The Basics of Forex Trading

Forex also referred to as foreign exchange, FX, or currency market is a decentralized global market for world currencies to trade. It consists of banks, businesses, governments, investors, and traders who exchange and speculate on currencies. The forex market is the biggest, most liquid market globally with an average trading volume of more than $5 trillion. The market transacts business 24 hours a day, 5 days a week.

Forex Trading

The Forex market does not have a centralized marketplace. Unlike stocks, trading is carried out “over the counter”. For retail traders, Forex trading is speculating the price of one currency against another. For example, if you think the GBP is going to rise against the USD, you can buy the GBP/USD currency pair low, then sell it at a higher price to make a profit. In case the opposite happens – the USD strengthens, you will make a loss – if you sell.

The first currency (GBP) is the base, which you hope will go up against the second (USD) which is the quote. Most Forex traders seek to make a profit from fluctuations in the exchange rates of two currency pairs.

Traders can speculate currencies’ future direction by taking either a long (buy) or short (sell) position. This depends on whether you think the currency’s value will increase or decrease. Forex price movements are caused by currencies either appreciating (strengthens) or depreciating in value (weakening).

Example of a GBP/USD pair

GBP is the base currency and USD is the quote. If the price of the GBP/USD pair is 1.29, it means that 1 GBP is equal to 1.29 U.S. dollars. If the number appreciates, it means the GBP is getting stronger and if it depreciates it means the USD is getting stronger.

Currency Pairs

Most commonly traded currency pairs are divided into three groups, in relation to popularity and liquidity. They are majors, minors, and exotics.

  • Majors: They’re most liquid or most actively traded. They constitute about 85% of total trading volume in the FX markets. Their spreads are also tighter in comparison to minor currency pairs. Examples are EUR/USD, USD/JPY, and EUR/GBP.
  • Minors: These are not as actively traded as the major currencies, and therefore tend to fluctuate frequently. In comparison to the majors, their spreads are also wider due to medium sized liquidity in the market
  • Exotics: These currency pairs are seldom traded. As a result, exotic currency pairs are illiquid and more expensive to trade with wider spreads. They are viewed as having higher risk profiles compared to common currency pairs. Examples include the Mexican Peso (MXN), Polish Zloty (PLN) and Norwegian Krone (NOK).

Forex Trading Terminology

The FX market has its own set of vocabulary. Some of them are:

  • Cross Rate

An exchange rate between two currencies which are not the official currency of the country in which the exchange rate quote is given. This happens when for example a U.K. newspaper is quoting two different currencies for instance USD and JPY. However, if the same newspaper is quoting GBP and USD it wouldn’t be considered a cross rate since the quote involves the U.K. official currency.

  • Pip

This is the minimum increment of price movement a currency can make. Also known as point or points. Example, 1 pip for the GBP/USD = 0.0001 and 1 pip for the USD/JPY = 0.01

  • Margin

Margin is a good faith deposit that a trader puts up as collateral to hold open a position.  Some people confuse margin as a fee to a broker. It’s not a trading cost but part of the trader’s account equity set aside and allocated as a margin deposit.  When trading with a margin, the amount of margin required to hold open a position is determined by trade size. As trade size goes up, your margin requirement will go up as well.

  • Leverage

Leverage is a consequence of margin. It allows the trader to control larger trade sizes. Traders use it to intensify their returns. Losses can also be intensified when using leverage, therefore its usage should be reserved. For example, a trader decides to trade one mini lot of the GBP/USD. This trade is equal to controlling 10,000 GBP. Since the trade is 10 times larger than the equity in the trader’s account, it’s said to be leveraged 10 times or 10:1. In case the trader had purchased 30,000 units of the GBP/USD, which is equal to 30,000 GBP, their account would have been leveraged 30:1.

  • Spread

This is the difference between the sell quote and the buy quote or the bid and offer price. For example, if GBP/USD quote is 1.5200/05, the spread is the difference between 1.5200 and 1.5205, or 5 pips. To break even on trade, a position needs to move where the trade is by an amount equal to the spread.

Types of Forex Brokers

There are five types of Forex brokers. These are:

  • Dealing Desk (DD) – This kind of broker is a market maker. Market makers usually offer fixed spreads and can decide to quote above or below actual market prices. Market makers complement the trader, who doesn’t trade directly with the liquidity providers. Makers get paid through the spreads. They can also take the opposite trades of their clients – your losses are his profits.
  • No Dealing Desk (NDD) – This forex broker offers direct access to interbank markets. A genuine NDD broker never re-quotes prices. This allows traders to trade during economic announcements with no limits. Despite the spreads on offer are lower, they are not fixed. They can increase when volatility increases during major economic announcements. NDD brokers can charge a commission on each trade or decide to increase the spread.
  • Straight Through Processing (STP) – A computer without the need of broker involvement processes transactions immediately.
  • Electronic Communication Network (ECN) – ECN brokers display real-time order book info that features processed orders and prices offered by banks on the interbank market. ECN brokers charge a commission on the traded volume.

Multilateral Trading Facilities (MTF)

  • This exchange allows buyers and sellers of financial markets to amalgamate to non-discretionary rules. The broker guarantees price efficiency and clears transactions. In comparison to a traditional exchange, multilateral trading tools provide better discretion, faster order execution, and lower brokerage fees.

Forex Trade Strategies

Listing your trading strategies or guidelines is comparable to having a manual for trading. Some of these strategies include:

  • Trading on Technicals: This refers to using charts and graphs to recognize potential buy and sell levels.
  • Trading on Fundamentals: Also known as trading the news. This is studying news event and economic data to help determine trading opportunities. They focus on interest rates, employment, and trading opportunities.
  • Trading when Indicators Conflict: Traders at times will deal with conflicting info as they try to predict the future direction of a currency.
  • Trading Discipline: Successful trading demands discipline to stick to a strategy no matter the market direction. However, if the trade is going against the best analysis available, cut your losses and move on.

Being a Forex trader can provide you with a potential fascinating lifestyle of a successful profession, anywhere in the world. It’s not an easy trade, but determination and discipline can get you there. However, caution is needed as trading in Forex carries its own risks, and may not be appropriate for everyone. Before you embark on Forex trading consider your investment objective, the level of experience and risk appetite.

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If you already actively trade the financial markets, adding leveraged forex to your portfolio is an alternative way to take advantage of price movements, without having to buy the underlying asset.

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Forex market size and liquidity

Forex daily turnover

The 2016 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in foreign exchange markets averaged $5.1 trillion per day in April 2016.

Forex Centres

In April 2013, for the first time, Singapore surpassed Japan in average daily foreign-exchange trading volume with $383 billion per day.

Top 10 currency traders

The foreign exchange market is divided into levels of access. At the top is the interbank foreign exchange market, which is made up of the largest commercial banks and securities dealers.

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