Forex (FX) stands for foreign exchange. Imagine you are traveling overseas. One of the things you need to take care of is getting some cash of the country you are planning to visit. So you go to a bank and exchange the currency you have for the currency of a country you are traveling to. The bank exchanges the money at a specific rate. The process of exchanging currencies is called foreign exchange. To help you understand how foreign exchange is used for making profit, we have gathered some of the basic principles of forex in this article.
- Forex is a market where the currencies are exchanged.
- Currencies are always traded in pairs, so a trading instrument of the forex market is called a currency pair.
- Forex offers a few benefits compared to other markets, including high liquidity, low transactional costs, and low minimum deposit requirements.
- The main risks associated with forex are a misinterpretation of trends, leverage risks, and broker risks.
What is Forex and How Does it Work?
So, what is forex market? FX is defined as a market for the trading of currencies. With trillions of dollars of daily turnover, the forex market is now the biggest marketplace in the world. The market is decentralized, and trading is conducted electronically over-the-counter. If stocks are traded in specific places (e.g., the New York Stock Exchange), currencies are traded worldwide through a decentralized dealer network.
Forex market functions continuously from Sunday at 4 pm until Friday at 4 pm Central time. This schedule is due to the vast span of time zones where forex trading takes place. There are four trading sessions that follow each other throughout the day. They are:
- Pacific session
- Asian session
- European session
- North American session
Anyone exchanging currency is a forex market participant. As for the volume of trades, the most prominent market players are central and commercial banks. Large corporations and hedge funds also play significant roles in the forex market. Brokers and dealing centers serve as mediators between buyers and sellers and make trading accessible to other market participants. And the last group is individual traders, including those who exchange money for non-commercial purposes and those willing to speculate on rate fluctuations and make a profit. Thus, if you have ever exchanged money, you can consider yourself a forex market participant as well.
Hedging vs. Speculation
When talking about forex in a commercial sense (beyond our travel example), we usually talk about hedging or speculation.
"To hedge" in the financial world means to limit exposure to the risks associated with an investment. In terms of forex, these risks are unpredictable currency rate changes. Companies dealing with international trade and operating huge sums of money bear the risk of financial losses due to currency rate fluctuations. To protect themselves from this risk, they use the foreign exchange market.
Speculation in forex implies trading for profit. And this is the side of the market that catches the attention of individual traders. So, in the narrow sense, forex is simply a process of exchanging currencies for profit-making purposes. The trading decisions are based on predictions about the future price of a currency.
A Brief History of Forex
In its broad definition, currency exchange appeared thousands of years ago following the first usage of money (rocks or shells back then). However, the contemporary interpretation of forex began to develop after one important historical event that took place back in 1973. That year the Bretton Woods system was abolished and replaced by the freely floating currency system. The floating exchange rate dominates in the world economies now and declares little or no intervention of regulators into determining currency rates. It basically means that a currency rate is fluctuating according to supply and demand for this currency.
Since 1973, forex has endured a few stages of transformation. The appearance of the Internet and the development of trading software has made it accessible to the general public. As the number of brokers was increasing and competition among them rose, spreads were falling, making forex an even more attractive market for retail traders.
Forex Trading Basics
If you are thinking about opening a trading account and starting to trade, let us introduce you to key forex concepts. Understanding those will help you find the answer to the question "How does forex work?".
So what do they trade in the forex market? The Forex’s financial instruments are currency pairs. A currency pair consists of two currencies (base currency and quoted currency). In the EUR/USD pair, EUR is a base currency, and USD is a quoted currency. Base currency is the one we buy or sell when opening an order. Quoted currency is present to reflect the price of a base currency. Let’s see an example.
Josh is an American traveling to Europe for a week. He goes to the bank to buy €500. In order to get euros, he needs to pay the equivalent of €500 in dollars. Here, the EUR is a base currency, and the USD is a quoted currency.
Every currency pair is accompanied by a quote (quotation). A quote is an exchange rate of a currency. Unlike quotations in banks, quotes in the trading terminal will look somewhat like 1.18096, showing the tiniest element of a currency’s price known as "pips".
If Josh sees that EUR/USD = 1.18, he can easily count how much of a quoted currency (USD) he must pay. 500 × 1.18 = $590.
When exchanging big sums of money (and this is what professional traders do), the slightest movement of an exchange rate makes a difference. The tiniest change that may take place is one pip. The picture below shows an example of a quotation. The pip is the last number of a quotation. If it changed from 1.17451 to 1.17452, we would say that the pair gained one pip. 10 pips equal to 1 point.
When looking at a chart in a trading terminal, it’s easy to notice how frequently the quotation changes. One second it’s 1.18397, then it turns 1.18395, and then again bounces back to 1.18397. These moves are justified by the supply/demand ratio determined by all traders present in the market. When some big players like a car manufacturer exchange hundreds of millions of dollars, the quote may change more dramatically than just gain or lose a few pips.
Bid and ask
A currency price is usually reflected in two numbers. They are called the bid and ask prices. Ask price is the price you need to pay in order to buy a unit of currency. Conversely, the bid price is the price you would get by selling a unit of currency.
If Josh canceled his trip on the same day and decided to sell back €500, he would do it at a different rate – $1.16 for €1. So 500 × 1.16 = $580. As a result, he would lose $10 because of the bid and ask difference.
If you have ever exchanged money in a bank or a currency exchange kiosk, you too have probably noticed that the currencies’ buying and selling prices are always different. The selling price is always higher than the buying price. Buying currency at a lower rate and selling it at a higher rate makes these operations profitable for a bank.
In forex, the same thing applies to brokers. They benefit from the difference in bid and ask price, known as a spread. It is in a trader’s best interest to trade with a broker that offers the lowest spread. Let’s have a look at the example below.
Spreads are usually low (1-3 points) for the most popular currency pairs, including EUR/USD, GBP/USD, USDJPY, USD/CAD, etc. Less frequently traded currency pairs tend to have relatively high spreads.
Currency pairs are traded in specific quantities called lots. The most common lot sizes are:
- A standard lot that equals 100,000 units of a base currency;
- A mini lot (or 0,1 lot) equals 10,000 units of the base currency;
- A micro lot (0,01 lot) allowing to trade 1,000 units of the base currency.
Forex broker is a company that serves as a mediator between a trader and a currency market, providing access to a trading platform. Every Forex broker offers different trading conditions, and it's in a trader’s interest to choose a broker with the most beneficial ones.
When choosing a broker, it is crucial to consider such factors as:
- Trading conditions (small spreads, no withdrawal fees, etc.);
- The variety of instruments (the more, the better);
- Efficient customer support (available round the clock);
- The license (considered to be more secure);
- Reliable trading platform.
Leverage is a tool that allows traders to gain more profit with a relatively small investment. In other words, it’s the money of a third party used in one’s trade with the aim to multiply income. If you, for example, are willing to deposit $1,000 of your funds and take advantage of 1:100 leverage, you can trade $100,000. Professional traders tend to use the leverage quite often.
Obviously, the use of leverage not only boosts potential profit but also multiplies risks of financial loss. Even though there are mechanisms that will protect a trader from ending up with a negative balance, it is essential to acquire risk management skills before turning to leverage.
Margin is a term associated with leverage. It is an amount of money a trader must deposit in order to enter into a leveraged position. The amount of money required for getting leverage is called a margin requirement. This requirement may be as small as 1% of a trade or as big as 20% of it. The size of the margin requirement depends on:
- the size of leverage a trader wants to get;
- the currency pair a trader is planning to trade.
In the example above, the margin requirement for 1:100 leverage is $1,000.
How to Trade Forex
How to Predict Currency Price?
It must be clear by now that in order to make money in forex, one has to make the correct prediction of what the price of a particular currency pair will be in the future. Two main approaches to forecasting the price moves are fundamental and technical analysis. Fundamental analysis deals with political and macroeconomic events that can affect the price of a currency. These may include everything from the US presidential election results to the Bank of Japan’s decision regarding interest rate. Professional traders follow up on the news to enhance their trading plans.
Technical analysis, in its turn, involves the study of past market data, such as price and volume transformations. It employs various technical indicators that show the history of price moves in a given period of time. Technical analysis adherents believe that price action tends to repeat itself, and the study of price patterns helps determine where the price will be at a specific time in the future. Although both types of analysis have their pros and cons, most traders tend to make their trading decisions based on the combination of evidence.
Sound trading decisions are made in accordance with a calculated strategy. Otherwise, trading turns into gambling, where the profit or loss is determined by nothing but luck. The problem is that luck is rare, and the stakes are high. This is why it is crucial to stick to a sound strategy that will keep you on the right track. A well-designed plan will help you answer the question of how to trade currency in the most profitable way. Some of the most common trading approaches include position trading, day trading, swing trading, and scalping. These approaches, in their turn, offer multiple strategies to help traders reach their goals.
Best Trading Strategies for Beginners
Half the success in forex is a well-designed and backtested strategy. A strategy in forex is a fixed plan of actions aimed at profiting from currency trading. There are many strategies and their variations to choose from. Although, not each of them might suit any trader. A strategy choice must be justified by the aim and resources available to an individual trader. This is one of the reasons why picking the right strategy is essential and worth spending time on.
If you want to start with a simple and effective strategy, we recommend learning to trade based on Support and Resistance levels. These are two widely used technical indicators that help determine when the price will change its direction. This strategy can be implemented in 5 simple steps:
- Identify support and resistance.
- Wait for a directional move to resistance.
- Wait for price rejection at resistance.
- Open a short (sell) position on the next candle after the rejection, setting stop-loss right above resistance.
- Exit the trade once the price approaches to support.
The same steps can be made in the opposite direction (entry at support, exit at resistance). In the example above, the trader could lose if the price broke through the resistance level and hit the stop-loss. In this case, the order would be closed automatically, and the trader would suffer an insignificant loss. On the contrary, successful implementation would bring a larger profit. Thus, paying attention to the risk/reward ratio of every trade is the key to success.
Which Currency Pair to Trade?
The most commonly traded currencies in the Forex market are often called major currencies or simply majors. They include EUR/USD, GBP/USD, USD/JPY, USD/CHF, AUD/USD, GBP/JPY, EUR/JPY, and USD/CAD. These pairs make around 90% of all trading volume. All the other pairs are minor pairs (GBP/CAD, CHF/JPY, NZD/JPY, etc.) and exotics (currencies of the emerging and developing economies).
Traders choose a currency pair according to the potential profit opportunities they see in it. It is also worth noting that some currency pairs might work great with particular strategies and fail with others. For example, carry traders are interested in currency pairs with big interest rate spreads (AUD/JPY and NZD/JPY), while scalpers look for volatile pairs.
We recommend beginners practice trading one of the major pairs. The reason for this is that majors usually have pretty narrow spreads, which reduce your transactional costs.
How to Trade Forex
Like any other type of investment, forex trading is accompanied by certain risks. These risks can be divided into:
Leverage associated risks
Forex offers a high amount of leverage. On the one hand, it is a good thing as it allows traders with relatively small deposits to boost their income. On the other hand, leverage used by inexperienced traders in trades based on untested strategies may result in significant losses.
Misinterpretation of trends
One thing about currency is that so many things can affect its price. It has already been said that most of the world’s currencies are driven by supply and demand. What determines supply and demand? These factors include inflation rate, the economic performance of a particular country, interest rates, and so much more. This is why the future price movements of a currency may be so hard to predict.
Not paying enough attention to a broker’s conditions is one of the biggest mistakes a novice trader can make. To make sure that the broker you want to deal with is trustworthy and won’t trade against you, do your research. Check if the broker has a license, read carefully about trading conditions, and check reviews.
Why Trade Forex Anyway?
Forex offers many advantages compared to other markets, including but not limited to the ones listed below.
Currencies stand out of other types of assets as the most liquid ones. The liquidity of a particular asset is the ease at which this asset can be converted into cash. Holding a liquid asset allows a trader to react quickly to market moves and promptly get out of a trade if undesirable movements occur. This is what makes forex an attractive market for an investor. High liquidity also means low spreads, which, as you already know, is a big advantage.
Unlike other markets, forex welcomes trades round the clock, five days a week. This again means that you can enter and leave a trade at any time you believe is the best for it. Compare it with stocks – The New York Stock Exchange, for example, functions from 9:30 am to 4:00 pm ET Monday through Friday.
Profit potential from both rising and falling prices
Forex offers no restrictions on directional trading, which means that you can earn whether an asset’s price moves up or down. They say a trader goes long (buys a currency pair) when its price is about to rise. A trader goes short (sells a currency pair) when it is about to lose value. Selling a currency pair means getting rid of depreciating currency (base currency) in favor of the quoted currency.
Low transaction costs
In general, forex brokers have small transaction fees that either represent the spread or/and withdrawal fees. Although these costs differ from broker to broker, in general, forex transactions aren’t very pricy.
Low minimum deposit requirements
Deposit requirements vary from broker to broker, but in general, the minimum entry threshold is relatively low compared to other markets. For example, you can start forex trading on Justforex with only $1. Although such a small investment doesn't promise any impressive returns, it provides an opportunity to learn trading with minimum risk.
Forex Trading Software
Brokers offer various trading platforms to their clients. The most popular of those is MetaTrader 4 (MT4) and its updated version MetaTrader 5 (MT5). MetaTraders are popular among novice traders and experienced ones. The difference between MT4 and MT5 platforms is that MT5 has a few more analytical tools, such as additional timeframes. Despite these improvements, many traders prefer MT4 as it offers hedging functions. We recommend you try both platforms and choose which one works best for you.
How to Start Learning Forex
We strongly advise people interested in currency trading to open a demo account and take time and practice in order to learn forex trading. It is a good idea to read books on forex. You can find some helpful literature in our top 5 list. One of these books may become an actual forex trading tutorial for you and help you get a sense of what fx strategy is. Remember that practice and learning have brought people like Warren Buffet and George Soros where they are now. Few people would decide to run a marathon if they didn’t have any experience in running long distances. In the same way, nobody should risk their money if they never tried trading before.
Once you feel confident in your overall forex education and have a backtested strategy at hand, start a real trading account, make an investment, and earn money in the foreign exchange market.