A Basic Guide To Forex Trading
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Foreign exchange trading (often known as forex trading or FX) is the global market for exchanging foreign currencies. Forex is the world's largest market, and the deals that take place there influence everything from the price of items imported from China to the amount you spend for a margarita while vacationing in Mexico.
What Is Forex Trading?
At its most basic, forex trading is analogous to currency exchange while going abroad: a trader buys one currency and sells another, with the exchange rate fluctuating based on supply and demand.
Currencies are traded on the foreign exchange market, a global marketplace that operates 24 hours a day, Monday through Friday.
All forex trading takes place over the counter (OTC), which means there is no physical exchange (as there is with stocks) and the market is overseen by a global network of banks and other financial institutions (rather than a central exchange, such as the New York Stock Exchange).
Most trade activity in the FX market occurs between institutional traders, who work for banks, fund managers, and multinational organizations. These traders may not intend to take physical ownership of the currencies; instead, they may speculate or hedge against future exchange rate swings.
For example, a forex trader might buy US dollars (and sell euros) if she believes the dollar's value will rise, allowing her to buy more euros in the future. Meanwhile, an American corporation with European operations could use the forex market as a hedge if the euro declines, reducing the value of their income received abroad.
How Currencies Are Traded
All currencies are issued a three-letter code, similar to a stock's ticker symbol. While there are over 170 currencies in the globe, the United States dollar is used in the vast bulk of forex trading, thus knowing its code, USD, is very useful. The euro is the second most popular currency in the forex market, and it is accepted in 19 European Union countries (code: EUR).
Other popular currencies include the Japanese yen (JPY), the British pound (GBP), the Australian dollar (AUD), the Canadian dollar (CAD), the Swiss franc (CHF), and the New Zealand dollar (NZD).
All forex trading is defined as a combination of the two currencies being traded. The following seven currency pairs, known as the majors, account for approximately 75% of activity in the forex market.
EUR/USD
USD/JPY
GBP/USD
AUD/USD
USD/CAD
USD/CHF
NZD/USD
How Forex Trades are Quoted
Each currency pair indicates the current exchange rate between two currencies. Here's how to understand such data, using EUR/USD (the euro-to-dollar exchange rate) as an example:
The base currency is the euro, which is on the left.
The currency on the right (the US dollar) is the quote currency.
The exchange rate indicates how much of the quoted currency is required to purchase one unit of the base currency. As a result, the base currency is always expressed as one unit, but the quote currency fluctuates depending on the current market and the amount required to purchase one unit of the base currency.
If the EUR/USD exchange rate is 1.2, then €1 will buy $1.20.
When the exchange rate rises, the base currency's value relative to the quote currency increases (since €1 buys more US dollars), and when the exchange rate falls, the base currency's value decreases.
A quick note: Currency pairs are typically presented with the base currency first and the quote currency second, although there is a historical convention for how some currency combinations are written. For example, USD-to-EUR conversions are listed as EUR/USD rather than USD/EUR.
Three Ways to Trade Forex
Most forex trades are not done to exchange currencies (like you would at a currency exchange while traveling), but rather to speculate on future price changes, similar to stock trading. Forex traders, like stock traders, seek to acquire currencies whose values they believe will rise relative to other currencies while selling currencies whose purchasing power they believe will fall.
There are three strategies to trade forex, which will satisfy traders with diverse goals:
The spot market- This is the principal forex market where currency pairs are traded and exchange rates are set in real-time based on supply and demand.
The forward market- Instead of executing a trade right now, forex traders can enter into a binding (private) contract with another trader to lock in an exchange rate for a specified quantity of currency on a future date.
The futures market- Similarly, traders can use a standardized contract to purchase or sell a predetermined amount of currency at a specific exchange rate on a future date. This is done on an exchange rather than privately, similar to the forwards market.
Forex traders generally use the forward and futures markets to speculate on or hedge against future currency price swings. The exchange rates in these markets are determined by what is happening in the spot market, the largest of the forex markets, and where the majority of forex trades are performed.
Forex Terms To Know
Every market has its jargon. Before you start trading forex, you need to be aware of the following terms:
Currency pairs- All forex trades include a currency pair. In addition to the majors, there are less typical trades (such as exotics, which are currencies from emerging countries).
Pip- A pip, short for percentage in points, is the smallest price shift that can occur within a currency pair. Because forex prices are quoted to at least four decimal places, one pip equals 0.0001.
Bid-ask spread- Exchange rates, like other assets (such as stocks), are established by the highest price that buyers are willing to pay for a currency (the bid) and the lowest amount that sellers must sell (the ask). The bid-ask spread is the difference between these two sums and the final price at which deals will be conducted.
Lot- Forex is exchanged in lots, which are standardized units of currency. The normal lot size is 100,000 units of currency, however, micro (1,000) and mini (10,000) lots are also available for trading.
Leverage- Because of the huge lot sizes, some traders may be unwilling to risk so much money to make a trade. Leverage, or borrowing money, enables traders to engage in the forex market without having to invest the full amount of money required.
Margin- Trading using leverage, however, is not free. Traders must make an initial deposit, often known as a margin, before trading.
What drives the forex market?
Currency prices, like those in other markets, are determined by the supply and demand of sellers and purchasers. However, there are other macroeconomic factors at work in this market. Interest rates, central bank policies, the rate of economic growth, and the country's political situation can all have an impact on currency demand.
The forex market is open 24 hours a day, five days a week, allowing traders to respond to news that may not effect the stock market until much later. Because so much of currency trading is based on speculation or hedging, traders must be aware of the factors that could trigger sharp currency fluctuations.
Risks of Forex Trading
Source: inveslo.com
Because forex trading needs leverage and traders employ margin, it carries more risks than other types of assets. Currency prices are continually fluctuating, but only in small quantities, thus traders must execute massive deals (using leverage) to make money.
This leverage is beneficial if a trader makes a winning wager because it increases profits. However, it can amplify losses, sometimes exceeding the initial loan amount. Furthermore, if a currency's value falls too far, leverage users risk facing margin calls, which may force them to sell securities purchased with borrowed cash at a loss. Aside from potential losses, transaction expenses can accumulate and deplete what was once a profitable trade.
On top of that, keep in mind that those who trade foreign currencies are small fry in a sea of sophisticated, professional traders—and the Securities and Exchange Commission warns about potential fraud or information that may be confusing to new traders.
Perhaps it's a good thing that forex trading isn't as popular with private investors. According to DailyForex, retail trading (also known as non-professional trading) accounts for only 5.5% of the worldwide market, and some of the largest online brokers do not even offer forex trading.
Furthermore, the majority of retail traders who engage in forex trading struggle to make a profit. According to CompareForexBrokers, 71% of retail FX traders have lost money. This makes forex trading a method best left to professionals.
Why Forex Trading Matters for Average Consumers
While the average investor should generally avoid the currency market, what occurs there affects everyone. The real-time activity in the spot market will have an impact on the price we pay for exports as well as the cost of travel abroad.
If the value of the US dollar rises relative to the euro, it will become less expensive to travel abroad (your US dollars can buy more euros) and purchase imported products (from vehicles to clothing). On the other hand, as the dollar falls in value, it becomes more expensive to fly abroad and import things.
If you intend to make a large purchase of an imported item or travel outside the United States, you should keep an eye on the exchange rates set by the currency market.