What Is Forex Trading? A Guide for Beginners
What is Forex Trading?
Foreign exchange, also known as Forex, is a market that allows buyers and sellers to exchange currencies with each other at a mutually agreed price. This enables individuals, companies, and central banks to convert one currency into another which is known as forex trading.
If you have ever traveled internationally, you have likely participated in a Forex transaction.
While some Forex transactions are conducted for practical reasons, a majority of currency conversions are done for the purpose of making a profit. The high volume of currency exchanged daily leads to substantial price changes in some currencies, making them highly volatile. This volatility presents traders with an opportunity to make high profits, but at the same time increases the chances of risk as well.
Overview and History of the Forex Market
Forex, or foreign exchange, is a decentralised market for the trading of currencies. Unlike traditional stock exchanges, Forex operates 24/7 and doesn't have a physical trading venue. Instead, it consists of a network of computer systems and trading terminals that allow participants, including institutions, investment banks, commercial banks, and retail investors, to exchange currencies.
The Forex market has a long history, with evidence of currency exchange and bartering dating back centuries. However, the modern Forex market as we know it today was established after the Bretton Woods accord in 1971, which allowed currencies to float freely against each other. The values of individual currencies are determined by supply and demand and are monitored by foreign exchange trading services.
Commercial and investment banks conduct a majority of Forex trades on behalf of their clients, but there are also speculative opportunities for trading one currency against another for professional and individual investors. As an asset class, currencies offer two distinct benefits: the interest rate differential between two currencies and profit from changes in the exchange rate.
Types of Forex Market
There are three main markets in Fx trading: the spot market, the forward market, and the futures market, each with its own unique characteristics and significance.
1. Spot Market: The spot market is where currencies are bought and sold based on their exchange rate. The price is determined by supply and demand and is calculated based on several factors including interest rates, economic performance, political situations and future performance of one currency against another. A finalised deal in the spot market is known as a spot deal, which is a bilateral transaction where one party delivers a currency and receives another currency at a predetermined exchange rate value. Spot trades take two days for settlement and are usually made for the purpose of speculating about future price movements.
2. Forward Market: The forward market is where forex traders can enter into a private agreement with another trader to buy or sell a currency at a future date and at a predetermined price in the OTC market. The forward market is OTC, meaning contracts are bought and sold between two parties who determine the terms of the agreement between themselves. It is used primarily by forex traders who want to speculate or hedge against future price changes in a currency.
3. Futures Market: The futures market is where traders can opt for a standardised contract to buy or sell a predetermined amount of a currency at a specific exchange rate of a future date. Futures contracts include details, regarding the number of units being traded, delivery dates, settlement dates, and minimum price increments. The futures market is similar to the forward market in that it is used primarily by forex traders who want to speculate or hedge against future price changes in a currency.
4. Options Market: The options market is where forex options are traded on certain currency pairs, giving holders the right, but not the obligation, to enter into a forex trade at a future date and for a pre-set exchange rate. Forex options give forex traders the ability to speculate about future price movements in a currency. Options provide forex traders with an additional tool to manage their risk and speculate on price movements in the market.
How to Trade Forex?
Trading in foreign currencies, also known as forex trading, involves the simultaneous purchase of one currency and sale of another. The currency pair, which is treated as a single unit, is bought or sold through forex brokers. There are two types of pairs that traders usually like to trade, forex majors and minors. There are exotic pairs as well, but those are only for experienced traders.
The price of a currency pair is quoted as the bid (buy) and ask (sell) price, with the bid price being the price at which the trader will buy the base currency and the ask price being the price at which the trader will sell the base currency.
The base currency is sold and the quote or counter currency is received when selling a currency pair, and the opposite happens when buying a currency pair.
If you are wondering what base and quote currency is then, the first currency in the pair is called the base currency, while the second currency is referred to as the quote currency. Let's take GBP/USD as an example, here GBP is the base currency and USD is the quote currency.
All forex trades are quoted in pairs, with the price of a forex pair representing how much one unit of the base currency is worth in the quoted currency.
Each currency in the pair is represented by a three-letter code, let's take the same pair as an example, the currency pair GBP/USD involves buying the Great British pound (GBP) and selling the US dollar (USD).
If the base currency appreciates in value relative to the quote currency, the price of the forex pair will increase, and if it depreciates, the price will decrease. If you believe that the base currency is likely to strengthen against the quote currency, you can buy the pair, also known as "going long". Conversely, if you believe it will weaken, you can sell the pair, known as "going short".
In the case of the GBP/USD currency pair, the Great Britain Pound (GBP) is the base currency, and the US dollar (USD) is the quote currency. The exchange rate represents how much of the quote currency is needed to purchase one unit of the base currency. When the exchange rate rises, it means that the base currency has gained value relative to the quote currency, and when it falls, it means the base currency has decreased in value.
Categories of Forex Pairs
Currency pairs are categorised based on their fx trading volume and liquidity.
Major Pairs: The most widely traded and liquid currency pairs, known as Major Currency Pairs, involve the U.S. dollar and are referred to as the "majors". The major currency pairs include EUR/USD, USD/JPY, GBP/USD, USD/CHF, AUD/USD, and USD/CAD. These currency pairs trade 24 hours a day from Sunday night to Friday at 5 PM U.S. Eastern time and tend to have the tightest spreads.
Minor Pairs: Currency pairs that are not associated with the U.S. dollar are referred to as Minor or Cross Currency Pairs. These pairs have slightly wider spreads and are not as liquid as the majors, but still have sufficient liquidity. Examples of minor currency pairs include EUR/GBP, GBP/JPY, EUR/CHF, etc.
Exotic Pairs: Exotic currency pairs are those involving currencies from emerging markets and are less liquid and have wider spreads compared to the major and minor pairs, For instance, USD/SGD, EUR/TRY, USD/ZAR, etc.
What Moves the Forex Market?
The Forex market is a complex and dynamic market, with multiple factors contributing to its movements. These factors include supply and demand, news reports, market sentiment, economic data, and credit ratings.
Let's delve deeper into each of these elements to gain a better understanding of what drives price fluctuations in the Forex market:
Central banks play a significant role in controlling the supply of currency, which can have a significant impact on its price. For instance, if a central bank injects more money into an economy, it can cause its currency's price to drop.
News Reports and Market Sentiment
The sentiment surrounding a particular region or country can have a significant impact on its currency's price. If positive news reports emerge about a region, it will encourage investment and increase demand for that region's currency. On the other hand, negative news reports can lead to a decrease in investment and a lower currency price.
On the other hand, market sentiment is often influenced by news reports, and it can play a crucial role in driving currency prices. If traders believe that a currency is headed in a particular direction, they will trade accordingly, and this may influence others to follow suit, increasing or decreasing demand.
Economic data provides valuable insights into the performance of an economy and the potential actions of its central bank. For example, if inflation in the eurozone rises above the 2% target of the European Central Bank (ECB), traders may start buying the euro in anticipation of higher interest rates, leading to an increase in the EUR/USD price.
A country's credit rating is an assessment of its likelihood of repaying its debts, with a high credit rating being seen as a safer investment option than a low credit rating. Upgrades or downgrades in a country's credit rating can significantly impact its currency price.
Pros and Cons of Forex Trading
Low Trading Costs
Forex trading costs are generally low compared to other financial markets. For major currency pairs, the dealing spreads are usually tight, reducing the trading costs. However, the spreads for minor and exotic currency pairs tend to be wider, leading to increased trading costs for those pairs.
Another reason to trade forex is that the market has got the largest notional value of daily trading compared to other financial markets. This provides high liquidity, allowing for efficient and easy filling of large orders without significant price deviations. The forex market operates continuously 24 hours a day, eliminating the possibility of price manipulation and anomalies.
Low Capital Requirements
Forex trading allows for tight spreads in terms of pips, enabling traders to start with a small amount of initial capital. Margin trading with high leverage is also available, making it easier to achieve better profit potential with limited capital.
Ability to go Long or Short
Forex traders can buy or sell currency pairs freely without any restrictions. Taking a position in forex involves simultaneously going long or short the base currency against the counter currency.
The forex market is open continuously 24 hours a day from 5 p.m. EST Sunday to 5 p.m. EST Friday. The various trading sessions, corresponding to major global money centres, provide different levels of liquidity for specific currency pairs.
The forex market is highly volatile, and traders can suffer significant losses due to macroeconomic and geopolitical developments outside of their control. The 24/7 markets make it challenging to regularly monitor prices and volatility, making it essential to have a well-planned approach and strict stop losses in place.
High Leverage Can Be Highly Risky
Forex trading offers high leverage, magnifying profits and losses. A leverage of 100:1 means a trader only needs $1 to take a position worth $100. Online forex trading can quickly turn into a loss-making nightmare without a robust understanding of leverage, efficient capital allocation, and strong emotional control.
In the end, I'd say that the forex market offers a lucrative opportunity to people who are interested in trading but these opportunities come with greater risk. Therefore, traders should put in time and effort to gain knowledge and hone their trading skills.
If you are a trader, do share your experience in the comments!