Forex trading is the foreign exchange of currency between countries. Individuals and businesses trade foreign currency for tourism, trade, and business. The ultimate goal, as is the case in any trade, is to make a profit. Because foreign currencies are volatile, they provide ample room for profits while providing just as much risk.
Check out our beginner’s guide on Forex trading below.
History of Forex trading
Trading currencies and goods as been around for centuries, but Forex trading as we know it today only started in the early 1970s. Towards the end of World War II, United States, Canada, Australia, Japan and some European countries set up rules for financial management and relationships. These rules were part of the Bretton Woods system.
The system collapsed in 1971 when the United States terminated the convertibility of the US Dollar to gold. Multiple currencies like the US Dollar and British Pound became free-floating, which effectively created Forex trading as we know it today. Although the Bretton Woods system collapsed, it did create two institutions that still have a major influence on the FX market today: the World Bank and the IMF.
Understanding Forex trading
Forex trading, or FX trading, is a group of buyers and sellers trading currencies directly. There isn’t a market – the trades take place OTC or over-the-counter. Traders conduct transactions on computer networks 24 hours a day because the major forex markets are all in different time zones.
The major markets include:
- New York
- Zurich
- London
- Tokyo
- Hong Kong
- London
- Singapore
- Sydney
- Paris
The price of foreign currencies change quickly and are quite volatile throughout the day, which is part of what makes them so lucrative for investors. You can actively trade them (day trades) or hold positions that predict the future value.
The spot market
The spot market is the most common forex market. This is the ‘actual’ exchange of the currency between the pair (two currencies). The trade takes place instantly but actually settles in two days. It’s not based on a future price; it’s based on today’s values.
The market determines the current price based on supply and demand. The demand varies based on a variety of factors, such as the economic and political climate of the country, interest rates, and any ‘assumptions’ throughout the world about the country and currency.
The forward Forex market
Unlike the spot market, the forward market is an agreement to buy or sell currency in the future. The forex contract is for a specific price and for trade on a specific date. You don’t trade actual currencies with the forward forex market; you trade contracts that give you a claim to the specified amount of currency at a future date.
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Future Forex market
A futures contract is a legally binding contract between the buyer and seller. Like the forward market, you agree on a price for the trade and exchange contracts. The contract includes the number of units, the settlement date, and the price increments.
Forwards and futures contracts help hedge against large variations in currency exchanges in the future. The contracts can be bought and sold before the expiration date.
Forex pairs
Forex is always listed in pairs – the base currency and the quote currency. You sell your currency, (e.g. USD) to buy a foreign currency, which is the quote currency. The quote is the cost of one unit of the foreign currency in the base currency dollars.
For example, if you’re trading USD for Swiss franc, it would be CHF/USD. If it was trading at 1.03, this means one franc is equal to 1.03 US dollars. If the franc’s price increases, the price of the pair goes up. If the franc’s price decreases, the price of the pair goes down.
Pip
A pip is the base unit in a currency price and usually the last decimal of a quoted price. It’s used to express the change in value between two currencies. For example, if the US Dollar (USD) against the British Pound (GBP) moves from 0.7800 to 0.7801, that .0001 change in value is 1 pip.
Most currencies use 4 decimals but there are a few exceptions like the Japanese Yen (JPY), which is using two decimals.
Spread
In forex trading, the spread means the difference between the sale (bid) price and the buy (ask) price of a currency pair. The spread tends to be very low for the most popular currency pairs, for example, the US Dollar and the Euro. Typically it’s 1 pip or even less. Other, less popular currency pairs, have much higher spreads. Bear in mind that the value of the currency must exceed the spread before it becomes profitable.
Margin
If you trade, you have to put in some money to open and maintain a new position. You have to retain this money in your trading account. The amount of money you retain in your account when opening a trade is called margin.
Margin is a part of your funds that your broker retains in order to keep your trade open so you could cover a potential loss of the trade. Let’s say you want to buy $10,000 worth of USD/EUR. You don’t need to put in the full $10,000 but only a fraction of that, something like $300. This amount depends on who your broker or CFD provider is. More on that later on.
Leverage
This is one of the reasons why forex trading is so popular as you get much higher leverage with forex than with other financial instruments like stocks. Leverage is the amount of capital provided by a broker to increase the volume of trades. It’s the ratio of your funds to the size of the broker’s credit, meaning it’s borrowed money to increase potential returns. The size of leverage varies and depends on trading conditions.
An example:
- The value of a contract is 10,000 units of the base currency, so for USD/EUR that would be $10,000.
- Let’s say the leverage ratio for your broker is 1:10 and you have $100 in your account. This would allow you to trade a currency pair with a $1,000 position size.
- If your trade is successful, your profits are maximized by 10 through leverage, but your losses could also be multiplied by 10.
Hence, it’s vital to understand how leverage works as it should be used with caution. The most popular leverage in forex is 1:100, meaning for every $100 you invest you will have $10,000 available for trading.
How it works
You can trade forex two ways – CFDs and through a broker.
CFDs are leveraged forex trades. You don’t actually trade the commodity. Instead, you trade contracts that leverage what the currency will do. In other words, you exchange the difference between the currency’s current price (when you buy it) and the closing price (when you sell it). You can buy long or short positions. A long position assumes the price will increase and a short position assumes the price will decrease. If the opposite happens, you realize a loss.
You may also trade using a broker. You assume the same positions but operate on margins. The margins tend to get very high, which puts you at risk of great loss, but also puts you in a position for great profits, if the investment works out.
Once you choose your method, you’ll need to create a strategy. Try creating the strategy long before you make your first trade. This helps eliminate the emotional component that can occur when trading forex, causing you to make rash decisions. Do your research and find a strategy that takes into consideration your risk tolerance and desired outcome.
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The benefits of trading Forex
It sounds risky, but so are all other investments. While forex isn’t recommended for beginning traders, there are plenty of benefits experienced traders may experience including:
- Liquidity – The forex market is one of the largest trading markets which makes it easy to exit out of should you need the cash. In non-liquid markets, it’s hard to find a buyer, even if you’re willing to take a loss to liquidate your investment.
- Around-the-clock-trading – Because trading works around the world, there are always trades to be made no matter the hour.
The risks of Forex trading
As with any investment, there are downsides you should consider:
- Leverage – Having leverage can be exciting and risky at the same time. Try not getting caught up in the emotions of a potential ‘huge win,’ leveraging too much and putting your entire portfolio at risk.
- Education – Trading foreign currencies has a major learning curve that you must understand before attempting the trades. This includes how the market works as well as the economics of it all in order to predict what currency values will do.
Getting started with Forex trading isn’t hard. It’s not regulated like the stock market, so you can start with as much or as little as you want in your account. Try keeping your forex trades for a single currency to 1% of your account balance when you start. It’s vital that you build your experience and education about forex before trading since it works so differently from the stock market. Decide, do you want to actively trade (day trade) or hold long or short positions and predict the changes?
Forex trading can be a lucrative way to diversify your portfolio if you have the right knowledge and experience to make it happen.
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