What Is Forex Trading?
The foreign exchange market or FX as it is commonly known is the world’s most traded currency market, with an average daily trading volume of a whopping $5 trillion dollars.
Let’s put this into perspective.
The US market alone trades about $260 billion a day. Although this is a huge sum of money, it is a relatively small fraction in comparison to forex trading.
Forex trading involves the exchange of one currency against another, with it’s lucrativeness lying in the attempt of traders to profit by buying and selling currencies whilst taking a risk as to whether these currencies will go up or down in price.
The forex market is open 24 hours a day for 5 days a week, and is traded by institutions, banks and individuals alike. Interestingly, about 5-6% of that $5 trillion dollars, or about $300-400 billion, is traded by retail traders (basically individuals).
Your basic trading day starts off in Sydney, moving on to Tokyo, London, Frankfurt and then to New York. Though forex trading is open 24 hours during the 5-day interval, certain hours of the day are more active than others. Especially the hours with currency pairs that involve the US dollar, from about 16:00 to 24:00 GMT.
The second most active currency pairs are those involving European pairs like the Euro, the Swiss franc and the British pound. These are mostly active from the timeslot of 8:00 to about 16:00 GMT. Another group of active pairs are those involving currencies like the Australian dollar and the Japanese yen. These pairs are mostly active at about 00:00 to 08:00 GMT.
Whereas other financial markets are centralized, the forex market has no centralized marketplace, and as such currencies are traded over the counter for whatever market is open at the time.
Understanding Currency Pairs
Forex trading involves the simultaneous buying and selling of one currency against another. This is called trading in pairs. Price fluctuations determine how much you buy or sell a currency for.
As you can imagine, there are quite a number of currency pairs. However, the ones that are the movers and shakers of the currency industry are those that are directly related to the biggest economies in the world like the USA, Britain, France and Japan.
- Major Currency Pairs
Currency pairs that contain the US dollar as one side of the pair are categorized as the majors. These currencies are the most traded and the most active pairs. Here is a table that shows the pairs and the countries they stand for.
- Minor Currency Pairs
The minor currency pairs involve those currencies that don’t have the US dollar as one of the pairs. These are also known as the crosses or the cross-currency pairs. The most active ones are the EUR designated pairs like the EUR/CHF, EUR/GBP, EUR/CAD, EUR/AUD, EUR/NZD, EUR/SEK and the EUR/NOK. These pairs are also called the Euro Crosses.
The Yen crosses are those pair combinations that have the Japanese yen as one of the pairs. These pairs include the EUR/JPY, NZD/JPY, AUD/JPY, CAD/JPY, GBP/JPY AND THE CHF/JPY.
Our third type of cross is the Pound cross. This cross, as you probably guessed, includes the British pound coupled to other minor currencies. These include the GBP/CHF, GBP/AUD, GBP/CAD and the GBP/NZD.
- Exotic Pairs
Last but not least we have the exotic pairs. These pairs are called such because they include the pairing of a major currency with a currency from a third world emerging country. These include countries like South Africa, Saudi Arabia, Brazil and Hong Kong.
The Bid and Ask Price
The bid and ask price is a term that is used to indicate how much a currency is bought for and how much it is being sold for. The easiest way to explain it, is to use Investopedia’s explanation. The bid and ask is a two-way price quotation. The bid price is the highest amount a buyer is willing to pay for a security, while the asked price is the lowest amount the seller is willing to accept.
If you look at it from a logical point of view then the buyer will always try to push the price down, while the seller would try to push the price up. When both the buyer and seller agree on a price, a trade occurs.
Let’s use an example:
Security X is quoted at: $9.45/$9.55
$9.45 is the bid price, the highest amount a buyer is willing to pay, whereas
$9.55 is the ask price, the lowest amount the seller is willing to accept.
So, if you’re a buyer you would buy at $9.55, because that’s the lowest amount the seller is willing to accept. If you’re a seller you’d sell at $9.45, because that’s the highest amount a seller is willing to pay.
Transactions like these are normally handled by a market maker. The market maker is the middle person between the buyer and seller. The market maker always wants to make sure that they buy at the lowest price and sell at the highest possible price. In this way they can make a profit from the difference, which is called the spread.
Important Terms to Know
Learning about forex unfortunately involves a number of different terms that, if you know them, will make your learning curve easier.
At its most basic term a pip is the change in value between two currencies. Thus, if the EUR/USD moves in value from 1.1120 to 1.1121, that change in value, which in this case is 0.0001, is one pip. Most currency pairs are priced to 4 decimal places; therefore, the pip is understood to be the last decimal place of a price quote.
However, keep in mind that apart from the pip, there is also a pipette, which is simply a 5 decimal place instead of the 4-decimal place of the pip.
0.12367 – The 7 is the pipette, because it occupies the 5th decimal place
Though most currency pairs go out to 4 decimal places, there are those pairs that go out to 2 decimal places like the Japanese yen.
For example, the pip for GBP/USD might be quoted as 0.0001, whereas for the USD/JPY it might be 0.01.
- A Spread
The difference between the bid and ask price is known as the spread. When dealing with bid and ask prices, we are indicating the price you pay on the base currency.
In the case of the EUR/USD currency pairs, the EUR is the base currency, while the USD is the counter currency. Let’s look at an example.
EUR/USD 1.2800 means that 1 EUR is exchanged for $1.2800. In the image below the Metatrader software shows the bid and ask prices. Calculating the difference gives us the spread. In the case below, the spread is 0.0003 or 3 pips.
1.1204 and 1.1207 – Difference being 0.0003
The spread is how brokers, in many cases, make money. However, it is not the only way they do.
There are two types of spreads. The fixed spread and the variable spread. As their names indicate, the fixed spread stays the same no matter whether market conditions change, whereas variable spreads fluctuate with market changes.
Major currency pairs normally have thin spreads, meaning that the difference between the bid and ask price is minimal. Because of this people prefer to trade the majors.
The margin is the amount of money a trader “borrows” in order to increase their possible ROI (return on investment). The borrowing is not really a loan of real money. It is almost like piggybacking on the back of your broker. Making use of their funds to trade with. If a forex trader wants a particular amount of return on an investment, they have to look at how much money they should invest in order to gain a percentage of that investment as profit.
For instance, if a trader wants to trade $100,000, then a 1% margin means that they would need to deposit $1,000 into the margin account. The rest of the money, the other 99%, is provided by the broker. Contrary to popular belief, the margin is not a fee.
This amount of money can best be described as a portion of your money put aside from your balance, in order to keep your trade open and active.
Leverage and margin cannot be defined one without the other. Leverage can best be described as having the ability to use a big amount of money for trading, none or little of it being yours, and borrowing the rest.
As an example, you want to control a trade of $100,000. Your broker takes a $1,000 from your account, setting it aside. This amount is described in a ratio of 100:1. Your $1,000 constitutes a 100th of the amount you want to invest.
If you go into a trade, and it is profitable, your leverage would increase your profits exponentially by a hundred times. However, should your trade go south, you could also lose a huge amount of money.
How to Trade Forex
To trade forex, there are a few steps you first need to take; however, these steps are quite easy. First you need to sign up with a forex broker. After signing up it is important to familiarize yourself with their platform as you will be trading from there.
Fortunately, many reputable forex brokers have courses or guides to help you get started. The next step would be to experiment with trading by testing out their demo account. A demo account has fictitious money, usually in the amount of $100,000, enough for you to experiment with and fail or succeed, without the fear that accompanies losing real money.
What to Look for In a Forex Broker?
Brokers are not all the same, and as such it is good to know what each broker offers in order to make an informed decision. However, when wading through all the information regarding a broker, you can become a bit overwhelmed, especially when you don’t know what you ought to look for. We have just recently published an article about the best forex brokers in 2019, where you can find detailed insights.
The best and most trusted forex brokers are:
Here is a list of 7 things that you can use as a guide when choosing a forex broker:
- Transaction costs
In all trades you will make, you will always have some type of cost attached to it, whether it is spread fees or a commission. Therefore, it is good to find the most affordable rate out there.
- Trading platform
Most brokers have their own platform or a customized version of a popular trading software like Metatrader. Always make sure to check what the platform offers. Does it have technical and charting tools? Does it have enough information to help you trade without difficulty? For more information check out our article about the best platforms for online trading.
A broker must fill you in on the best price for your order. There is, under normal conditions, nothing that should prevent your broker from filling you in at the market price whenever you click buy or sell. The speed of your filling is very important. Remember that a difference of a few pips can make it hard for you to win a trade.
- Deposit and withdrawal
Good forex brokers should allow you to deposit or withdraw funds without hassle. There is nothing withholding a broker from making your funds easily accessible to you.
Each broker should have a level of security. It is important to check out the credibility of a forex broker. Luckily it is not that hard to do as there are regulatory agencies all around the world.
- Customer service
Make sure to pick a broker that offers active customer service. They should be easily contactable especially when you need to make split second decisions.
- Essential factors
The leverage the broker offers is very important, because it is hard if not nearly impossible to open a trade with little to no money. Most brokers offer a 50:1 ratio leverage, whereas others go up to as much as 800:1.
Apart from leverage, the spread is also important. Forex brokers make money from the spread, thus it is wise and beneficial to go with a broker who offers a low spread.
Trading Platform and Software
After opening a broker account, next would be for you to fund your account. In this way you will be able to trade. Most brokers will provide you with a link to their trading software, which you can download to your computer. Many have mobile versions as well to download to your smartphone in order to trade as you go.
Another very efficient type of software is the SaaS (software as a service) version of the trading platform. What this means is that you don’t download any software, but rather log onto your online account to trade. The most popular training platform is called MT4 or MT5, which stands for Metatrader version 4 or version 5.
Upon accessing the trading platform, you will now be able to trade.
Different Types of Trading Orders
Below is a list of the most common trading orders on trading platforms.
Market Order – The market order is a type of order you enter to buy or sell at the best available price. For instance if the bid/ask price for GBP/USD is at 1.2710/1.2713 respectively, then you would buy at a price of 1.2713. Clicking the buy button would execute the deal at that exact price.
Take Profit Order – The take profit order is an order used to automatically close a position, once a profit is made.
Stop Loss Order – The stop loss order is an order that is executed to prevent additional losses in case the price goes against you.
Advantages and Disadvantages of Forex Trading
Advantages of Forex Trading
No commissions – Forex trading incurs no commission fees, no brokerage fees or government fees. Neither clearing fees or exchange fees. Forex brokers make money through the spread.
No fixed lot size – Most other markets require you to buy a fixed lot size. For instance, when buying silver futures, you are required to do so at 5000 ounces a contract. In forex you determine your own lot.
Low transaction costs – Transaction costs in forex are typically less than 0.1%, whereas for larger transactions you could pay as little as 0.07%.
24hour access – The trade is open all the time (except during weekends). The market does not sleep.
Leverage – With leverage you have the ability to make vast amounts of money while keeping risk capital to a minimum.
Cannot be manipulated – Since the forex market is not affiliated to one single entity it cannot be controlled by anyone.
Disadvantages of Forex Trading
It is a risk – As with all other markets where speculation is involved, there is risk involved with forex trading. Using huge percentages of leverage can, if the trade turns on you, work to your disadvantage.
High volatility – The forex market is highly volatile, and as such prices can swing disastrously high or low within a matter of seconds.
Lack of transparency – Because forex trading is so deregulated and dominated by brokers, you don’t at first realize that you are trading against professionals. Thus, you have no control over how your order is filled and may not even get the best price. If you think you are not the right guy to trade forex or don’t want to take that risk on your we can highly recommend you to check out managed forex account options, where you invest money in other professional traders.
Forex trading can be very lucrative, but only when done right. Because of the risk involved, and the fact that your trades can turn against your initial order, you can lose a huge amount of money. Therefore, it is imperative that you be strong-minded, are well prepared regarding the technical nature of the trade and have a keen eye regarding the movement of prices.