (OHLC) for a transaction. The day’s beginning price is represented by a dash on the left, and the closing price is represented by a similar dash on the right. Colors are occasionally used to signify price fluctuation, with green or white used for increasing prices and red or black used for falling prices.

Currency traders may use bar charts to determine if it is a buyer’s or seller’s market.

Candlestick Charts

Candlestick charts were invented in the 18th century by Japanese rice sellers. They are more aesthetically attractive and simpler to read than the previous chart kinds. The top section of a candle represents a currency’s initial price and greatest price point, while the lower portion of a candle represents its closing price and lowest price point. A down candle is tinted red or black and symbolizes a time of dropping prices, while an up candle is shaded green or white and shows a period of growing prices.

Candlestick chart patterns and shapes are used to determine market direction and movement. Hanging man and shooting star are two popular candlestick chart shapes.

Pros and Cons of Trading Forex

Pros and Cons of Trading Forex

Pros
  • Forex markets have the highest daily trading volume in the world and hence the greatest liquidity. In typical market situations, this allows you to initiate and exit a position in any of the major currencies in a fraction of a second for a tiny spread.

  • The currency market is open 24 hours a day, five days a week, beginning in Australia and finishing in New York. The extended time horizon and coverage provide traders with more possibilities to profit or offset losses. Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich are the main currency trading hubs.

  • Because leverage is widely used in forex trading, you may start with minimal cash and quadruple your earnings.

    The automation of forex markets allows for the speedy implementation of trading techniques.

  • Forex trading normally follows the same laws as conventional trading and needs considerably less initial money; hence, trading forex is simpler than trading equities.

  • The FX market is less centralized than the stock or bond markets. There is no centralized exchange that controls currency transaction activities, hence the possibility of manipulation (through insider knowledge about a business or stock) is smaller.

Cons
  • Despite being the world’s most liquid marketplaces, FX trading are far more volatile than conventional markets.

  • Excessive leverage has caused numerous dealers to go bankrupt suddenly.

  • Forex banks, brokers, and dealers provide a high level of leverage, allowing traders to hold enormous positions with very little money of their own. Leverage in the 100:1 level is relatively unusual in forex. A trader must understand how to employ leverage and the hazards it puts into an account.

  • Understanding economic fundamentals and indicators is required for successful currency trading. To comprehend the fundamentals that influence currency prices, a currency trader must have a big-picture knowledge of the economies of different nations and their interconnectivity.

  • Because forex markets are decentralized, they are less subject to regulation than other financial markets. The amount and kind of regulation in forex markets are determined by the trading jurisdiction.

  • Forex markets lack products that generate consistent income, such as dividend payments, which may appeal to investors who are not interested in exponential profits.

Why Do People Trade Currencies?

Forex is used by businesses and dealers for two major reasons: speculation and hedging. Traders utilize the former to profit from the increase and fall of currency values, while the latter is used to lock in pricing for production and sales in foreign markets.

Are Forex Markets Volatile?

The forex market is one of the most liquid in the world. As a result, they are less volatile than other markets, such as real estate. The volatility of a currency is determined by a variety of variables, including the country’s politics and economy. As a consequence, events such as economic insecurity in the form of a payment failure or a trade imbalance with another currency may cause severe volatility.

Are Forex Markets Regulated?

The jurisdiction governs forex trading regulation. Countries such as the United States have advanced infrastructure and marketplaces for conducting currency trading. As a result, forex transactions are strictly controlled by the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC).However, because of the high level of leverage utilized in forex transactions, emerging nations such as India and China impose limits on the businesses and money that may be used in forex trading. Europe is the biggest FX trading market. The Financial Conduct Authority (FCA) is in charge of overseeing and regulating currency transactions in the United Kingdom.

Which Currencies Can I Trade in?

Because high liquidity currencies have a ready market, their price behavior in reaction to external events is smooth and predictable. The US dollar is the world’s most traded currency. It appears in six of the seven currency pairings with the highest market liquidity. Currencies with little liquidity, on the other hand, cannot be traded in big lot sizes without causing considerable market activity. These currencies are often used by underdeveloped nations. When they are combined with the money of a developed nation, they constitute an unusual pair. A pairing of the US dollar and India’s rupee, for example, is termed an exotic pair.

How Do I Get Started With Forex Trading?

The first step in learning how to trade forex is to get familiar with the market’s operations and terminology. Following that, you must devise a trading plan depending on your financial situation and risk tolerance. Finally, you should create an investment account. It is now simpler than ever to establish and fund an online forex account and begin trading currencies.

The Bottom Line

Day trading or swing trading in small sums is simpler in the forex market than in other markets for traders, particularly those with minimal capital. Long-term fundamentals-based trading or a carry trade may be successful for people with longer time horizons and greater capital. Understanding the macroeconomic fundamentals that drive currency prices, as well as prior expertise with technical analysis, may assist beginner forex traders in becoming more lucrative.

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