What is Forex?
The foreign exchange market or “forex market” is where foreign currencies are exchanged for one another. Forex is the largest financial market in the world with the most liquidity. The forex market is traded 24/5 and has over $6 trillion daily turnovers, dwarfing stock market exchanges such as the NYSE that have $22.4 billion daily turnovers. The rate at which each currency pair is exchanged is called the “exchange rate”. The exchange rate is a market-determined rate and therefore changes based on the forces of supply and demand, the largest factors of this being by international trade, investment, and speculation. Forex trading involves forex traders speculating on how these rates will change and attempting to make a profit from their movements by buying the currency you believe will appreciate and selling the one you believe will depreciate.
For example, let’s take the major currency pair of Euros and US dollars. The symbol representing this exchange rate is EUR/USD (the first currency in this currency pair is EUR and is known as the “base currency”; the second currency: USD is known as the “quote currency”). The exchange rate might be quoted as something like 1.1813. This exchange rate means that 1 euro can be exchanged for 1.18134 US dollars.
Usually, forex market fluctuations are calculated in “pips” (Percentage In Point). One pip is equal to one one-hundredth of a percent, or the fourth decimal place in an exchange rate in the case of EUR/USD: 0.0001.
Let’s say you believe the euro will increase in value relative to the US dollar, you would buy euros in exchange for US dollars. If correct and the Euro increased in value relative to the US dollar, and now the exchange rate is at 1.20134 (an increase of 200 pips) and you exchange your Euros back into euros you would have made a profit. How much you would have made would depend on how many US dollars and euros you bought. If you only bought one euro, then your profit would have been 2 US cents, but if you bought 100,000 euros, your profit would be $2,000 US dollars. Conversely, if the exchange rate had moved in the opposite direction to 1.16134 then you would have lost 2 US cents (if you had bought one euro) or $2,000 (if you had bought 100,000 euros). This example illustrates how you can make or lose money trading forex.
How can I trade forex?
Unless you’re a large bank or institutional investor, you won’t be able to directly participate in the market, moving around the underlying currencies. This is where your forex broker comes in. They allow retail investors to trade derivatives contracts, known as contracts for difference (CFDs) which are derived from the exchange rates of the underlying currencies. This allows retail traders to either speculate or hedge positions within the Forex market. You can enter an over-the-counter derivative contract with your forex broker, essentially a contract exchanging the difference in the value of underlying security between trader and broker.
It’s also important to note that these derivatives are usually leveraged, meaning you can open much larger positions than the amount you have deposited in your account. For example, if your broker offers 30:1 leverage you only require 3.33% of the capital required to open a given position. To buy 3,000 euros for USD at 1.20134 you would require 120.134 USD in your account rather than 3604.02. This makes it easier to gain the necessary exposure. However, this also magnifies your losses which could be significant if you face volatility.
Always remember to only trade money you’re willing to lose.
You’ll also need a trading platform, a place that streams real-time prices—the bid and ask prices—for you to trade on. The ask price is the price that you can buy a base currency for and the bid price is the price that you can sell the base currency for. The most popular trading platform for forex is MT4, or MetaTrader 4, along with MT5, or MetaTrader 5. Most retail forex brokers offer these platforms.
How can I make money trading forex?
As a forex trader, you make money by predicting the price movements of various exchange rates. Obviously no one can predict the future, and if the markets move against you then you can make losses. This means practicing good risk management is essential. To help predict the movements of prices involves developing your own forex trading strategy. Most trading strategies are based on one or more of three main types of analysis: fundamental analysis, technical analysis, and sentiment analysis.
Technical analysis is the process of analyzing historical price data on a chart to come to conclusions about where the price is likely to go. Fundamental analysis involves using economic data and reports, such as interest rates, inflation, trade between countries, etc., to understand the factors affecting the exchange rate and where the exchange rate might go as a result. Sentiment analysis is the process of figuring out how the speculative market “feels” about the exchange rate. If sentiment analysis concludes that most traders are feeling bullish about GBP/USD then that might be a buy signal for a sentiment analyst. Keep in mind, none of these three ways of analyzing the market are “better” than the other, nor are they mutually exclusive. We recommend testing your trading strategy using a demo account using simulated funds until you are confident your strategy is consistently profitable before you fund a live account with real money.
How can I avoid losing money trading forex?
Risk management is an important part of trading in any market, but it is especially true in the currency market where the most successful traders are masters of managing their risk. One of the simplest tools forex traders have to manage their risks are protective stop-loss orders and take-profit orders, where a position is automatically closed when the pricing of the asset hits a predetermined level. Forex traders usually place their stop-loss and take-profit orders based on the risk-reward ratio that they expect from a trade based on their own analysis. For example, if the AUD/USD exchange rate is at 0.73731 and a trader believes it will increase by 10 pips, at a 1:2 risk-reward ratio, you would open a trade putting your take-profit at 0.73831 (10 pips above the market price), and your stop-loss at 0.73681 (5 pips below market price).
Another important risk-management tool is understanding the amount of money that you want to put on each trade or your “lot size”. For currency pairs 1 lot = 100,000 units of currency. e.g. opening a EUR/USD trade of 1 standard lot would be buying 100,000 Euros. Obviously, the amount of money you put on each trade will depend on your account size and risk appetite. Generally, around 2% of your account per trade is a relatively standard amount of risk per trade, but you may want to increase or decrease this amount based on your risk appetite.
Currency trading is a risky and complicated practice and you must always be learning throughout your forex trading journey. However, it is certainly possible to be a profitable and successful trader with the right amount of commitment and perseverance.