What Is Forex Trading? A Beginner’s Guide
What Is Forex Trading? A Beginner’s Guide .....
Foreign exchange (Forex) trading is the process of buying one currency and selling another with the goal of making a profit from the trade. Forex (FX) is a portmanteau of the words foreign and exchange. According to a 2022 triennial report from the Bank for International Settlements (a global bank for national central banks), the daily global volume for forex trading reached $7.5 trillion in 2022.
Read on to learn about the forex markets, how they work, and how to start trading.
KEY TAKEAWAYS:-
- The foreign exchange (forex or FX) market is a global marketplace for exchanging national currencies.
- Because of the worldwide reach of trade, commerce, and finance, forex markets tend to be the world's largest and most liquid asset markets.
- Currencies trade against each other as exchange rate pairs. For example, EUR/USD is a currency pair for trading the euro against the U.S. dollar.
- Forex markets exist as spot (cash) and derivatives markets, offering forwards, futures, options, and currency swaps.
- Some market participants use forex to hedge against international currency and interest rate risk, speculate on geopolitical events, and diversify portfolios, among other reasons.
What Is the Forex Market?
The foreign exchange market is where currencies are traded. This international market's most unique aspect is that it lacks a central marketplace. Instead, currency trading is conducted electronically over the counter (OTC). This means that all transactions occur via computer networks among traders worldwide rather than on one centralized exchange.
The market is open 24 hours a day, five and a half days a week. Currencies are traded worldwide in the major financial centers of Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich—across almost every time zone. This means the forex market begins in Tokyo and Hong Kong when the U.S. trading day ends. The forex market can be highly active at any time, with price quotes changing constantly.
How Does the Forex Market Work?
The FX market is the only truly continuous and nonstop trading market in the world. In the past, the forex market was dominated by institutional firms and large banks, which acted on behalf of clients. But it has become more retail-oriented in recent years—traders and investors of all sizes participate in it.
Where Is It?
An interesting aspect of world forex markets is that no physical buildings function as trading venues. Instead, it is a series of connected trading terminals and computer networks. Market participants are institutions, investment banks, commercial banks, and retail investors from around the world.
Who Trades on It?
Currency trading was very difficult for individual investors until it made its way onto the internet. Most currency traders were large multinational corporations, hedge funds, or high-net-worth individuals (HNWIs) because forex trading required a lot of capital.
Commercial and investment banks still conduct most of the trading in forex markets on behalf of their clients. But there are also opportunities for professional and individual investors to trade one currency against another.
What Is Forex Trading?
Forex trading, or FX trading, involves buying and selling different currencies with the aim of making a profit. At its core, forex trading is about capturing the changing values of pairs of currencies. For example, if you think the Euro will increase in value against the U.S. Dollar, a speculator might buy Euros with Dollars. If the Euro's value rises on a relative basis (the EUR/USD rate), you can sell your Euros back for more Dollars than you initially spent, thus making a profit.
In addition to speculative trading, forex trading is also used for hedging purposes. Hedging in forex is used by individuals and businesses to protect themselves from adverse currency movements, known as currency risk. For example, a company doing business in another country might use forex trading to hedge against potential losses caused by fluctuations in the exchange rate abroad. By securing a favorable rate in advance through a forex transaction, they can reduce the risk of financial uncertainty and ensure more stable profits or costs in their domestic currency. This aspect of forex trading is crucial for international businesses seeking stability in their financial planning.
Forex trading features favorable aspects like high liquidity, meaning it's easy to buy and sell many currencies without a significant change in their value. Additionally, traders can use leverage, which allows them to control a large position with a relatively small amount of money. However, leverage can also amplify losses, making forex trading a field that requires knowledge, strategy, and an awareness of the risks involved.
Forex trading is also distinctly global, encompassing financial centers worldwide, which means that currency values are influenced by a variety of global events. Economic indicators such as interest rates, inflation, geopolitical stability, and economic growth can significantly impact currency prices. For instance, if a country's central bank raises its interest rates, its currency might strengthen due to the higher returns on investments denominated in that currency. Similarly, political uncertainty or a poor economic growth outlook can lead to a currency's depreciation. This global interconnectivity makes forex trading not just a financial activity but also a reflection of worldwide economic and political dynamics.
How to Start Trading Forex
Trading forex is similar to equity trading. Here are some steps to get yourself started on the forex trading journey.
- Learn about forex: While it is not complicated, forex trading is an undertaking that requires specialized knowledge and a commitment to learning.
- Set up a brokerage account: You will need a forex trading account at a brokerage to get started with forex trading.
- Develop a trading strategy: While it is not always possible to predict and time market movement, having a trading strategy will help you set broad guidelines and a road map for trading.
- Always be on top of your numbers: Once you begin trading, check your positions at the end of the day. Most trading software already provides a daily accounting of trades. Make sure that you do not have any pending positions to be filled and that you have sufficient cash in your account to make future trades.
- Cultivate emotional equilibrium: Beginner forex trading is fraught with emotional roller coasters and unanswered questions. Discipline yourself to close out your positions when necessary.
Types of Markets
Forex is traded primarily via spot, forwards, and futures markets. The spot market is the largest of all three markets because it is the “underlying” asset on which forwards and futures markets are based. When people talk about the forex market, they are usually referring to the spot market.
The forwards and futures markets tend to be more popular with companies or financial firms that need to hedge their foreign exchange risks out to a specific future date.
Spot Market
The spot market is where currencies are bought and sold based on their trading price. That price is determined by supply and demand and is calculated based on several factors, such as:
- Current interest rates
- Economic performance
- Geopolitical sentiment
- Price speculation
A finalized deal on the spot market is known as a spot deal. It is a bilateral transaction in which one party delivers an agreed-upon currency amount to the counterparty and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, it is settled in cash.
Although the spot market is commonly known as one that deals with transactions in the present (rather than in the future), these trades take two days to settle.
Forwards and Futures Markets
A forward contract is a private agreement between two parties to buy a currency at a future date and a predetermined price in the OTC markets. In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves.
A futures contract is a standardized agreement between two parties to take delivery of a currency at a future date and a predetermined price. Futures trade on exchanges and not OTC. In the futures market, futures contracts are bought and sold based on a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange (CME).
Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments that cannot be customized. The exchange acts as a counterparty to the trader, providing clearance and settlement services.
Unlike the spot, forwards, and futures markets, the options market does not trade actual currencies. Instead, it deals in contracts that represent claims to a certain currency type, a specific price per unit, and a future date for settlement.
Both types of contracts are binding and are typically settled for cash at the exchange in question upon expiry, although contracts can also be bought and sold before they expire. These markets can offer protection against risk when trading currencies.
In addition to forwards and futures, options contracts are traded on specific currency pairs. Forex options give holders the right, but not the obligation, to enter into a forex trade at a future date.
Using the Forex Markets
There are two distinct features of currencies as an asset class:
- You can earn the interest rate differential between two currencies.
- You can profit from changes in the exchange rate.
So, you can profit from the difference between two interest rates in two different economies by buying the currency with the higher interest rate and shorting the currency with the lower interest rate. For instance, before the 2008 financial crisis, shorting the Japanese yen (JPY) and buying British pounds (GBP) was common because the interest rate differential was substantial. This strategy is sometimes referred to as a carry trade.
Forex for Hedging
Companies doing business in foreign countries are at risk due to fluctuations in currency values when they buy or sell goods and services outside of their domestic market. Foreign exchange markets provide a way to hedge currency risk by fixing a rate at which the transaction will be completed. A trader can buy or sell currencies in the forward or swap markets in advance, which locks in an exchange rate.
Locking in the exchange rate helps them reduce losses or increase gains, depending on which currency in a pair is strengthened or weakened.
Forex for Speculation
Factors like interest rates, trade flows, tourism, economic strength, and geopolitical risk affect the supply and demand for currencies, creating daily volatility in the forex markets. This creates opportunities to profit from changes that may increase or reduce one currency’s value compared to another. A forecast that one currency will weaken is essentially the same as assuming that the other currency in the pair will strengthen.
So, a trader anticipating price movement could short or long one of the currencies in a pair and take advantage of the movement.
Basic Forex Trading Strategies
The most basic forms of forex trades are long and short trades, with the price changes reported as pips, points, and ticks. In a long trade, the trader is betting that the currency price will increase and that they can profit from it. A short trade consists of a bet that the currency pair’s price will decrease. Traders can also use trading strategies based on technical analysis, such as breakout and moving averages, to fine-tune their approach to trading.
Depending on the duration and numbers for trading, trading strategies can be categorized into four further types:
- A scalp trade consists of cumulative positions held for seconds or minutes at most, and the profit amounts are restricted in terms of the number of pips.
- Day trades are short-term trades in which positions are held and liquidated on the same day. The duration of a day trade can be hours or minutes.
- In a swing trade, the trader holds the position for a period longer than a day, like days or weeks.
- In a position trade, the trader holds the currency for a long period, lasting as long as months or even years.
Forex Terminology
The best way to get started on the forex journey is to learn its language. Here are a few terms to get you started:
- Forex account: A forex account is used to make currency trades. Depending on the lot size, there can be three types of forex accounts:
- Micro forex accounts: Accounts that allow you to trade up to $1,000 worth of currencies in one lot.
- Mini forex accounts: Accounts that allow you to trade up to $10,000 worth of currencies in one lot.
- Standard forex accounts: Accounts that allow you to trade up to $100,000 worth of currencies in one lot.
- Ask: An ask (or offer) is the lowest price at which you are willing to buy a currency.
- Bid: A bid is the price at which you are willing to sell a currency.
- Contract for difference: A contract for difference (CFD) is a derivative that lets traders speculate on price movements for currencies without owning the underlying asset.
- Leverage: Leverage is using borrowed capital to multiply returns. The forex market is characterized by high leverages, and traders often use it to boost their positions.
Remember that the trading limit for each lot includes margin money used for leverage. This means the broker can provide you with capital at a predetermined ratio. For example, they may put up $50 for every $1 you put up for trading, meaning you will only need to use $10 from your funds to trade $500 in currency.
Charts Used in Forex Trading
Three types of charts are used in forex trading. They are:
Line Charts:-
Line charts are used to identify big-picture trends for a currency. They are the most basic and common type of chart used by forex traders. They display the closing trading price for a currency for the periods specified by the user. The trend lines identified in a line chart can be used to devise trading strategies. For example, you can use the information in a trend line to identify breakouts or a change in trend for rising or declining prices.
While useful, a line chart is generally used as a starting point for further trading analysis.
Bar Charts:-
Like other instances in which they are used, bar charts provide more price information than line charts. Each bar chart represents one day of trading and contains the opening price, highest price, lowest price, and closing price (OHLC) for a trade. A dash on the left represents the day’s opening price, and a similar one on the right represents the closing price. Colors are sometimes used to indicate price movement, with green or white used for periods of rising prices and red or black for a period during which prices declined.
Bar charts for currency trading help traders identify whether it is a buyer’s or seller’s market.
Candlestick Charts:-
Japanese rice traders first used candlestick charts in the 18th century. They are visually more appealing and easier to read than the chart types described above. The upper portion of a candle is used for the opening price and highest price point of a currency, while the lower portion indicates the closing price and lowest price point. A down candle represents a period of declining prices and is shaded red or black, while an up candle is a period of increasing prices and is shaded green or white.
The formations and shapes in candlestick charts are used to identify market direction and movement. Some of the more common formations for candlestick charts are hanging man and shooting star.
Pros and Cons of Trading Forex
Largest in terms of daily trading volume in the world
Traded 24 hours a day, five and a half days a week
Starting capital can rapidly multiply
Generally follows the same rules as regular trading
More decentralized than traditional stock or bond markets
Leverage can make forex trades very volatile
Leverage in the range of 50:1 is common
Requires an understanding of economic fundamentals and indicators
Less regulation than other markets
No income generating instruments
Pros Explained:-
- Forex markets are the largest in terms of daily trading volume globally and therefore offer the most liquidity. This makes it easy to enter and exit a position in any major currency within a fraction of a second for a small spread in most market conditions.
- The forex market is traded 24 hours a day, five and a half days a week—starting each day in Australia and ending in New York. The broad time horizon and coverage offer traders opportunities to make profits or cover losses. The major forex market centers are Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich.
- The available leverage in forex trading means that a trader's starting capital can rapidly multiply.
- Forex trading generally follows the same rules as regular trading and requires much less initial capital; therefore, it is easier to start trading forex than stocks.
- The forex market is more decentralized than traditional stock or bond markets. There is no centralized exchange that dominates currency trade operations, and the potential for manipulation—through insider information about a company or stock—is lower.
Cons Explained:-
- Leveraged trading can make forex trades much more volatile than trading without leverage.
- Banks, brokers, and dealers in the forex markets allow a high amount of leverage, meaning traders can control large positions with relatively little money.
- Leverage in the range of 50:1 is common in forex, though even greater amounts of leverage are available from certain brokers. Nevertheless, leverage must be used cautiously because many inexperienced traders have suffered significant losses using more leverage than was necessary or prudent.
- Trading currencies productively requires an understanding of economic fundamentals and indicators. A currency trader needs to have a big-picture understanding of the economies of the various countries and their interconnectedness to grasp the fundamentals that drive currency values.
- The decentralized nature of forex markets means it is less regulated than other financial markets. The extent and nature of regulation in forex markets depend on the trading jurisdiction.
- Forex markets lack instruments that provide regular income, such as regular dividend payments, which might make them attractive to investors not interested in exponential returns.
Are Forex Markets Volatile?
Forex markets are among the most liquid markets in the world. So, they can be less volatile than other markets, such as real estate. The volatility of a particular currency is a function of multiple factors, such as the politics and economics of its country. Therefore, events like economic instability in the form of a payment default or imbalance in trading relationships with another currency can result in significant volatility.
Are Forex Markets Regulated?
Forex trade regulation depends on the jurisdiction. Countries like the United States have sophisticated infrastructure and markets for forex trades. Forex trades are tightly regulated in the U.S. by the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC). However, due to the heavy use of leverage in forex trades, developing countries like India and China have restrictions on the firms and capital to be used in forex trading. Europe is the largest market for forex trades. The Financial Conduct Authority (FCA) monitors and regulates forex trades in the United Kingdom.
Which Currencies Can I Trade in?
Currencies with high liquidity have a ready market and exhibit smooth and predictable price action in response to external events. The U.S. dollar is the most traded currency in the world. It is paired up in six of the market's seven most liquid currency pairs. Currencies with low liquidity, however, cannot be traded in large lot sizes without significant market movement being associated with the price.
The Bottom Line
For traders—especially those with limited funds—day trading or swing trading in small amounts is easier in the forex market than in other markets. For those with longer-term horizons and more funds, long-term fundamentals-based trading or a carry trade can be profitable. A focus on understanding the macroeconomic fundamentals that drive currency values, as well as experience with technical analysis, may help new forex traders become more profitable.
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