What is Forex trading?
Forex is the short name for ‘foreign exchange’. It is a market about trading money. It is about measuring one money against another every other foreign currency. Forex trading is one of the largest financial markets in the world. Companies move capital across borders all the time, as do travellers, foreign workers, and governments. Billions of forex trading occur every 24 hours. There is a genuine need to exchange currencies.
Forex trading came about after the demise of Bretton Woods monetary system in early seventies. Before that, major currencies were based on gold. Now, most currencies fluctuate in value over time. Some drastically so. This is a characteristic of the fiat (ie, paper) monetary system. Once in a while, a central bank can even impose control on the value of its currency. The Swiss National Bank, for example, capped the value of the Swiss Franc in 2011 when the currency surged uncontrollably.
How does forex trading work?
Forex trading works by buying one currency against another and speculating on the price difference between the two. FX trading operates in all time zones five days a week; in all key financial centres like Tokyo, Singapore, Zurich, Frankfurt, London, New York. One exchange closes, the other opens.
Foreign exchange movements are relative. It is one value versus another, like a ratio. Most forex is priced relative to the US Dollar because of America’s outsized influence on world economy affairs, ie, the number of local currencies per US Dollar. When a FX rate is quoted without USD, it is called a ‘cross rate’.
In this video interview, we explain what forex trading is, how it works and the major risks and rewards.
Who are the best trading platforms to trade Forex with?
Forex is a 24-hour, 5-days a week market. Some brokers (like IG) even offer forex trading on th weekends. You can trade forex with CFDs futures, forwards, spread bets, or even exchange-traded funds (ETF). Because of this liquidity, there are forex trends that astute traders can exploit.
The best forex brokers are in the UK and are regulated by the FCA which means that they must adhere to a very strict set of rules when dealing with clients and marketing their services. All advertising must be balanced and fair. You’ll see lots of advertising from large brokers that offer forex trading through CFDs & Spread Betting. You can compare them here:
All of the above forex trading platforms only highlight their products – not how easy it is to make money. For whatever reasons you decide to trade Forex, “you pays your money, you takes your chance” – just make sure you use a regulated FOREX broker.
Different ways to trade forex
You can trade forex in a variety of ways. The most common being
Is forex trading profitable?
The connectivity of the internet has democratised forex trading.
The proliferation of advance trading software gives retail forex traders tools that only professionals had in the past. You can execute automatic trading strategies (algo) forex markets, where buying and selling orders can be set up automatically.
You can trade currencies both ways – buy and sell – easily and leverage is easily obtainable from brokers.
Hence, the forex market is well suited to tech-savvy, independent thinkers. Interestingly, returns from the forex market can be largely independent to that of the stock markets. This is because factors influencing forex returns are different to that of stocks or bonds. There are periods when exchange rates are trending while stocks prices are static. Multi-asset funds are thus eager for these returns from the forex market because it helps to lower overall volatility.
There are also forex strategies that exploit interest rate differential. Broadly speaking, you first borrow from currencies with lower interest rates and then buy currencies with higher interest rates. This is known as the ‘carry trade’. During 2003-2006 it was popular to borrow in Japanese Yen and buy Pound Sterling because interest rates were low in Japan and high in the UK.
What forex pairs to trade?
For beginners (or even intermediate) traders, you should focus on key forex pairs that are liquid. This is because liquid FX pairs generally have lower bid-ask spreads. Also, these forex pairs are floating (most of the time anyway) and are not controlled by the central banks. The top five forex denominations are:
- EUR-pairs (Euro was born on January 1, 1999)
This is followed by: CAD, AUD, SGD, CNY, MXN, among others. Countries with lots of commodity exports, such as Australia and Canada, are known as commodity currencies. The prices of commodities will impact their currencies to a certain degree.
Types of forex orders
There are two main type of entry orders.
Market orders are ones that you wish to enter straightaway (‘market’) or at certain levels (‘limit’) and there are advantages and disadvantages in each selection
- Market orders ensure you are in the market quickly but your entry price may be subject to the prevailing conditions when you buy into it.
- Limite orders may give you better entry prices, but you may not execute the order. Prices may have simply run away.
Risks of forex trading
Trading forex is a risky activity. Harbour no doubts about this.
|Pros of forex trading||Cons of Forex trading|
|👍Potential for quick profits||👎Risk of large losses|
|👍Forex market open 24/5||👎Hard to understand|
|👍Highly liquid market||👎Very volatile pricing|
The first risk is leverage. Many retail accounts lose over time because of the overly high leverage. Minute, random price movements decimate accounts equity quickly if traders are caught on the wrong side. Small losses piled up. This can lead to early termination of the account.
The second risk comes from sudden price moves.
For example, when the Swiss National Bank suddenly removed its cap in 2015 without prior warnings, it literally blew unrecoverable holes in many broker accounts because few traders expected the event. They were positioned in the wrong way – ie, the cap stays – and the removal of the cap led to huge moves in the opposite direction. Brexit was another such event.
Volatile price moves can lead to a dry-up in liquidity. Traders will experience in a huge increase in bid-ask spreads during these volatile periods, especially when brokers themselves are under stress.
The third risk comes from brokers. Choose your broker well. Inferior ones lead to higher spreads and commissions, which encroach returns and add transaction costs.
Occasionally, forex brokers can go bust, leaving customer accounts in limbo. Find you if your broker is regulated or not and if customers funds are segregated. Another risk comes from inappropriate trading strategies for the market.
For example, trend-following strategies may be suited for some forex pairs; while reversionary strategies for better in other pairs. You will need to backtest strategies and conduct some dummy trading to ensure that the strategy you choose is viable for that particular forex market.
Other classic trading mistakes include:
- overtrading the account,
- undercapitalised funding,
- a lack of basic risk control,
- inability to shift strategies over time.
Basic Forex Trading Strategy
Calling the market right is not actually that hard when trading forex. What is hard is to find forex trading strategies that can consistently increase your profits and limit your losses. Here are three forex trading strategies that should help:
Forex Market Timing
This is a form of technical analysis and a fairly well established forex trading strategy for ensuring that your entry and exit prices are well-timed.
Once you have found a trade that you like the application of market timing and a chartist’s view can help you gauge whether or not a price is overbought, oversold, in trend or due a reversion. Investors Intelligence, FuturesTechs, and Acuity Trading all have good packages to help with this.
Technicals are tricky to trade though on unless you have a good and experienced eye for the market. Trading currency based on economic events that are either priced into or not price into the market is a good option though. Although with this you are not really trading currency, you are trading economic events, but using FX to try and profit from yoru predictions.
Many traders enter into forex position correctly but fail to manage it appropriately once it is open. Discipline is a key factor in increasing profits and a lack of it is a massive contributor to excessive losses.
All traders should have a strategy of running profits and cutting losses.
If a trade is not going your way, close it out and look for the next opportunity. If you are showing a profit don’t be too eager to lock it in, a good trade can yield good spread betting profits. You can look to lock in some profits by using guaranteed stops and trailing stops offered by the top forex brokers as part of your risk mitigation strategy.
Economic figures and trading forex
Economic indicators as just as important for forex trading as they are for stock, index and commodities trading. For the simple reason that they move the market.
Before you enter any trade, part of your forex trading strategy should be to look for key upcoming economic data releases.
Most forex brokers provide a good economic diary on their website that shows who and what is reporting. The reason this should be part of your forex trading strategy is that if you enter a position based on technical and fundamental analysis then results or economic data are released it totally re-balances price.
It could result in an absolute change in direction and bear no relation to your entry strategy. Trading forex can be particularly tricky on the release of key economy data. Five set of economic figures you should watch out for include the following:
- GDP figures
- Unemployment rate
- Inflation figures
- Manufacturing/Services data
- Retail/Consumer spending
The key to trading forex around the release of these figures is the market’s reaction. If, say, the stock market reacted badly to a set of the GDP figures, it tells you something about the prior expectations. Too optimistic.
So you should definitely keep abreast of future economic data releases and plan accordingly. Note the market consensus. Read more on the top economic indicators to trade here
Technical analysis versus fundamental analysis for forex trading
Forex trading can be based on fundamentals or technical.
In general, the former use macro insights to produce buy and sell recommendations. The latter use prices only to determine entry and exit orders. Some may use both (hybrids).
Which is more effective?
It depends on two issues. The first one is, which system are you more compatible with? The second issue regards your ability to follow the method. Some traders eschew technical analysis because they believe technical analysis to be no better than random trading.
Meanwhile, many CTA funds have profited from using technical analysis methods exclusively. So the argument about which method is better is futile. The key is trader-strategy compatibility.
Managing risk when trading forex
When starting forex trading (or investing), the first rule to learn is that no one will be profitable 100% of the time. Even the greatest investor can’t achieve this feat.
What this means is that you will need to prepare for losses on a significant amount of the trades.
Losses can be separated into two types
- small recurring ones
- large devastating ones
To survive long term, you will need to avoid the latter totally.
Remember this rule of thumb: A 50% loss means the fund needs a 100% gain just to breakeven.
A 90% loss? You will need a 900% gain to return to the starting point! How often do you see this sort of gain?
How do you avoid large losses? One, do not bet too much on any single trade. Diversify into different pairs.
Second, ensure small losses do not swell into large losses. Stop it every time. How? Use stop losses.
Swallow one’s ego and take the loss when they are small. When a trade is going against your way, it could last for a long time. Getting out is the preferred method. Some forex trading platforms offer guaranteed stop losses where the trade will be taken off once prices move adversely against you.
On small – but consecutive – losses, either you break trading altogether or lower position sizes. Small repeated losses can be demoralising because they can last for some time. Predicting when the tide will turn for that particular strategy is hardly possible.
Alternatives to trading forex
- Index trading – a bit easier because it’s based on the fundamental values of the companies it consists of. Also slightly less volatile.
- Commodities trading – pegged to a single commodity like Gold or Oil. Still good news flow, but very volatile
- Stock Trading – basically taking a bet on a single company – loads to choose from and with a huge amount of research available. The stocks in the top indices are the less volatile with the best liquidity.
- Fixed income trading – trading interest rates within a fixed range
- Fixed income investing for income – buying bonds and gilts to receive income from coupons – low risk and relatively low reward. Unless you buy junk bonds well below par in which case the risk and reward increase significantly.
- Dividend investing – buying shares with high dividend yields to receive income from the dividends. A bit riskier than bond investing, but there is capital upside (and downside) to consider.
- Options trading – you can trade options on almost anything. If you are buying you pay your premium and that is your max loss on the option (can be more if you are delivered on). If you are selling loses are unlimited so watch out.
- Cryptocurrency trading – the highest risk of trading as cryptocurrencies are about as volatile as they come with a price purely dependent on investor demand.
Best time of day to trade Forex
Tthere are two times when the market is potentially most liquid for forex trading and certain times when you really shouldn’t be trading at all.
The two best times of day to trade Forex is the open and close – when everyone else is trading.
This is because the better the liquidity, the better orders are filled and there is some momentum and trend to the intra-day market.
The two best times are generally after the other financial (stock/commodity/fixed income) markets open in London and New York.
To a lesser extent, the markets are also more liquid around the close.
Throughout the rest of the day, the best forex brokers will always have good liquidity for traders. But you can compare the services of all the Forex spread betting brokers in the UK on our comparison tables.
Worst time to trade forex
The absolute worse time of day to trade Forex is just before economic figures like the ECB rate decision or the non-farm payrolls are announced.
The markets are always fairly illiquid some time before are forex traders flatten positions. Economic figures can seriously move the market with very thin volume.
If you are day trading the FX futures listed on the CME (you won’t through spread betting or CFDs) liquidity can be next to zero as bids and offers are pulled above and below the market. This will then be replicated in the prices quoted by the spread betting firms. After all the top spread betting firms tend to try and hedge all positions nowadays.
This means you can end up getting stopped out through your price with bad slippage (unless you are using a spread betting guaranteed stop). Economic figure releases also skew trends and make the market very unpredictable. If you are trading the forex market in the short term (intra-day) it makes more sense to stick to the most liquid pairs and market hours.
If you take a longer-term view there are always opportunities int he exotic forex pairs. Just beware the more exotic the wider the spreads.
Forex Trading FAQ:
Can you make money trading Forex?
Yes, you can make money trading Forex, but you can also lose a lot. If you are trading forex as your main source of income you need a large amount of money to begin with.
There is an old city joke: How do you make a small fortune trading Forex? Start with a large one…
The best forex brokers in the UK provide access to the most liquid and highly traded FX pairs because they are there. They’re not Everest, you don’t have to trade them just because they are there. Or think you can chuck in your nine-to-five job and try and become a professional trader because you’ve seen some flash git with a rented Lambo in a fake Instagram Forex trading lifestyle story.
The best forex traders, and by “best” I mean professional and institutional Forex traders that manage billion-dollar hedge funds, make money by having an effective day trading strategy based on significant post-execution trade management. In actuality, the top traders only really get it right about half the time – which are pretty poor odds considering that FX prices either go up or down on a scaled basis.
The best forex hedge funds in the world definitely won’t make 50% back for their investors per year, every year. But we’ll use that as an example anyway.
If you have £10k in the bank and want to trade Forex for a living and make a 50% return on your money you’ll earn the grand total of £5,000 per year. Which is £416 per month. The good news is that if that’s you’re only income then you won’t have to pay tax because you’ll be earning less than someone on benefits.
What if you had £100,000? Well then you would have worked very hard to save that much and it would be a shame to lose it all trading Forex. But if you insist, and you make a 50% return (let’s say you do it with a spread betting broker so you don’t have to pay tax on your profits) you can at best make £50k a year (or just over £4,000 a month). £4k a month is probably a lot less than you earned before if you managed to save £100k. And to be honest with you if you are making a 50% return trading Forex, then you are spending about 20 hours a day researching the markets and glued to the screens.
Not, as social media may have you believe, sitting by the pool or on a rooftop escaping the winter sun in Thailand.
Don’t be taken in by get-rich-quick schemes and run like the wind from any broker that advertises profits are easy. And don’t get scammed into trading with some bucket shop offshore broker run by a bunch of telesales staff.
Can you trade forex scalping?
Yes you can, but you need a forex trading platform that offers DMA, or hedges your orders. Read our guide to scalping here.
When should you trade Forex?
Quite frankly whenever you want. The market is there and it’s there to be traded, beaten, outperformed, hedged and enjoyed. If you fancy it, trade it. But go in with your eyes open. If you want to try and make some money why should the European regulator (ESMA) insist on scaring you with other peoples CFD trading losses? After all, maybe you’ll be part of the 20% that makes money.
Is getting it right half the time in Forex trading enough?
Just read Art of Execution, it’s a fantastic book by Lee Freeman-Shor who managed around $2bn at Old Mutual. Over 7 years he gave 45 of the world’s top investors between $25m and $150m to invest in their best ideas. Turns out that most of these ideas were wrong.
But and this is a big BUT. Even though most of their trading ideas lost money, overall the investors made a profit. How so? Well, read the book, you’ll thank me for it. It’s only 200 pages. We also covered this when we wrote about how to find out what the hedge funds are shorting.
Simon Savage was quoted in the FT say that a GLG manager with a 50% success rate is considered a good stock picker. True the above two examples are about stock trading, but it translates to all trading. The way professional currency traders make money is by having an effective Forex trading strategy. This strategy is basically run your profits and cut your loses – the only way to trade.
Can you give up your day job to trade forex?
No, you cannot. Foreign exchange is one of the riskiest markets in the world to speculate on.
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