Introduction: What is Forex Trading?
The words “forex trading” provide the definition of this activity. The word FOREX, is coined from “FOReign EXchange”. Forex is another word for foreign currencies. So the definition of “forex trading” is simple: it is the practice of trading currencies, or buying and selling of currencies in order to generate a profit from the activity.
The sole aim of any kind of trading activity anywhere in the world is to be able to sell the product or the asset at a higher price than it was bought for. Trading may also be done by selling an asset for a high price, and purchasing that asset once more at a lower price, thus retaining the asset and also having some profit on the transaction.
These two scenarios also play out in the trading of currencies. Currency trading involves two currencies: you have to use one currency to buy another, or you sell one currency to get another. Either way, the trade has to be done at a reference price: a price that is agreeable to both buyer and seller for the transaction to occur. This is known as the rate of exchange or exchange rate.
What are the Pros and Cons of Forex Trading?
- The forex market is a 24 hour market with well-defined periods of volatility that present trading opportunities.
- The forex market is very liquid, which means there is no shortage of buyers and sellers at any time.
- The forex market is amenable to being traded with automated trading systems.
- Rapid and wide currency movements provide a lot of day trading opportunities.
- News trades have a schedule. Therefore news trades can be planned beforehand.
- The forex market is a virtual market. You can connect to this market from anywhere in the world using an internet-connected device.
- Forex trades do not expire, so there is no fear of sudden liquidation of positions from contract expirations (as is the case in commodity markets).
- There are various ways to trade forex. You can trade spot contracts, forwards and forex options.
- The forex market is very risky and it is very easy to lose money if the trader does not know what he or she is doing.
- Many retail traders are unable to afford to trade with the more transparent ECN models.
- The forex market maker brokerage model presents significant conflicts of interest.
- True mastery of the forex market takes time
How is the FX Market Structured?
The online forex market does not have a central location. Stock markets usually have a physical exchange. For instance, the New York Stock Exchange is located in Wall Street, New York. The commodities markets in Chicago have a location. But for the forex market, there is no central location. Rather, the forex market is virtual and global. Connectivity is maintained via the internet, and this connection is what links all the participants in the online forex market together.
So who are the participants in the online forex market?
- Central Banks
- Institutional traders such as hedge funds, prime brokers, major banks, retail brokers.
- Retail traders.
The image below shows the hierarchy of the forex market.
Some central banks occasionally come to the currency market to buy or sell large quantities of either their own currencies in exchange for other currencies, in an attempt to artificially alter the exchange rates of their currencies. This process is also known as currency intervention. The Bank of Japan and the Swiss National Bank have at various times, performed actions that are tantamount to currency interventions. These are not regular events and only occur once in a while. It may even take several years for a central bank to intervene sequentially. However, central bank interventions are important because their actions can alter the demand-supply dynamics of currencies very quickly. More commonly, central banks will affect interest rates as a consequence of their monetary policy actions. When central banks intervene in the currency market, they perform large transactions with major banks that constitute the liquidity providers in the interbank market.
The next level of market participation comes from the institutional traders. They constitute 90% of the daily transaction volumes in the market. The 2016 Triennial Survey of the Bank of International Settlements puts daily turnover in the forex market at $5.1 trillion. That gives us an idea of just how much daily volume comes from the banks, hedge funds, prime brokers and market makers that make up the institutional traders. Institutional traders provide the bulk of market liquidity in the FX market.
At the bottom of the ladder are the retail traders. They are the individual traders who open accounts with a few hundreds or thousands of dollars with a retail broker. They account for 10% of market volume. Due to the very small component of liquidity that they contribute, they cannot participate in the interbank market directly. Therefore, they rely on market makers to generate pricing and trade executions from the liquidity chunks that the market makers have acquired from the interbank market.
Every currency can be abbreviated with 3 alphabets, according to the ISO Standard 4217. This standard picks the first two letters in a currency acronym from the country of origin, and the final letter from the currency name. There are few exceptions (such as the MXN, which is the Mexican Peso. Here, MX comes from Mexico, but the currency name is represented with an N).
Here is a list of currencies and their 3-letter acronyms.
|Great Britain Pound||GBP|
|Great Britain Pound||GBP|
|New Zealand Dollar||NZD|
|South Africa Rand||ZAR|
|South Korea Won||KRW|
|Turkish New Lira||TRY|
|United Arab Emirates Dirham||AED|
Currencies: Major, Minor and Exotic
The currency pairs in forex are divided into major, minor and exotic currencies. The major currencies are the most liquid currencies in the forex market. In descending order, these are the top 10 currency pairs by liquidity and traded volumes in the forex market.
- US Dollar
- Japanese Yen
- British Pound
- Australian Dollar
- Swiss Franc
- Canadian Dollar
- Renminbi (Chinese Yuan)
- Swedish Krona
Constituting more than 80% of trading volume in the FX market, the major currency pairs include:
The minor currency pairs (or FX minors) include the following:
The exotic currency pairs are relatively illiquid pairs and carry very wide spreads as a result of their illiquidity. These pairs usually feature currency pairings of the Swedish, Danish and Norwegian Crowns, the South African Rand, Turkish Lira and Mexican Peso.
These lists are by no means exhaustive. On your forex platform, you will probably see more minor and exotic currency pairs than are listed here.
Forex Trading Basics
Here are some elements of forex trading. It is important to understand these elements as they play a crucial role in a trader’s ability to trade the market effectively.
- Fundamental Analysis
Exchange rates of forex pairs are wholly determined by forces of demand and supply. These forced are captured in a schedule of economic and political events known as the economic news calendar (also known as Economic Calendar or Forex News Calendar). No other market has such a schedule. The forex news calendar is a compendium of news releases on economic variables or political events which will ultimately sway the sentiment of the major market participants to either buy or sell a currency in exchange for another. Analyzing these news releases in order to determine whether to buy or sell a currency is known as fundamental analysis.
There are various fundamental news releases in an economic calendar. These are divided into low-impact, medium-impact and high-impact news events. There are many versions of the economic news calendar online, and you will also find this calendar on the MT4 platform. Typically, the impact of a news release can be color-coded or it can be assigned stars according to the level of market impact.
- Low-impact news are assigned a green color, one to two stars and generally do not cause movements in currency pairs.
- Medium-impact news are assigned an amber colour, three stars and usually move the currencies very minimally. Usually these movements are not enough to create trading opportunities.
- High-impact news events are assigned a red colour, four to five stars, and usually create sufficient volatility to cause significant movements in currency pairs. The high-impact news are the tradable news items and are the ones mostly followed by market participants.
Economic Calendar on FXStreet
What are the high impact news events, and why do they sway the sentiment of market participants?
- Interest Rate Decisions
- Gross Domestic Product (GDP)
- Employment Data
- Manufacturing Data
- Inflation data: Producer Price Index and Consumer Price Index (PPI and CPI)
Due to the variation in economic conditions in different countries which produce the currencies being traded, some of the high-impact news releases listed above may be more important in one country and less important in another. Furthermore, some news releases tend to affect just more than one currency. For instance, GDP and manufacturing data out of China tends to affect the Australian Dollar, as the Australian economy depends a lot of exports of raw materials to China’s industries.
It should also be noted that what may constitute a low or medium impact news for one currency, can actually be of high impact with regards to another currency. Therefore, it is best to search the Economic Calendar to see just which high-impact news are listed for a particular currency pair.
- Technical Analysis
Price information of currency pairs is displayed on the charts. Currencies can therefore be analyzed using technical analysis. Technical analysis involves the use of patterns, candlesticks, wave patterns and indicators, all in a bid to forecast future price action and to make timely trade entries.
- Leverage/Margin Requirements
In order to ensure that traders can afford to setup forex trades with far less money, the concept of leverage was introduced. Leverage enables traders to setup trades of a higher amount than their capital can ordinarily carry. In a forex leverage, the trader contributes a small portion of the required capital to collateralize the trade. This is known as the margin. The broker provides the rest of the capital.
Leverage in forex stretches from 1:2, and is capped at 1:20 for FX minors and 1:30 for FX majors on the trading platforms of UK and EU platforms. Australian brokers still offer a leverage cap of 1:500. Brokers in other parts of the world offer varying caps on leverage, with the most popular being 1:500.
Currency movements are very small, usually in the order of 4 or 5 decimal places. So a change in value in a currency pair is usually in the order of 1 pip, or 0.0001 points. If a currency pair were to change value by 25 pips, this would only be a move of 0.0025 points, which is very small indeed.
In order to magnify the monetary value of the change in exchange rate, large volumes of trade must be performed. In forex, trade volumes are measured in lots, with a Standard Lot being equivalent to $100,000. If you were to use $100,000 to trade a change in 25 pips, this would equate to a change of 100,000 X 0.0025 = $250. The question is: how many retail traders can afford to $100,000 to trade a typical forex position? There are not many who can afford this.
Margin requirement = cost of the trade volume/leverage
To use our previous example, a leverage of 1:30 will mean that the trade only requires 100,000/30 or $3,333 to trade a Standard Lot. For a mini-lot which is 1/10th of a Standard Lot, the requirement is only $333. Even with leverage, the full value of any profit or loss for a trade is settled on the trader’s account.
Forex trades on retail trading platforms do not attract commissions. Rather, each trade is charged a spread once the position is opened, which is the difference between the bid and ask prices in a currency quote. Forex trades on institutional trading platforms, or on ECN/non-dealing desk platforms are charged both spreads and commissions. Commissions are usually charged as a flat rate per Standard Lot on both the trade entry and exit.
- Price Quotes
Forex exchange rates are quoted in pairs. A price quote has a price on the left, known as the Bid price, and a price on the right known as the Ask or offer price. Long trades are fulfilled at the ask price, and short trades are fulfilled at the bid price.
If GBP/USD is quoted at 1.30220/1.30231, the bid price is on the left (1.30220) and the ask price is on the right (1.30231).
- Trading Volumes
Sizes of forex positions are measured in lots. A Standard Lot is worth $100,000. It is the standard reference for position sizing in forex. 1 lot can be subdivided into mini-lots (0.1 to 0.99 lots), and micro-lots (0.01 to 0.099 lots).
- Monetary Value Per Pip
A PIP stands for Percentage Interest Point. This is the smallest unit of measurement of a change in exchange rates for a currency pair. The monetary value of a Standard Lot of a currency pair is $10 per pip. How is this calculated?
- 1 pip = 0.0001 points.
- 1 Standard Lot = 100,000 units of a currency.
- Monetary value per pip = 100,000 X 0.0001 = 10 units.
Using the same calculation, 1 mini-lot is worth $1 per pip, and 1 micro-lot is worth 10 cents per pip.
How Forex Trading Works
As defined above, forex trading is the buying or selling of one currency against another, in an attempt to profit from the change in the initial rate at which the two currencies were exchanged. This is the reason for currencies being traded in pairs. Profiting from forex can occur from price movements in both directions. If you are buying, you profit when prices go up. If you are selling you profit when currency rates drop. This is how both trading scenarios work.
1. Profiting from an Increase in Exchange Rates
A forex trader profits from an increase in exchange rate if the base currency (i.e. the currency which is listed on the left side in a currency pair) is bought. In other words, if the trader is buying the GBP/USD, or going long on the GBP/USD, a profit will be made if the rate at which the transaction occurred goes up and the trade is exited at the new price.
- For example, if Trader Kobe feels that the exchange rate on the GBP/USD will go up, he would have to buy or “go long” on the GBPUSD. He buys 2,500 British Pounds at an exchange rate of 1.3000. He will therefore spend $3,250 to acquire 2,500 GBP.
- In the forex trading world, this trade would be to go long on the GBP/USD at 1.3000.
- In a few hours, the rate rises from 1.3000 to 1.3120. To get a profit, Kobe closes the trade by selling his 2,500 British Pounds at the new rate, getting $3,280 back.
- Kobe’s profit would be $3,280 – $3,250, which is $30.
In the real world of forex, trades are leveraged. If Kobe decides to use a leverage of 1:10 for this trade, this means he would only need a tenth of the total cost of the trade ($2,500). Therefore the cost to Kobe would be 1/100 of $2,500, which is $250. So Kobe would only need to put down $250 in margin for the trade.
2. Profiting from a Decrease in Exchange Rates
A trader can also profit if exchange rates fall. To do this, the trader would have to sell or “go short” on the currency that the trader believes will weaken in value. Let us illustrate this using another trade by Kobe.
- This time, Kobe feels that the US Dollar will weaken relative to the Japanese Yen and decides to sell S13,000 for Japanese Yen at a rate of 100 Yen to 1 US Dollar. He gets 1.3 million Yen in this transaction.
- In 2 days, the exchange rate is now 98.20 Yen to the US Dollar. Kobe decides to use his Yen to re-acquire the US Dollar. He will get $13, 238 in return using this new exchange rate.
- Kobe’s profit will be $13, 238 – $13,000 = $238.
This is how money is made in the forex market. You can buy an undervalued currency and gain from it when it increases in value, or you can sell an overvalued currency and profit when you reacquire it at an undervalued price.
Practical forex trading on a forex platform will have to account for the following:
- A spread is paid to the broker for the currency pair being traded. Different currency pairs have different spreads.
- The trader will have to choose from various leverage provisions.
- The trader must use an appropriate trade volume, and this trade volume must conform to risk management principles.
Types of Forex Brokers
Two categories of forex brokers exist in the forex market.
a) Market Makers/Dealing Desk (DD) Brokers:
They operate the dealing desk model. This model generates prices and offers trade execution from the dealing desk department. This is where the bulk of retail forex trading is done. Market makers bridge the liquidity gap between retail traders and the interbank market. These brokers offer the popular MT4 and MT5 trading platforms, as well as other platforms that cater to the retail end of the market.
b) Non-Dealing Desk (NDD) Brokers:
This is the institutional-style brokerage model where pricing and execution of trades is handled by the liquidity providers in the interbank FX market. There is no dealing desk intervention. Liquidity needs mean that only traders with a lot of money to spare can open accounts with NDD brokers. These brokers offer complex trading platforms, most of which are proprietary in nature and have additional features that go beyond trading alone.
What You Need to Trade Forex
To trade forex, you need the following:
- Access to the virtual forex market. This is done using a trading platform provided by a broker. You must open an account and verify your identity and residence by submitting an international passport, or drivers’ license (certain countries only), as well as a utility bill/bank statement.
- You must have a funded trading account. You will need trading capital with which to provide margin to conduct your forex trades. This requires access to a payment method that is acceptable to your broker
- You must have some level of training to understand how to trade the forex market. Many brokers now offer introductory courses on forex trading for beginners.
- You must have an internet-connected trading station (computer, smartphone or tablet device) with which to buy and sell currencies on the trading platform.
How to Perform a Forex Trade
Let us assume that you want to buy the GBPUSD, after performing your analysis and you feel it will rise in value. How do you trade this on the most popular retail trading platform (MT4)?
- Click on “New Order”, or you press the F9 button on your computer. Alternatively, you can also right click on the chart of the currency pair you want to trade, and click on “New Order”.
- If you want to buy at market price, simply enter the parameters you want for your trade such as the lot size (i.e. volume), the Stop Loss, Take Profit, etc. For pending orders, change the Order Type to “Pending Order”, and select the type of pending order to be used.
- Click on the “Sell by Market” or “Buy by Market” tabs to execute the market orders, or click on “Place” to execute your pending orders.
In this example, a sell order has been placed. If the price of the GBP falls relative to the USD, a profit will be made. If the price rises relative to the market price and the stop loss is hit, the trade ends in a loss.
Forex trading is the buying and selling of currencies in order to generate a profit from the exchange rate differentials that occur between the currencies in question, as they are subjected to the vagaries of market forces. The number of forex pairs you will find on a trading platform differs from broker to broker. However, we can comfortably state that there are no less than 50 currency pairs in the forex market. Forex trades do not expire. They will remain open as long as you want, provided there is enough margin to maintain the running position, and provided your active trade does not hit your stop loss or take profit targets. The active trades will also roll over at the close of the trading day by 5pm EST. The MT4 platform is loaded with charts and all kinds of tools that are commonly used for technical analysis. Some MT4 brokers also offer their clients access to a technical analysis service from Trading Central. On EU/UK forex platforms, you can trade major forex pairs at a leverage of 1:30, and minor forex pairs at a leverage cap of 1:20. International brokers located outside the UK and EU provide forex leverage that can be as high as 1:500. The MT4 platform is suitably built for use with a forex Virtual Private Server (VPS). Some MT4 brokers also provide free access to a forex VPS for traders who have funded live accounts. All active positions will remain open and will be rolled over to the next trading day. You can use a forex robot to trade on brokers that offer the MT4 to their clients. Traders who operate STP and ECN accounts, investment banks, high net-worth investors, hedge funds and central banks, buy and sell currencies at the interbank market. This is also where the liquidity providers are found. Liquidity providers in the forex interbank market include:
Forex trading is the buying and selling of currencies in order to generate a profit from the exchange rate differentials that occur between the currencies in question, as they are subjected to the vagaries of market forces.
The number of forex pairs you will find on a trading platform differs from broker to broker. However, we can comfortably state that there are no less than 50 currency pairs in the forex market.
Forex trades do not expire. They will remain open as long as you want, provided there is enough margin to maintain the running position, and provided your active trade does not hit your stop loss or take profit targets. The active trades will also roll over at the close of the trading day by 5pm EST.
The MT4 platform is loaded with charts and all kinds of tools that are commonly used for technical analysis. Some MT4 brokers also offer their clients access to a technical analysis service from Trading Central.
On EU/UK forex platforms, you can trade major forex pairs at a leverage of 1:30, and minor forex pairs at a leverage cap of 1:20. International brokers located outside the UK and EU provide forex leverage that can be as high as 1:500.
The MT4 platform is suitably built for use with a forex Virtual Private Server (VPS). Some MT4 brokers also provide free access to a forex VPS for traders who have funded live accounts.
All active positions will remain open and will be rolled over to the next trading day.
You can use a forex robot to trade on brokers that offer the MT4 to their clients.
Traders who operate STP and ECN accounts, investment banks, high net-worth investors, hedge funds and central banks, buy and sell currencies at the interbank market. This is also where the liquidity providers are found.
Liquidity providers in the forex interbank market include: