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 variety of reasons, most notably commerce, trade, and tourism. According to the Bank for International Settlements’ 2019 triennial report (a global bank for national central banks), daily forex trading volume reached $6.6 trillion in 2019.
Currency trading can be risky and complicated. Because the system has such large trade flows, it is difficult for rogue traders to influence currency prices. This system contributes to market transparency for investors who have access to interbank trading.
Retail investors should spend time learning about the forex market before deciding on a forex broker (We recommend Hero FX, click here for a 50% deposit bonus) and determining whether it is regulated in the United States or the United Kingdom (U.S. and U.K. dealers have more oversight) or in a country with laxer rules and oversight. It’s also a good idea to find out what kind of account protections are available in the event of a market downturn or if a dealer goes bankrupt.
Continue reading to learn about the forex markets, what they are used for, and how to get started trading ⤵️
What Is the Forex Market?
Currency is traded on the foreign exchange market. Currency is important because it allows us to buy goods and services both locally and across borders. To conduct foreign trade and business, international currencies must be exchanged.
If you live in the United States and want to buy cheese from France, you or the company from which you buy the cheese must pay the French in euros (EUR). This means that the importer in the United States would have to exchange the equivalent value of US dollars (USD) for euros.
The same is true for traveling. A French tourist visiting Egypt cannot pay in euros because the currency is not accepted locally. The tourist must exchange his or her euros for local currency, in this case the Egyptian pound, at the current exchange rate.
One distinguishing feature of this international market is the absence of a central marketplace for foreign exchange. Rather, currency trading is done over the counter electronically (OTC),This means that all transactions take place through computer networks among traders all over the world, rather than on a single centralized exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded in almost every time zone in the major financial centers of Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich. This means that when the trading day in the United States ends, the forex market in Tokyo and Hong Kong begins anew. As a result, the forex market can be extremely active at any time, with price quotes changing on a regular basis, (Click here for forex trading sessions and times)
A Brief History of Forex
The forex market has been around for centuries in its most basic form. To purchase goods and services, people have always exchanged or bartered goods and currencies. However, as we know it today, the forex market is a relatively new invention.
Following the collapse of the Bretton Woods agreement in 1971, more currencies were allowed to float freely against one another. Individual currency values fluctuate based on demand and circulation, and are monitored by foreign exchange trading services.
The majority of forex trading is done on behalf of clients by commercial and investment banks, but there are also speculative opportunities for professional and individual investors to trade one currency against another.
Currency as an asset class has two distinct characteristics:
1. You can profit from the difference in interest rates between two currencies.
2. You can profit from currency fluctuations.
An investor can profit from the difference between two interest rates in two different 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 very common due to the large interest rate differential. This strategy is also known as a carry trade.
⚡ NOTE: Prior to the Internet, currency trading was extremely difficult for individual investors. Because forex trading required a large amount of capital, most currency traders were large multinational corporations, hedge funds, or high-net-worth individuals (HNWIs). With the help of the Internet, a retail market aimed at individual traders has emerged, providing easy access to the foreign exchange markets through banks or brokers acting as a secondary market. Most online brokers or dealers provide individual traders with very high leverage, allowing them to control a large trade with a small account balance.
An Overview of Forex Markets
The foreign exchange market is where currencies are traded. It is the world’s only truly continuous and nonstop trading market. Historically, the forex market was dominated by institutional firms and large banks acting on behalf of their clients. However, it has become more retail-oriented in recent years, and traders and investors of all sizes have begun to participate.
One intriguing aspect 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 connections made via trading terminals and computer networks. Institutions, investment banks, commercial banks, and retail investors all participate in this market.
Foreign exchange markets are thought to be more opaque than other financial markets. OTC markets are where currencies are traded, and disclosures are not required. Large liquidity pools from institutional firms are a common occurrence in the market. One would think that the most important criterion for determining a country’s price would be its economic parameters. That, however, is not the case. According to a 2019 survey, the motivations of large financial institutions played the most important role in determining currency prices.
Forex is primarily traded through 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 largest of the three. When discussing the forex market, they are usually referring to the spot market. Forwards and futures markets are more popular among companies or financial firms that need to hedge their foreign exchange risks out to a specific 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 always been the largest. Previously, volumes in forward and futures markets outnumbered those in spot markets. However, the introduction of electronic trading and the proliferation of forex brokers increased trading volumes in forex spot markets.
On the spot market, currencies are bought and sold based on their current exchange rate. This price is determined by supply and demand and is calculated based on a number of factors, including current interest rates, economic performance, sentiment toward ongoing political situations (both locally and internationally), and expectations regarding the future performance of one currency relative to another. A completed transaction is known as a spot deal. A bilateral transaction in which one party sends an agreed-upon amount of one currency to the counterparty and gets an agreed-upon amount of another currency at the agreed-upon exchange rate value. After a position is closed, cash is the settlement method. Although it is often believed that the spot market deals with transactions in the now (rather than the future), these trades actually take two days to settle.
Forwards and Futures Markets
A forward contract is a private agreement between two parties in the OTC markets to buy a currency at a future date and at a predetermined price. A futures contract is a standardized agreement between two parties to take delivery of a currency at a predetermined price and date in the future. Futures are traded on exchanges rather than over the counter.
Contracts in the forwards market are bought and sold OTC between two parties who agree on the terms of the agreement. Futures contracts are bought and sold on public commodity exchanges such as the Chicago Mercantile Exchange based on a standard size and settlement date (CME).
The National Futures Association (NFA) regulates the futures market in the United States. Futures contracts contain specific details such as the number of units traded, delivery and settlement dates, and minimum price increments that cannot be changed. The exchange acts as the trader’s counterparty, providing clearance and settlement services.
Both types of contracts are legally binding and are usually settled for cash at the exchange in question when they expire, though contracts can be bought and sold before they expire. Currency forwards and futures markets can provide risk protection when trading currencies. These markets are typically used by large international corporations to hedge against future exchange rate fluctuations, but speculators also participate.
Options contracts are traded on certain currency pairs in addition to forwards and futures. Before the option expires, holders have the right, but not the obligation, to enter into a forex trade at a future date and at a predetermined exchange rate.
FUN FACT: Forwards, futures, and options markets, unlike the spot market, do not trade actual currencies. They instead deal in contracts that represent claims to a specific currency type, a specific 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 doing business in foreign countries are vulnerable to currency fluctuations when they buy or sell goods and services outside of their domestic market. Foreign exchange markets enable currency risk to be hedged by establishing a rate at which the transaction will be completed.
To accomplish this, a trader can buy or sell currencies in advance in the forward or swap markets, thereby locking in an exchange rate. Assume a company 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 plans to sell it for €150, which is competitive with other European-made blenders. If this strategy is successful, the company will profit $50 per sale because the EUR/USD exchange rate is even. Unfortunately, the US dollar begins to appreciate against the euro until the EUR/USD exchange rate reaches 0.80, implying that it now costs $0.80 to buy €1.00.
The company’s problem is that, while it still costs $100 to make 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 stronger dollar, the profit was much lower than expected.
The blender company could have mitigated this risk by selling the euro short and buying the US dollar at parity. In this way, if the value of the US dollar rose, the profits from the trade 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 offsets the trade losses.
This type 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 exist throughout the world within the 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 forex markets. There is an opportunity to profit from changes in the value of one currency in relation to another. Because currencies are traded in pairs, predicting one currency will weaken is essentially the same as predicting the other currency in the pair will strengthen.
Consider a trader who believes interest rates in the United States will rise 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 buy $1.00 AUD). The trader believes that higher US interest rates will increase demand for USD, causing the AUD/USD exchange rate to fall as fewer, stronger USDs are required to purchase a AUD.
Assume the trader is correct and interest rates rise, causing the AUD/USD exchange rate to fall to 0.50. This means that it costs $0.50 USD to purchase $1.00 AUD. The investor would have profited from the value change if they had shorted the AUD and gone long on the USD.
How to Start Trading Forex
Trading forex is similar to trading stocks. Here are some steps to help you get started in forex trading.
- Learn about forex: While it is not difficult, forex trading is a project in and of itself that necessitates specialized knowledge. Forex trades, for example, have a higher leverage ratio than equities, and the drivers of currency price movement differ from those of equity markets. For beginners, there are several online courses available that teach the ins and outs of forex trading.
- Open a brokerage account: To get started with forex trading, you will need to open a brokerage account. Commissions are not charged by forex brokers. Instead, they profit from the spreads (also known as pips) that exist between the buying and selling prices.
Setting up a micro forex trading account with low capital requirements is a good idea for new traders. These accounts have variable trading limits and allow brokers to limit trades to as little as 1,000 units of a currency. A standard account lot is equivalent to 100,000 currency units. A micro forex account will assist you in becoming more familiar with forex trading and determining your trading style.
- Create a trading strategy: While it is not always possible to predict and time market movement, having a trading strategy will assist you in establishing broad guidelines and a trading road map. A good trading strategy is based on your current situation and finances. It takes into account the amount of money you are willing to put up for trading as well as the amount of risk you can tolerate before losing your position. Remember that forex trading is mostly done with high leverage. However, it also provides greater rewards to those who are willing to take the risk.
- Keep track of your numbers: Once you start trading, always check your positions at the end of the day. Most trading software already includes a daily trade accounting. Check to see if you have any pending positions to fill and that you have enough cash in your account to make future trades.
- Develop emotional equilibrium: Beginning forex trading is fraught with emotional ups and downs and unanswered questions. Should you have held on to your position for a little longer to make more money? How did you miss that report about low GDP numbers, which resulted in a drop in the overall value of your portfolio? Obsessing over such unanswered questions can lead to perplexity. That is why it is critical to maintain emotional equilibrium despite profits and losses in your trading positions. Be strict about closing out positions when necessary.
Forex Terminology
The best way to begin your forex journey is to learn the language. To get you started, here are a few terms:
A forex account is a type of currency trading account. There are three types of forex accounts based on the lot size:
Micro forex accounts: These accounts allow you to trade up to $1,000 in currency in a single lot.
Mini forex accounts: These accounts allow you to trade up to $10,000 in currency in a single lot.
Standard forex accounts: These accounts allow you to trade up to $100,000 in currency in a single lot.
TOP TIP: Keep in mind that the trading limit for each lot includes leveraged margin money. This means that the broker can lend you money in a predetermined ratio. For example, they may put up $100 for every $1 you put up for trading, implying that you will only need to use $10 of your own money to trade $1,000 in currencies.
The lowest price at which you are willing to buy a currency is known as the ask (or offer). For example, if you place an ask price of $1.3891 for GBP, that figure represents the lowest amount you are willing 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 given currency is in charge of constantly putting out bids in response to buyer inquiries. While bid prices are generally lower than ask prices, when demand is high, bid prices can be higher than ask prices.
Bear market: A bear market is one in which currency prices fall. Bear markets are the result of a market downtrend caused by depressing economic fundamentals or catastrophic events such as a financial crisis or a natural disaster.
Bull market: A bull market is one in which all currency prices rise. Bull markets indicate a market uptrend and are caused by positive news about the global economy.
Contract for difference (CFD): A contract for difference (CFD) is a type of derivative that allows traders to speculate on currency price movements without actually owning the underlying asset.
A trader who believes the price of a currency pair will rise will buy CFDs on that pair, while those who believe the price will fall will sell CFDs on that currency pair.
Because leverage is used in forex trading, a CFD trade gone wrong can result in significant losses.
Leverage is the use of borrowed capital to increase returns. The forex market is known for its high leverage, and traders frequently use these leverages to boost their positions.
For example, in a trade against the JPY, a trader might put up $1,000 of their own money and borrow $9,000 from their broker. Because they have used very little of their own money, the trader stands to profit significantly if the trade goes in the right direction.
A high-leverage environment, on the other hand, increases downside risks and can result in significant losses. In the preceding example, if the trade goes in the opposite direction, the trader’s losses will multiply.
Lot size: Currency is traded in standard increments known as lots. Standard, mini, micro, and nano are the four most common lot sizes. The standard lot size is 100,000 units of the currency. Mini lot sizes are 10,000 units, and 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 significant impact on the overall profits or losses of the trade. The greater the lot size, the greater the profit (or loss), and vice versa.
Margin: The money set aside in an account for a currency trade is known as margin. Margin money assures the broker that the trader will remain solvent and able to meet financial obligations even if the trade does not go as planned. The margin amount is determined by the trader and customer balance over time. For forex trades, margin is used in conjunction with leverage (defined above).
A pip is an abbreviation for “percentage in point” or “price interest point.” It is the smallest price change in currency markets, equal to four decimal points. One pip equals 0.0001. One pip equals one cent, and 10,000 pip equals one dollar. The pip value varies according to the standard lot size provided by a broker. Each pip in a standard $100,000 lot will be worth $10. Because currency markets use significant leverage in their trades, small price movements (measured in pips) can 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 commissions; instead, they profit from spreads. Many factors influence the size of the spread. Some of them are the size of your trade, currency demand, and volatility.
Sniping and hunting is the practice of buying and selling currencies near predetermined points in order to maximize profits. Brokers engage in this behavior, and the only way to catch them is to network with other traders and look for patterns of such activity.
Basic Forex Trading Strategies
Fundamental Forex Trading Strategies
A long trade and a short trade are the two most basic types of forex trades. A long trader is betting that the currency price will rise in the future and that they will profit from it. A short trade is a bet that the price of a currency pair will fall in the future. Traders can also fine-tune their trading approach by employing technical analysis strategies such as breakout and moving average.
Trading strategies are classified into four types based on their duration and number of trades:
A scalp trade consists of positions held for seconds or minutes at most, with profit amounts limited in terms of pips. Such trades are meant to be cumulative, which means that small profits made in each individual trade add up to a tidy sum at the end of the day or time period. They rely on price swing predictability and cannot withstand high volatility. As a result, traders tend to limit such trades to the most liquid pairs 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 can last for hours or minutes. To maximize their profit gains, day traders must have technical analysis skills and knowledge of important technical indicators. Day trades, like scalp trades, rely on incremental gains throughout the day to trade.
In a swing trade, the trader holds the position for a longer period of time than a day, such as days or weeks. Swing trades can be useful during major government announcements or times of economic turmoil. Swing trades, because they have a longer time horizon, do not necessitate constant market monitoring throughout the day. Swing traders should be able to gauge economic and political developments and their impact on currency movement in addition to technical analysis.
In a position trade, the trader holds the currency for an extended period of time, which can be months or even years. Because it provides a reasoned basis for the trade, this type of trade necessitates more fundamental analysis skills.
Charts Used in Forex Trading
In forex trading, three types of charts are used. They are as follows:
Line graphs
Line charts are used to identify a currency’s long-term trends. They are the most basic and widely used type of chart among forex traders. They display the currency’s closing trading price for the time periods specified by the user. A line chart’s trend lines can be used to develop trading strategies. For example, you can use trend line information to identify breakouts or changes in trend for rising or falling prices.
A line chart, while useful, is generally used as a starting point for further trading analysis.
Bar graphs
Bar charts, like other types of charts, are used to represent specific time periods for trading. They contain more price data than line charts. Each bar chart represents one trading day and includes the opening, highest, lowest, and closing prices (OHLC) for a trade. The day’s opening price is represented by a dash on the left, and the closing price is represented by a similar dash on the right. Colors are sometimes used to indicate price movement, with green or white used for rising prices and red or black used for falling prices.
Currency traders can use bar charts to determine whether it is a buyer’s or seller’s market.
Candlestick Diagrams
Candlestick charts were invented in the 18th century by Japanese rice traders. They are more visually appealing and easier to read than the previous chart types. The upper portion of a candle represents a currency’s opening price and highest price point, while the lower portion of a candle represents its closing price and lowest price point. A down candle is shaded red or black and represents a period of declining prices, whereas an up candle is shaded green or white and represents a period of increasing prices.
Candlestick chart formations and shapes are used to determine market direction and movement. Hanging man and shooting star are two popular candlestick chart formations.
Why Do People Trade Currencies?
Forex is used by businesses and traders for two main reasons: speculation and hedging. Traders use the former to profit from the rise and fall of currency prices, while the latter is used to lock in prices for manufacturing 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 factors, including the country’s politics and economy. As a result, events such as economic insecurity in the form of a payment default or a trade imbalance with another currency can cause significant volatility.
Are Forex Markets Regulated?
The jurisdiction governs forex trade regulation. Countries such as the United States have advanced infrastructure and markets for conducting forex trades. As a result, forex transactions are strictly regulated by the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC). However, because of the high level of leverage used in forex trades, developing countries such as India and China impose restrictions on the firms and capital that can be used in forex trading. Europe is the largest forex trading market. The Financial Conduct Authority (FCA) is in charge of overseeing and regulating forex transactions in the United Kingdom.
Which Currencies Can I Trade in?
Because high liquidity currencies have a ready market, their price action in response 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 pairs with the highest market liquidity. Currencies with low liquidity, on the other hand, cannot be traded in large lot sizes without causing significant market movement. These currencies are typically used by developing countries. When they are combined with the currency of a developed country, they form an exotic pair. A pairing of the US dollar and India’s rupee, for example, is considered an exotic pair.
How Do I Get Started With Forex Trading?
The first step in learning how to trade forex is to become familiar with the market’s operations and terminology. Following that, you must devise a trading strategy based on your financial situation and risk tolerance. Finally, you should open an investment account. It is now easier than ever to open and fund an online forex account and begin trading currencies.
We also recommend that as you familiarize yourself with the complexities of the Forex market that you use some form of copy trading learn/earn service!
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