Forex is the largest and most liquid financial market in the world, with trillions of dollars traded daily. As an OTC (over-the-counter) market with no centralized exchange, it is also one of the least understood. In this article we’ll guide you through the key points you should know before you participate.
A Brief History of Forex
The first major forex market was launched in Amsterdam in the 17th century, where currencies were exchanged between parties from England and Holland. In the early 19th century, currency exchange was a major part of the operations of Alex. Brown & Sons, the first investment bank in the United States.
The Bretton Woods Agreement in 1944 required currencies to be pegged to the US dollar, which was in turn pegged to the price of gold. The agreement was made in order to prevent competitive devaluations of currencies and to boost international economic growth.
In 1971, the Bretton Woods Agreement collapsed after US President Richard Nixon announced a suspension of the US dollar’s convertibility into gold. By 1973, the world’s major currencies began to float freely against each other.
In the mid-1980s currency trading took place using a system called Reuters Dealing that allowed banks to get currency quotes from each other in real time. Forex trading began to enter the mainstream in the late 1990s. This was driven by widespread access to personal computers and the internet, along with brokers offering leveraged currency trading via their software platforms. Prior to this, the forex market had largely been the domain of major banks and financial institutions.
What is Forex Trading?
Trading is not centralized at a physical location or an exchange, as with the equities and futures markets. Instead, various financial institutions trade currencies between themselves via a global network known as the interbank market. This market runs 24 hours a day, 5 days a week (from 5 p.m. EST on Sunday until 4 p.m. EST on Friday).
How Does Forex Trading Work?
Trading forex involves simultaneously buying one currency and selling another. Currencies are traded in pairs, e.g. the Euro against the US Dollar (EUR/USD). The first currency in the pair is called the base currency and the second is called the counter or quote currency.
So if the EUR/USD is trading at 1.14149, this means that €1 is worth $1.14149. The exchange rate is the amount of the quote currency (USD) that is equal to 1 unit of the base currency (EUR).
If you are bullish and believe the base currency in a currency pair will appreciate against the quote currency, you can buy (go long) the pair. If you are bearish and think the base currency will weaken against the quote currency, you can sell (go short) the pair.
A standard lot size in forex trading is 100,000 units of the base currency. For this contract size, each pip (a standard price increment) is worth $10. Many firms now offer access to trading in mini lots of 10,000 and micro lots of 1,000.
Forex pairs are broken down into different categories as follows:
- Major pairs. EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, AUD/USD, and NZD/USD are considered to be the major currency pairs.
- Minor pairs. These are currency pairs that include any two of the major currencies excluding USD. For example, GBP/EUR and AUD/JPY.
- Exotic pairs. These are pairs that are made up of a major currency against one from an emerging economy. For example, EUR/TRY and USD/HUF.
Uses of the Forex Markets
The forex market is used for a variety of different purposes.
- Major companies doing business in foreign countries use the forex market to hedge against risk in currency price movements.
- Traders aim to profit by speculating on the price movements of currencies.
- Portfolio managers use the forex market to diversify their holdings.
How to Start Trading Forex
Before starting to trade forex, it is beneficial to spend some time learning about the market and factors such as the risks of using leverage. There are many great free resources available online to help you with this, such as the education section of this website.
To begin trading forex you will need to open an account with a brokerage firm. This is normally a relatively fast and easy process that can be done online via the broker’s website.
It is advisable to work with a broker that is regulated by a top-tier government agency. For example, brokers regulated by the UK Financial Conduct Authority (FCA) guarantee that client funds are held in segregated accounts and provide negative balance protection. In addition, there is a compensation fund available in the event of broker insolvency. Meanwhile, forex brokers based offshore typically have very little regulatory oversight and are more risky to work with.
Many brokers require very low minimum deposits to get started. In fact, there is often a $0 minimum to open an account. Due to regulatory requirements, some brokers now have a ‘Know your Customer’ (KYC) questionnaire as part of the application. This aims to ensure that brokers understand your risk tolerance, market knowledge, and overall financial situation. It may include some basic questions about trading forex and CFDs.
New forex traders should be aware of overnight swap fees. These are the fees for holding a leveraged position overnight and can add up to be substantial. Another common fee among forex brokers is an inactivity fee, which is charged after an account has been dormant for a set period.
Most brokers offer a free demo account where you can practice trading without risking any real money. Before trading in a live account it is a good idea to develop a strategy and test it in a demo account. In addition, micro accounts and flexible lot sizes allow new traders to practice with real money while keeping risk to a minimum. Starting a trading journal is a great practice for new traders as it helps to identify strengths and weaknesses and track progress.
Basic Forex Trading Strategies
Forex trading strategies can be broken down into two major categories: fundamental and technical.
Trading based on economic news is an example of a fundamental strategy. A trader may be watching the US employment report and see it come in worse than the consensus expected by analysts. They may then decide to buy EUR/USD based on an expectation that the dollar will weaken on the disappointing US data.
Technical strategies rely on an analysis of price data. Looking for price breakouts in the direction of the prevailing market trend is an example of a technical trading strategy. The London Opening Range Breakout (LORB) is an example of such a strategy. At the time of the London open, traders using this strategy look for the price of GBP/USD to break out above a recent high or below a recent low on the hourly chart with the expectation that price will continue to trend in that direction.
Another basic technical strategy is to trade using price action. Here traders look for specific chart patterns that indicate whether price is likely to reverse or continue to trend in the same direction. The Pin Bar is a popular reversal pattern. Here, price reaches a new high (or low) and then reverses to close near where it opened, indicating a lack of conviction among the bulls (or bears).
Forex traders operate across a range of different time frames.
- Scalpers get in and out of trades within seconds or minutes, hoping to profit from relatively small fluctuations in price.
- Day traders by definition close their market positions by the end of the day. This can help lock in profits and avoid the risk and cost of holding trades overnight.
- Swing Traders typically hold trades for days or weeks. This style of trading allows traders to potentially profit from major price moves in the market.
- Long-term investors hold market positions for months or even years. Holding such long-term positions in the forex market has the potential benefits of profiting from major price trends and also being able to earn interest from a positive interest rate differential.
Charts Used in Forex Trading
The most popular chart types in forex trading are Bar Charts, Candlestick Charts and Line Charts.
- Bar Charts show the opening and closing prices, as well as the highs and lows of a financial instrument over a set period.
- Candlestick Charts are similar to Bar charts in that they display the high, low, open, and closing prices for a set time period. Candlesticks make it easy for traders to understand whether the market is bullish or bearish within a given period by coloring the area between the open and close green or red. Green is used when the market closes higher than the open and red is used when the market closes lower than the open.
- Line Charts simply draw a line from one closing price to the next closing price. This chart type makes it easy to view price trends but offers little insight into what took place over each time period.
Is Forex Trading Profitable?
Forex trading can be profitable, but the statistics shared by major brokerage firms show that the majority of traders lose money.
|Forex and CFD Broker||Percentage of Retail Clients that Lose Money|
Major factors leading to trader losses include inappropriate use of leverage, lack of education, and costs of trading such as spreads or commissions. It should also be emphasized that timing the market and trying to predict short-term moves in the market are extremely difficult.
What is Margin in Forex?
Margin is the initial capital required to open and hold a leveraged position in the market. For example, a margin requirement of 1% equates to available leverage of 1:100. This means that with $1,000 a trader can control a market position of $100,000. Margin is a percentage of the full value of a trading position that a trader must have available in their account in order to place and hold the trade.
Brokers have different margin requirements and available leverage depending on their location and the requirements of local regulators. For example, traders with United Kingdom-based brokers have access to 1:30 leverage, reflecting a margin requirement of 3.3%. This is because 1:30 is the maximum leverage allowed for standard accounts by the UK Financial Conduct Authority (FCA). Meanwhile, the requirements of offshore regulators are far less stringent.
Traders with accounts at brokers based offshore often have access to leverage as high as 1:500, with a margin requirement of just 0.2%.
Making use of low margin requirements and trading with high leverage allows traders to dramatically increase their exposure to movements in the market. Leveraged trading comes with a high level of risk. Often described as a ‘double-edged sword’, leverage can magnify both profits and losses.
What is the Spread in Forex?
The spread is the gap between the bid and offer (also known as ‘ask’) prices of a currency pair. For example, imagine that in EUR/USD the bid price is 1.14123 and the offer price is 1.14133. This means that the best price that you can currently buy EUR/USD is 1.14133 and the best price you can currently sell at is 1.14123. In this case, the spread, the difference between the bid and offer prices, is one pip. Pip is an acronym for “percentage in point” or “price interest point” and is a unit of measurement expressing the change in value of an exchange rate.
View the live currency rates below:
What is a Pip in Forex Trading?
Pip is an acronym for percentage in point and represents a unit of price change in a currency pair. In most cases, pips are the smallest price increment of a currency pair and are in the fourth decimal place. A pipette is one tenth of a pip, usually in the fifth decimal place.
Pros and Cons of Forex Trading
Forex trading has important advantages and disadvantages compared with other markets. Recent developments in the equities market, such as the advent of fractional share trading and commission-free trading, have eroded some of the advantages of forex.
Pros of Forex Trading
- Ease of access. Forex trading accounts can often be opened online within a half-hour and funded with as little as $100. As a true 24/5 market, traders can easily get in and out of positions at any time of the day or night.
- Fees. Since the forex market is decentralized, there are no exchange or clearing fees. Normally, the costs of entering a trade are priced into the spread, unless you are trading with an ECN ( Electronic Communications Network) broker when there is an additional commission. ECN brokers provide direct access to other participants in the market, rather than taking the other side of client trades.
- Leverage. The forex market offers an unusually high level of leverage, which is typically seen as an advantage. As mentioned above, increased leverage can amplify both gains and losses, so it does not always work in the trader’s favor.
- Flexibility of lot size. Traders are usually not restricted to trading full-sized lots of 100,000 units of the base currency. Many brokers offer trading in mini lots of 10,000 units or micro lots of 1000 units.
- Ease of short selling. The ability to short sell a currency pair is a given, while in other markets such as stocks, this is not the case.
- Liquidity. The massive size of the forex market and tremendous volume of trading means that it is a highly liquid market. This makes it more likely that you will receive the price intended when executing a trade. An additional benefit is that highly liquid markets are harder to manipulate, which creates a better trading environment for all participants.
Cons Of Forex Trading
- Lack of Regulation. Regulatory oversight is often limited in the forex market. For example, a trader opening an account with a broker regulated by the Cyprus Securities and Exchange Commission (CySEC) has the benefit of segregated funds, negative balance protection, and a compensation fund in the event that the broker becomes insolvent. A trader opening an account with a broker based offshore will not be guaranteed such protections. Making it more confusing is the fact that large brokers typically have multiple entities across the globe overseen by different regulators. If they have an entity regulated by CySEC, this will only protect the clients within the EU. If they also have an offshore entity, the clients with the offshore entity will not benefit from the same protections.
- Conflict of Interest. Market Maker/Dealing Desk forex brokers automatically take the other side of a client’s trade. This means that when a client loses money they will make money, creating an inherent conflict of interest.
- Dividends. Stocks sometimes make dividend payments which is something not present when investing in currencies. However, forex traders can potentially capitalize on different interest rates between currencies using a strategy known as the Carry Trade. This strategy is based on buying a pair where the base currency has a high interest yield and the quote currency has a low yield. In doing this the investor can earn the interest rate differential: the interest earned from buying the high yielding pair minus the interest paid from selling the low yielding pair. Leverage can be used to magnify earnings from the Carry Trade. For example, a 4% interest rate differential will become 400% at 1:100 leverage.
Is Forex Trading Legitimate and Legal?
Forex trading is a legal and legitimate form of trading. Unfortunately, due to the decentralized and often under-regulated nature of the market, it has become notorious for scams. Individuals must be careful to do their due diligence when selecting a broker and also be careful not to be lured into buying courses or software that promise quick profits.
The forex market has a language of its own. Here are some of the most commonly used terms in forex trading.
- Base Currency. The base currency is the first currency in a currency pair. The price of a currency pair shows how much the base (first) currency is worth in the second currency.
- Quote Currency. The quote currency is the second currency in any currency pair. The price of a currency pair shows how much it costs to purchase one unit of the base currency by selling the quote currency.
- Spread. The spread is the difference between a forex broker’s bid (buy) and offer (sell) quotes.
- Pip. A pip is usually the smallest price increment in a currency pair.
- Swap Fee. The swap fee is the sum that forex brokers charge for holding a leveraged market position overnight.
- Carry Trade. The Carry Trade strategy is based on simultaneously buying a high interest yielding currency and selling a lower yielding currency. In doing this investors can profit from the interest rate differential (the difference in the interest rate between the two currencies).
- Cable. Cable is a nickname for the GBP/USD currency pair. The term originated from the time when the GBP/USD exchange rate was transmitted via transatlantic cable.
- Loonie. Loonie refers to the Canadian dollar. The nickname is derived from Canada’s $1 coin, which has a picture of a loon on it.
- Kiwi. Kiwi is slang for the New Zealand Dollar. The Kiwi bird appears on New Zealand’s $1 coin.
- Greenback. Greenback is a term commonly used to refer to the US Dollar.
Forex is an interesting market for short-term traders, swing traders, and long-term investors. The market lends itself well to both technical and fundamental trading strategies. Being highly liquid and an uninterrupted 24/5 market also makes forex a good market for automated and algorithmic trading.
- Can I trade forex with $100? Yes, there are many brokers that offer trading with initial deposits of $100 or less.
- Can I trade forex with Robinhood? Robinhood does not currently offer forex trading.
- Should I trade forex or stocks? The forex market has some advantages over trading stocks. These include the high available leverage, volatility, and liquidity of the forex market.
- Which forex pairs correlate? Examples of currency pairs with positive correlations include AUD/USD vs. NZD/USD and EUR/USD vs. GBP/USD.
- Is forex a pyramid scheme? No, the forex market is not a pyramid scheme.
- Which forex pairs move the most? The most volatile instruments are typically minor or exotic currency pairs. AUD/JPY, USD/SEK, and USD/TRY are examples of highly volatile currency pairs.
- How do forex brokers make money? Forex brokers make money via the bid/offer spread, commissions, overnight swap fees, and miscellaneous fees such as inactivity fees or withdrawal fees.