What is Forex Trading?

If you’ve just asked what is forex trading read on for our guide to understanding 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.  For example, pound sterling versus the US Dollar.

The first thing to know about forex market is that it never sleeps. 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.

The second thing when wanting to discover what is forex trading is to know is that forex 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.

The third thing you should understand is that forex trading only came about after the demise of Bretton Woods monetary system in early seventies. Before that, major currencies are 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.

The last thing you need to note is that 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’.

Best Brokers For Trading Forex

Forex is a 24-hour, 5-days a week market. Prices never stop blinking. You can trade forex with CFDs futures, forwards, spread bets, or even exchange-traded funds (ETF). Because of this liquidity, there are forex trends which astute traders can exploit.

Read more about these top Forex brokers:

Or compare all brokers for Forex trading with  our comparison tables 

3 Reasons why you may consider buying and selling forex

The connectivity of the internet has democratised forex trading. The proliferation of advance trading software give you tools that only professionals had in the past. You can execute algo trading in forex markets, where buying and selling orders can be set up automatically. You can trade currencies both ways – buy and sell – easily. Leverage is easily obtainable from brokers. Hence, 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 may be 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.

Lastly, there are 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 (three letters of :

  • USD-pairs
  • EUR-pairs (Euro was born on January 1, 1999)
  • GBP-pairs
  • JPY-pairs
  • CHF-pairs

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

Broadly speaking, there are two main type of entry orders. One that you wish to enter straightaway (‘market’) or at certain levels (‘limit’).

There are advantages and disadvantages in each selection. The former ensures you are in the market quickly but your entry price may be subject to the prevailing conditions when you buy into it. The latter may give you better entry prices, but you may not execute the order. Prices may have simply run away.

What are the risks of trading forex

Trading forex is a risky activity. Harbour no doubts about this.

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, and the inability to shift strategies over time.

Trading forex around economic figures

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 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

Should you use technical analysis or fundamental analysis for forex trading

Forex trading can be based fundamentals or technicals. What’s the difference?

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 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.

Read more on technical analysis versus fundamental analysis here

Three tips on managing risk when trading forex

When embarking on trading activities (or investments), 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. The first is small recurring ones. The second is 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. Get out is the preferred method.

For some spread betting firms, there is a 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.

Read more on Forex trading strategies here

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