What is Forex? A comprehensive guide for beginners
The term "Forex" — also known 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 decentralized 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 aim of Forex trading is to profit from changes in the value of one currency relative to another. You can make a profit by buying a currency and then selling it at a higher price, or by first selling it and then buying it back at a lower price.
To understand how this works in practice you need to understand what exactly a currency pair is. Currencies are priced relative to other currencies. If you buy Euros (EUR) the price you pay will depend whether you are exchanging US Dollars (USD), British Pounds (GBP) or another currency for those Euros.
A currency pair consists of a base currency and a counter or reference currency. The base currency is the first currency in the quote, and the counter currency is the second. The counter currency is the reference currency in which the base currency is being quoted.
Let’s take an example of the EUR/USD being quoted at 1.1017-1.1019. In this example, the EURO is the base currency and the USD is the reference currency. The Euro price is being quoted in USD. So, you would pay 1.1019 USD, to buy 1 Euro. If you wanted to sell 1 Euro, you would receive 1.1017 USD.
For most pairs, the most liquid currency is usually quoted first. However, when the USD is paired with the British Pound, Euro, New Zealand Dollar, or Australian Dollar, the USD is quoted second.
If the base currency is a foreign currency, the quote is known as a direct quote. If the base currency is the domestic currency, the quote is known as an indirect quote.
Currency pairs are divided into three categories:
- The most widely traded currency pairs in the world are known as the majors. They include the EUR/USD, USD/JPY, GBP/USD, AUD/USD, USD/CHF, NZD/USD and USD/CAD. You will notice that these pairs all include the USD.
- Currency pairs that include two of the currencies listed above, but not the USD, are known as minor currency pairs. These pairs are also known as cross currency pairs or crosses. Examples include EUR/GBP, AUD/JPY and GBP/CAD.
- Exotic currency pairs include one major currency and one other. The second currency is usually the currency of a developing nation like Turkey, Thailand or South Africa. However exotic currencies also include those of quite developed nations like Singapore and Hong Kong.
An important aspect of Forex trading is liquidity. If two countries have a healthy trading relationship, the currency pair with their two respective currencies should be very liquid. On the other hand, a currency pair that includes the currencies of two countries that don’t have trading relationships may be illiquid.
The major and minor currency pairs are the most popular to trade due to high liquidity levels. These pairs can be traded on any time frame as the spread is narrow. Exotic pairs can be traded but require larger price movements to cover trading costs. This means you will need high levels of volatility, or a longer time frame.
Types of Forex trading strategies
There are several approaches to analyzing and trading currencies:
- Fundamental analysis considers the difference between the economies of two countries and how that may affect the relative strength of each currency. This includes interest rates, money supply and trade balances.
- Technical analysis considers the price action of the pair. Price patterns, indicators and support and resistance levels are used to identify profitable trading opportunities.
- Traders also use news, market sentiment and algorithms to identify potential trading opportunities.
- Scalping strategies take advantage of short-term price movement that may last seconds or minutes to generate profits.
- Day traders use technical analysis to identify trades to hold minutes to hours. They close all positions at the end of the day.
- Swing traders hold positions for a few days to take advantage of larger price swings.
- Position traders and trend flowers hold positions for as long as few years. They follow major trends, or trade price patterns.
Lot sizes and how to calculate position size
One of the more confusing aspects of Forex trading is calculating the size of a position. The size of a position, which is the size of its exposure to the market, depends on the traded price, the lot size, and the number of lots.
So, what is a lot? A lot is the standardized trade size for Forex. One lot is 100,000 units of the base currency. So, if you buy 1 lot of EUR/USD at 1.1019, you are buying 100,000 Euros and you will be paying $ 110,190.
You probably noticed that if you are trading a lot size like that your minimum trade size would be quite large. Fortunately, you can also trade smaller lots:
- Mini lots are 10,000 units of the base currency
- Micro lots are 1,000 units of the base currency
- Nano lots are 100 units of the base currency.
How to learn to trade Forex
Any type of trading requires ongoing learning. It’s not like becoming a doctor where you first learn and then do. In the case of trading you need to simultaneously learn and practice what you learn.
You can start out with a demo account (which you can do for free with Libertex) but your learning curve will speed up when you have ‘skin in the game.’ Some of the most important lessons to learn concern the way you react when you make money and when you lose money. So, it’s a good idea to graduate to a live account as soon as you feel confident trading with a demo account.
To improve your knowledge, you should read books on trading, technical analysis and technical analysis. For Forex traders its worth learning about economics and monetary policy too, as this is what drives the value of a currency. There are also lots of very good videos and blogs on these topics available on the internet for free.
Finally, you should keep a journal, set goals and track your progress. The more systematic you are about the process of learning the more efficient your learning curve will be.
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.
Disadvantages and risks of Forex trading
Like any trading activity, Forex trading does come with some risks and drawbacks.
- Market risks
All trading instruments are subject to a range of market risks. Political, economic, and geo-political factors can contribute to increased volatility, which can make trading challenging.
- Potential for large losses
The use of leverage and margin can be used to increase profits but can also magnify losses. Forex traders must use leverage with caution, and make sure they are aware of the potential loss on each trade.
- Weekend Gaps
Because currency markets trade 24 hours a day, Forex traders do not have to worry about the overnight gaps that occur in other markets. However, Forex markets are closed over weekends, which can result I price gaps. Forex traders should be cautious when holding positions over a weekend.
Some currencies can go through extended periods with low liquidity. This can result in wider spreads and greater volatility. Even liquid currencies can become illiquid at certain periods of a trading session.
- Counterparty risks
Forex is not traded on centralised exchanges like equities and other instruments. This means there is less oversight of the way trading occurs, and traders may not be protected if a broker becomes insolvent.
- Regulatory risks
Forex brokers are regulated by several regulatory bodies which depend on the country where the broker is domiciled. Traders should always ensure their broker is certified by a reputable regulator.
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 open long or short positions. A long position means you are buying the base currency, and you are effectively short of the reference currency. The price will rise if the base currency strengthens or if the counter currency weakens. You will profit if you close the position at a higher price.
If you open a short position, you are selling the base currency and buying the reference currency. The price will fall if the base currency weakens, or if the counter currency strengthens. You make a profit by closing the position at a lower price.
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.
Frequently Asked Questions
What does Forex mean?
Forex is short for ‘Foreign Exchange’ and involves the trading of any currency for another currency.
What is Forex and how does it work?
The terms Forex, Forex trading and currency trading, refer to the trading of currencies. Forex is not traded on and exchange like shares, but on the ‘over the counter (OTC) markets.’ This means currency transactions take place directly between banks and other institutions. Forex traders can access the Forex market via platforms provided by brokers.
How much do you need to start trading Forex?
You can start live trading with Libertex with as little as $10. You can also open a demo account for free to learn more about Forex trading.
Can I trade Forex with S100?
Yes, absolutely. To generate an income, you will need a larger account, but the sooner you begin learning how to trade the better.
What is the difference between Forex and CFDs?
Forex includes currencies only, while CFDs (contracts for difference) include other asset classes like shares and commodities, as well as currencies. So, you can trade Forex directly, or you can trade CFDs on Forex pairs.
How can I learn Forex?
There are lots of free tutorials and videos online. A good place to start is the freeLibertex beginners trading course.
Is Forex trading easy?
Forex trading is easy, but profitable Forex trading requires time and effort. To be successful you need to find the style of trading that works for you and develop your own approach to trading.
Why do Forex traders fail?
Most Forex traders fail when they try to be an overnight success and they don’t manage their risk properly. Success requires patience, discipline, and hard work.
Is Forex trading a scam?
No, the Forex market is legitimate and is in fact the largest financial market in the world. There are however Forex brokers and trading schemes that are scams. They can be avoided by making sure anyone you deal with is regulated.
Is Forex trading illegal?
No, Forex trading is legal in nearly every country. Each country has different regulations regarding broker regulation and the amount of leverage available to retail clients. CFD trading is illegal in the US, which means CFDs on Forex are not available to US citizens. However, Forex trading itself is legal in the US.
How safe is Forex Trading?
All trading entails risk. The amount you can lose depends on your own risk management and discipline. That said, trading with unregulated brokers is not safe regardless of your risk management process.
How is Forex taxed?
The way Forex trading is taxed varies from country to country. In most cases profits on Forex trading are subject to capital gains tax.