What is Forex? A comprehensive guide for beginners
09 Aug 2018
Table of contents
What is Forex?
How does Forex trading work?
Why is FOREX the best investment option out there?
What does "spread" mean?
What is a pip?
What is leverage?
What are CFDs?
Bulls and bears: Long positions vs. Short positions
How do I get into FOREX trading?
The term "Forex" — also known more commonly as foreign currency trading, currency exchange or by its acronym "FX" — refers to Foreign Exchange or to transactions between currencies. Today, it is considered to be the most important exchange market in the world with over $5 trillion traded every single day. The combined volumes of all the stock markets in the world do not even come close to this figure. But, what does that mean to you? Well, if you take a closer look at the currency market, you're sure to come across some intriguing trading opportunities that you won't find with other investments.
Now, everyone will have experienced this kind of trading at some time or another, the obvious example being when they travel to another country and exchange their currency for the local one. Simple, right? That's the basic principle of Forex investments.
As for the price of each currency, that varies depending on its demand in relation to other currencies. In other words: the more in demand a given currency is, the higher its price will be and vice versa.
If you're still wondering exactly what Forex is, let's just say that it's basically a decentralised marketplace where you can trade all the major world currencies. It encompasses a wide range of different market actors, from the world's largest financial institutions dealing in big money transactions all the way to ordinary people converting a few dollars here and there. But they all have the same end goal — they either want to buy a currency and then sell it for more than they paid, or else sell a currency and then buy it back for less money.
To join the ranks of those already trading on the Grand Bazaar of exchange markets that is Forex, all you need is a computer, an internet connection and a trading account to complete your transactions. Yes, it really is that quick and easy!
How does Forex Trading work?
The basic aim of FX or Forex Trading is to make a profit by exchanging one currency for another at a favourable rate.
As touched on above, trading in this market means exchanging one currency for another. This being the case, all exchanges are described in pairs. As such, you are always able to see the price of the currency you wish to sell in relation to the one you are planning to buy. Let's suppose you want to buy one euro (EUR) using US dollars (USD), then you only need to check the EUR/USD price to see the current rate of exchange.
Before you go any further, make sure you know all the abbreviations and symbols for the currencies you will be trading. Earlier we talked about the euro and US dollar — whose respective abbreviations are EUR and USD — but these are not the only currencies available. We also have the British pound (GBP), the Canadian dollar (CAD), the Swiss franc (CHF), the Japanese yen (JPY), the Australian dollar (AUD) and the New Zealand dollar (NZD).
When we've learnt those, we begin to understand the currency pairs (EUR/USD, GBP/USD or any other), each of which has a unique price on the market. The price is determined on the basis of the amount of the second currency required to buy one unit of the first.
For instance, when you see EUR/USD = 1.4500, it means that with 1.45 USD you can buy 1 EUR. Therefore, if you want to buy 1,000 EUR, you will have to pay 1,450 USD. And that, in a nutshell, is how Forex works.
If we take a look at the currency comparison graphs, we see that the first currency is always the one that regulates the pair's movements. That is to say that, when a graph shows the euro rise, this means that the euro is listing higher than the US dollar. Conversely, when the price on the graph drops, it means that the euro is falling against the US dollar. The same applies to all other currency pairs!
The process is very similar when it comes to selling currency, too. It is highly likely that the price will have changed by the time you decide to sell. For example, it is entirely possible that when you come to sell the EUR 1,000 that you bought earlier, the exchange rate between the two currencies (EUR/USD) will have changed and might now stand at 1.5500. On selling, therefore, you will get USD 1,550 instead of the 1,450 you would have received at the previous price, meaning you have made a profit of $100.
By the same token, you can also lose money trading on the FOREX market. If at the time you decide to sell your €1,000, the EUR/USD exchange rate has fallen to 1.3500, then you would receive just $1,350. Since you had $1,450 to begin with, this would mean you made a loss of $100.
Why is FOREX the best investment option?
Foreign currency trading, or simply Forex as it's often called, is one of the most popular activities among investors today. More and more people are showing an interest in currency trading. Their reasons are numerous and varied, though many of them see it as a good source of trading income for the future. With the right strategy, people can definitely profit from this unique method of trading.
FOREX has a variety of benefits that are helping it to expand the online trading market:
- Greater liquidity
It is the most liquid market in the world with a trading volume in excess of $5 trillion. This means you can open and close positions more easily than in other less liquid markets.
- Low volatility
In the FOREX market, there are fewer variables affecting the price difference between two currencies. It is also far more predictable compared to other assets such as stocks, for example.
- Greater leverage
Leverage and volatility are closely linked. Since foreign exchange is a low volatility market, leverage will always be higher when trading with FOREX.
- Constant price updates
You are able to check prices in real time 24 hours a day, 5 days a week.
- It is decentralized
As a market founded on decentralization, it is much more accessible and this, in turn, enables trading volumes to expand further and further.
What does "spread" mean?
You have surely heard the word "spread" used endlessly in relation to the financial markets, but do you know its exact meaning?
Well, in most financial markets, you have three prices: the market price, the buy price and the sell price.
The word spread is used to refer to the difference between the supply (or sell) and demand (or buy) prices and is used for all shares and stock market derivatives.
In short, the spread is the difference between the sell price and the buy price.
In the chart margin, you can see the price for which you can buy the first currency and then compare it with the second currency.
Say the EUR/USD sell price is 1.300, if you want to buy €1, you should pay $1.30. Therefore, it would be advisable to make the purchase if you believe that the EUR will rise against the US dollar. In other words: you should buy only if you think you can sell your €1 for an amount greater than the $1.30 you paid for it.
In the event that you wish to sell, the chart will show you the price at which you can sell the first currency for the second.
If the EUR/USD sell price stands at 1.300, you could sell €1 at that price. However, it is only advisable to sell if you think that the price of the EUR will fall against the US dollar. Because then you could buy the same euro for less than the $1.30 you paid when you opened the position.
What is a pip?
A pip — short for point in percentage — is a very small measure of change in a currency pair traded on the foreign exchange market. It can be expressed either in terms of the quoted price or in terms of the underlying currency. A pip is a standardized unit and is the smallest amount by which a currency's quoted price can change.
If you see that the price of the EUR/USD pair has increased from 1.3600 to 1.3650, you can describe this as a rise of 50 pips. Therefore, if you bought at 1.36 and then you sell at 1.3650, your profit would be 50 pips. Of course, this is just meant to serve as an example.
The actual profit you receive will depend on the amount of currency you have purchased. For instance, if you bought micro lots (1,000 units) and trade with an account denominated in US dollars, the pip value will be $0.1. Thus, if your profit was 50 pips, this means you made $5. In the event you bought mini lots (one unit of 10,000), the pip value will increase to $1, making your profit $50. Similarly, when you purchase a standard lot (100,000 units), the pip value rises to $10, which translates to a profit of $500.
The same pip value will apply to all pairs where the US dollar appears in the second position. If it is listed as the first currency, though, the pip value will be different. To calculate this new pip value, you must divide the normal pip value by the current exchange rate. For example, if your currency pair is USD/CHF, you must divide $0.10 (micro lot value) by 0.9435 (the current exchange rate for CHF) to get $0.1060 (new pip value). If JPY is part of your pair, as in USD/JPY, you must follow the same steps and then multiply your result by 100 at the end.
What is leverage?
Leverage essentially means using something small to control something bigger. In the specific case of currency trading, it means having a small amount of capital in your account that you use to control a larger amount elsewhere in the market.
If, for instance, FOREX offers you a leverage of 1:100, it means that you can trade with 100 times more money than the amount of your initial deposit. That means that, if you want to invest in 100,000 EUR/USD, you now only need €1,000. However, these kinds of trades come with much higher risk... Let's suppose you're using a leverage of 1:100: your losses could then be multiplied by a factor of 100. So only go for it if you are completely sure.
Advantages of leverage:
- Increase profits
The first and probably the most important benefit of trading with leverage is that it allows you to earn more money with less effort. Whatever it is you're trading and however much of it, the main purpose of leverage is to increase your per-trade profits.
- Increase capital efficiency
It follows that by increasing the amount of money you can earn per trade, you will naturally increase your capital efficiency, too. To understand the whole technical process better, consider your capital as an asset with the potential to offer a return.
Look at it this way: if it takes two days to generate £100 with unleveraged positions, leverage would mean that it takes a much shorter period of time to earn the same £100. This means your capital can be reinvested more and thus bring you more frequent profits.
- Mitigate low volatility
Another key advantage of leverage, especially when it comes to currency trading, is that it has the effect of mitigating low volatility. It is usually volatile exchanges that generate the highest profits. That's because these markets are moving in wider cycles than more stable instruments.
Take care when using leverage in Forex! Leverage can help you amplify your earnings, but it can also lose you a lot of money. Use it responsibly.
What are CFDs?
CFD trading is a popular form of derivatives trading. CFD trading allows you to speculate on the rises and falls of fast-moving financial markets (or instruments), such as stocks, indices, commodities, currencies and other liquid assets.
Trading with CFDs in currency pairs allows you to trade in two ways. The first involves waiting for the base currency of the pair to move higher; while the second one requires you to buy immediately if you expect the price to fall.
- With the first option, you start by buying CFDs in the pair you want. In this case, your profit comes from the increase in the value of the pair as of the moment you buy the CFD up until you decide to close the position.
- If you select the second option, you are looking to sell CFDs in your pair. In this case, your profit is derived from the decrease in the value of the pair.
Advantages of CFDs:
- Liquidity: CFD prices are a direct reflection of what is happening in the underlying market. This means that CFDs provide access to liquidity in the wider market, in addition to the liquidity offered by the broker.
- The ability to work in different financial markets from one account: many brokers dealing with these instruments offer CFDs based on shares from different markets around the world, as well as other types of financial instruments such as gold, silver, oil, stock indexes, sectors, commodities, government bonds, currencies, etc. This gives traders the opportunity to diversify their trading and investments by maintaining a wider portfolio of options.
- Ability to work at any time: many brokers offer their clients extended hours, which means they can work with certain instruments or markets such as the FTSE and Dow, even after the underlying market has closed for the day.
- Traders can work for as long as they like: CFDs do not have a fixed maturity date.
- There is no set contract size. Traders can work with volumes of any size.
- CFDs are less complicated than options and guarantees: the direct price and liquidity of any given CFD are reflected in the underlying market.
Contracts for Difference (CFDs), are part of a group of derivative financial products which permit the use of leverage. This means that you can trade more money than you actually have, which increases your profit potential, but also amplifies your possible losses. For this reason, traders should have some previous experience of using leverage before trying it with CFDs as profits or losses could considerably exceed the amount invested.
Bulls and bears: Long positions vs short positions
The terms "bull" and "bear" are used to identify the two types of investors we encounter in the exchange market.
Bulls are unsurprisingly found most commonly in bull markets. This type of investor is optimistic and expects the price to rise and so prefers long positions as a way of making money. Therefore, in the context of FOREX, a long position is opened when the investor buys a pair of currencies and waits for the price to rise.
Bears, on the other hand usually reside in bear markets, where investors are pessimistic and expect prices to fall, thus electing to open short positions. With respect to the specific case of FOREX, a short position is opened when the investor sells a pair of currencies hoping for its price to fall.
How do I start trading FOREX?
For the best results from Forex trading (Exchange Market), first make sure you follow these core principles:
Select the currency pairs you will be trading. For FOREX newcomers, we recommend currency pairs with high trading volumes. As a general rule, these will typically include the currencies of the world's biggest economies, such as the United States, European Union, United Kingdom, Japan or Switzerland.
Know all upcoming economic events likely to affect your pairs. Currencies can be influenced by things like releases of macroeconomic data on major global economies and economic decisions made by their issuing Central Banks. Knowing about these kinds of developments can tell you a lot about the strength or weakness of your currencies.
Set yourself a trading schedule. The best hours for trading are those during which volumes are at their highest. These typically coincide with the open and close of trade on the biggest foreign currency exchanges, e.g. New York, London and Tokyo.
Use technical analysis tools. If you want to make money trading FOREX, you simply must make use of technical analysis. This type of analysis involves using charts to study price trends.
Use leverage effectively. Knowing how to use leverage will help you to minimise your losses wherever possible. You need to set a "stop loss" or level of manageable loss for each trade. That way, you can avoid greater losses by closing a position that did not go as expected.
If you have made it this far, then you must have been able to grasp all the concepts explained in this article. These concepts will help you to understand graphs and how to track the appreciation or depreciation of your selected trading currency, so you can detect potentially profitable investment opportunities.
The next step is to create your own free FOREX demo account. Once you have such an account, you can practice choosing currency pairs and buying them if you think they will increase in value.
Then you will gradually acquire new strategies that will prepare you to start trading with real money. Eventually, these will help you become a prolific trader in one of the best positioned exchange markets in the world.
We recommend that you to consult our free lessons before you start trading with real money.
Remember: practice makes perfect... Start earning money with FOREX today!
Why should I trade with Libertex?
Libertex is an international brand with twenty years of experience in financial markets and online trading. Since 1997, Libertex has been helping investors trade stocks, currencies, indices, commodities, gold, oil, gas and other various financial instruments as effectively as possible. Libertex provides first class service to more than 2,200,000 clients across Latin America, Europe and Asia. Libertex's offering includes more than 150 different trade instruments. Libertex was named "Best Trading Application in the Eurasia Economic Union 2016" by the prestigious Global Banking & Finance Review, a leading online financial publication.
Libertex offers all its affiliates:
- Free demo account access
- 24/5 technical support
- Leverage up to 1:500
- Trading on any device from just one platform: Libertex or Metatrader 4/5
- No commission on withdrawals within Latin America