What is Forex Trading? A Beginner's Guide
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| What is Forex Trading |
Forex (FX) is short for 'foreign exchange,' which simply means trading one currency for another. Foreign exchange involves converting one currency into another for various reasons, typically for trading, business, or travel purposes. According to the 2022 triennial report by the Bank for International Settlements (a global bank for national central banks), the daily global volume for forex trading reached a whopping $7.5 trillion in 2022.Keep reading to understand what the forex market is, why it's essential, and how to start trading.
KEY TAKEAWAYS
- Forex, short for foreign exchange, is where you trade one country's currency for another.
- It's huge because of global trade, making it the world's biggest and most liquid market.
- You trade currencies in pairs, like EUR/USD for euros and US dollars.
- Forex has two parts: a cash market and a derivatives market with forward, futures, options, and currency swap contracts.
- People use forex to protect against currency risks, speculate on world events, diversify investments, and more.
What Is the Forex Market?
The foreign exchange market is where currencies are traded. The most unique aspect of this global market is the absence of a central exchange. Instead, currency trading occurs electronically over the counter (OTC). This means that all transactions happen through a network of computers among traders worldwide, rather than through a centralized exchange.
The forex market is open 24 hours a day, five and a half days a week. Currencies are traded globally in major financial centers like Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich—in nearly every time zone. This means the forex market starts in Tokyo and Hong Kong when the US trading day ends. As a result, the forex market can be highly active at any time, with constantly changing price quotes.
You've probably come across terms like FX, forex, foreign exchange market, and currency market. These terms are interchangeable and all refer to the forex market.
The forex market is open 24 hours a day, five and a half days a week. Currencies are traded globally in major financial centers like Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich—in nearly every time zone. This means the forex market starts in Tokyo and Hong Kong when the US trading day ends. As a result, the forex market can be highly active at any time, with constantly changing price quotes.
You've probably come across terms like FX, forex, foreign exchange market, and currency market. These terms are interchangeable and all refer to the forex market.
How Does the Forex Market Work?
The Forex market is the only trading market that never sleeps. In the past, it was mostly dominated by big institutions and banks acting on behalf of clients. But in recent years, it has become more retail-oriented, with traders and investors of all sizes participating in it.
Where Is It?
The intriguing aspect of the global forex market is that there's no physical building serving as a trading location. Instead, it's a network of trading terminals and connected computer systems. Market participants include institutions, investment banks, commercial banks, and retail investors from all around the world.Who Trades It?
Currency trading used to be quite challenging for individual investors until the internet came along. Most currency traders are large multinational corporations, hedge funds, or high-net-worth individuals (HNWIs) because forex trading requires a significant amount of capital.Commercial and investment banks still handle the majority of forex trading on behalf of their clients. However, there are also opportunities for professional investors and individuals to trade one currency against another.
Types of Markets
Forex is primarily traded through the spot, forward, and futures markets. The spot market is the largest of the three as it serves as the underlying asset for both the futures and forward markets. When people talk about the forex market, they typically refer to the spot market.
The forward and futures markets are more commonly used among businesses or financial firms that need to hedge against foreign currency risks at a specific future date.
Spot Market
The spot market is where currencies are bought and sold at current market prices. These prices are determined by supply and demand and are influenced by various factors such as:- Current interest rates
- Economic performance
- Geopolitical sentiment
- Price speculation
Deals completed in the spot market are known as spot transactions. These are bilateral transactions where one party delivers an agreed-upon amount of currency to the counterparty and receives a corresponding amount of another currency at the agreed exchange rate. After a position is closed, the transaction is settled in cash.
While the spot market is generally known for handling immediate transactions (rather than in the future), trade settlement in this market takes two days.
Forward and Futures Markets
Forward contracts are private agreements between two parties to buy currency on a future date at a predetermined price in the over-the-counter (OTC) market. In the forward market, contracts are bought and sold over-the-counter between two parties who establish the terms of the agreement themselves.Futures contracts are standardized agreements between two parties to receive delivery of a currency at a future date and a predetermined price. Futures trading takes place on exchanges, not OTC. In the futures market, futures contracts are bought and sold based on standardized sizes and delivery dates on public commodity markets, such as the Chicago Mercantile Exchange (CME).
Futures contracts have specific details, including the quantity of units traded, delivery and settlement dates, and minimum price increments that cannot be adjusted. The exchange acts as a counterparty for traders, providing clearing and settlement services.
Fast Fact
Unlike the spot, forward, and futures markets, the options market doesn't trade actual currencies. Instead, it deals with contracts that represent claims to a specific type of currency, at a specific per unit price, and with a future settlement date.
Both types of contracts are binding and are typically settled with cash on the respective exchange after their expiration, although contracts can also be bought and sold before they expire. This market can provide protection against risks when trading currencies.
In addition to forward and futures contracts, options contracts are traded on specific currency pairs. Forex options provide their holders with the right, but not the obligation, to conduct a forex trade in the future.
Using the Forex Market
There are two distinct features of currencies as an asset class:
- You can gain from the difference in interest rates between two currencies.
- You can profit from changes in exchange rates.
So, you can profit from the difference in interest rates in two different countries by buying the currency with the higher interest rate and selling the one with the lower interest rate. For instance, before the 2008 financial crisis, shorting the Japanese yen (JPY) and buying the British pound (GBP) was common because of significant interest rate differences. This strategy is sometimes referred to as a carry trade.
Forex for Hedging
Companies conducting business internationally face the risk of currency value fluctuations when buying or selling goods and services outside their domestic market. The foreign exchange market provides a way to hedge against currency risk by setting the exchange rate at which transactions will be settled. A trader can buy or sell currency in the forward or swap market in advance, which locks in the exchange rate.
Locking in the exchange rate helps companies reduce losses or increase profits, depending on which currency strengthens or weakens.
Locking in the exchange rate helps companies reduce losses or increase profits, depending on which currency strengthens or weakens.
Forex for Speculation
Factors like interest rates, trade flows, tourism, economic strength, and geopolitical risk influence the supply and demand for currencies, creating daily volatility in the forex market. This presents opportunities to profit from changes that can increase or decrease the value of one currency compared to another. Anticipating that one currency will weaken is essentially the same as assuming that another currency in a pair will strengthen.
So, a trader who anticipates price movements can either short or long one of the currencies in a pair and capitalize on those movements.
So, a trader who anticipates price movements can either short or long one of the currencies in a pair and capitalize on those movements.
Forex trading is similar to equity trading. Here are some steps to kickstart your forex trading journey:
- Learn About Forex: While not overly complex, forex trading is an endeavor that requires specific knowledge and a commitment to learning.
- Set Up a Brokerage Account: You'll need a forex trading account with a broker to start forex trading.
- Develop a Trading Strategy: While it's not always possible to predict and time market movements, having a trading strategy will help you establish broad guidelines and a roadmap for trading.
- Keep an Eye on Your Numbers: Once you begin trading, check your positions at the end of the day. Most trading software provides daily trade accounting. Make sure you don't have outstanding positions that need to be closed, and that you have sufficient funds in your account for future trades.
- Cultivate Emotional Balance: Forex trading for beginners is full of emotional ups and unanswered questions. Discipline yourself to close your positions when necessary.
Forex Terminology
The best way to begin your forex journey is by learning its language. Here are some terms to get you started:- Forex Account: A forex account is used for trading currencies. Depending on the lot size, there are three types of forex accounts:
- Micro Forex Account: Allows you to trade currencies up to $1,000 per lot.|
- Mini Forex Account: Allows you to trade currencies up to $10,000 per lot.
- Standard Forex Account: Lets you trade currencies up to $100,000 per lot. - Ask: The ask (or offer) is the lowest price at which you are willing to buy a currency.
- Bid: The bid is the price at which you are willing to sell a currency.
- Contract for Difference (CFD): A Contract for Difference is a derivative that allows traders to speculate on currency price movements without owning the underlying asset.
- Leverage: Leverage involves using borrowed capital to amplify profits. The forex market is known for its high leverage, and traders often use it to increase their positions.
TIP: Remember that the trading limit for each lot includes the margin money used for leverage. This means the broker can provide you with capital at a predetermined ratio. For instance, they might offer $50 for every $1 you put up for trading, meaning you only need to use $10 of your funds to trade $500 in currency.
Basic Forex Trading Strategies
The most fundamental forms of forex trading are going long and going short, with price changes reported in pips, points, and ticks. In long trades, traders bet that a currency's price will rise, allowing them to profit from it. Short trades involve betting that the price of a currency pair will fall. Traders can also use trading strategies based on technical analysis, such as breakouts and moving averages, to refine their trading approach.
Depending on the duration and number of trades, trading strategies can be categorized into four further types:
- Scalping: Scalping involves cumulative positions held for a very short time, often just seconds or minutes, with profit limited in terms of the number of pips.
- Day Trading: Day trading is short-term trading where positions are held and liquidated within the same day. The duration of day trades can vary from hours to minutes.
- Swing Trading: In swing trading, traders hold positions for a longer duration, typically days or even weeks.
- Position Trading: Position trading involves holding a currency for an extended period, which could be months or even years.
Types of Charts Used in Forex Trading
Three types of charts are used in forex trading. They are:1. Line Charts:
Line charts are used to identify the overall trend of a currency. They are the most basic and commonly used charts by forex traders. They display the closing price of a currency over a user-defined period. Trendlines identified on line charts can be used to design trading strategies. For example, trendline information can help identify breakouts or changes in the upward or downward price trend.Although useful, line charts are typically used as a starting point for further trade analysis.
2. Bar Charts:
Bar charts, also known as OHLC (Open, High, Low, Close) charts, provide more price information compared to line charts. Each bar represents one day of trading and includes the opening price, highest price, lowest price, and closing price for a trade. A vertical line to the left represents the opening price of that day, and a similar line on the right represents the closing price. Colors are sometimes used to indicate price movement, with green or white for periods of price increase and red or black for periods of price decline.Bar charts for currency trading help traders identify whether it's a buyer's or seller's market.
3. Candlestick Charts:
Candlestick charts were first used by Japanese rice traders in the 18th century. These charts are visually more appealing and easier to read compared to the chart types described above. The top part of the candle represents the opening price and the high point of a currency, while the bottom part indicates the closing price and the low point. Downward candles symbolize periods of price decline and are typically colored red or black, while upward candles represent periods of price increase and are usually colored green or white.Formations and shapes of candlestick charts are used to identify market direction and movement. Some common candlestick chart patterns include the hanging man and shooting star.
Pros and Cons of Forex Trading
Pros:- High Trading Volume: Forex boasts the highest daily trading volume globally, ensuring high liquidity.
- 24-Hour Market: Forex operates 24 hours a day, five and a half days a week, providing trading flexibility.
- Potential for Quick Profits: Thanks to high leverage, initial capital can multiply rapidly.
- Standardized Rules: Forex trading generally follows consistent rules, ensuring traders have a uniform understanding.
- Decentralization: Forex is less centralized compared to traditional stock or bond markets, reducing the potential for manipulation.
Cons:
- High Volatility: Leverage can make forex trading highly volatile and risky.
- High Leverage: Common leverage levels of 50:1 or higher can lead to significant losses if not used wisely.
- Need for Fundamental Understanding: Forex trading requires a grasp of economic fundamentals and economic indicators.
- Varying Regulations: Forex regulation levels differ by jurisdiction, posing potential imbalances.
- Lack of Regular Income: Forex lacks instruments that provide regular income, such as dividends, making it less attractive for income-seeking investors.
- Every trader should consider these pros and cons before engaging in forex trading and exercise caution when using leverage.
