What is Forex Trading? Read Our Free Guide To 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 that 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

Watch our video interview with Ryan O’Doherty, Head of Product Development at CMC Markets to find out more about forex trading

Today, we’re going to talk about forex brokers and forex trading. We’re here with Ryan O’Dougherty from CMC Markets. Ryan, welcome, thanks for joining us.

No problem.

So you’ve been with CMC for six or seven years now, is that?

No, 13 years now.

13 years. Alright, well I have not done my research there.

It’s been a while.

So at CMC, you’re a forex broker; you can trade forex through spread betting and CFDs. Do you want to quickly talk us through exactly what a forex broker does?

It’s a very exciting market, the FX market. It’s the most liquid market in the world. There’s almost, you know, US $5 trillion transacted on a daily basis. It’s quite a different market than some others. It’s off exchange, so it’s an OTC market that’s run through the interbank market, so the major banks, so the ones that are actually playing and creating this market and prices. But from a CFD and spread bet perspective, in trading in FX, you know, because of its liquidity and because of its size and its 24-hour nature, it’s a really exciting market for trying to play because the spreads are lower. You’ve also got a lot more opportunity. So it’s quite volatile, or it can be, and we’ll talk about how that volatility plays out through fundamental events and everything like that. So it’s really the buying and selling of currencies. You know, let’s say the pound versus US dollar, you think the pound is going to strengthen, the economy, let’s say in the UK, is going up, you can buy the pound versus US dollar and then profit from that movement going up.

And of all the customers you have, obviously, CMC’s a London-based broker, but you have offices all over the world, what does your sort of typical client look like? You know, is there a standard client or do you deal with everyone?

I would love to say yes but really, I mean after all the different events and all the clients that you speak you over the period, they all are very different. They’ve all got different levels of experience. Some clients are just getting into the markets, especially with new digital banking methods these days and being exposed to digital transfers for currencies, when clients are holidaying, people are more interested in the FX markets and how they change, and Brexit’s been one of those tools as well. You know, you’ve seen the pound drop significantly. So you get a lot of new-wave traders coming in that are learning about FX markets, because it has got that volatility, you know, there’s opportunity for them to make money based on that. But then you get a lot of the more experienced, so traders that have been trading out there for a long time, that are used to what the FX markets are doing, they feel very comfortable. But you know, trading through CFD and spread betting gives them the opportunity to set up their different order types and have that flexibility.

So of those two different types of traders, you’ve obviously got the short-term technical traders and you’ve got the slightly longer-term, event-driven, fundamental traders. Do you see a significant difference between the two or do they tend to overlap?

No, you do. It’s interesting to watch the way that people go about trading. So you will get a lot of people, and because FX trading can be very technical, there are key levels that are in the marketing, you can see them trending quite significantly.

Do you think they’re self-fulfilling prophecies?

I think there’s an element of both. I think there is a bit of self-fulfilling, because if you see a key level, then you know, if you’ve been in the market for a while and you think well actually, where do I take my profit, then a key resistance level is actually a great opportunity to cut some of the losses, see what happens afterwards. If it drops down, great, you can get back in, or if it goes above, then we might see more momentum going up, and then you can buy back in that way. So technical trading is a bit of a self- fulfilling prophecy. However, it’s something that a lot of traders are looking at. So it’s important to be aware of those key levels.

So you do have those technical traders, but you also have people that have been trading it for quite some time that are really familiar with the fundamental, and I find the fundamentals an extremely important part of FX trading. The economic calendar’s the perfect example. You get all these events being populated on a daily basis, so you get your CPI figures, your GDP, your non-fund payrolls. All signals of the health of an economy. And basically, FX trading or FX currency pairs and their value is a way of showing you how the economy’s going. So the UK economy’s going well, then you would expect the pound to be going up in value. Not always, but you know, generally, that’s the…

And you have those short-term economic figures, which tend to move the market in the short term, and then you have those sort of, you know, fantastic political events.

Somebody sending out a tweet. And you know, that’s a really good point, because you can be as fundamental as you like and then follow all of the events that are scheduled, and that does help you analyse the markets and figure out whether or not there might a long term. But then there’s all these sort of short-term, especially in the age of Twitter and news being sent to people very, very quickly, you’ll see the markets react to those quite rapidly. And that’s why it’s important, especially when trading FX, which is a margin product, to make sure that you’ve got your sort of risk management orders on, because these moves can happen at any time. You know, you’re not sure of when it’s going to happen. So make sure you put the risk management orders on.

So actually, you’ve just touched on the economic calendar there, which you have on your trading platform. Do you just want to quickly take us through, you know, what a foreign exchange trader would look at when trading?

So I’ve got a number of areas there, so I’ve got your FX quote panels up in the top right, so some of the major FX pairs, showing me what they’re pricing at at the moment and whether or not they’re up or down.

So they’re your spreads as well, aren’t they?

So they’ve got your spread under there; it’s got your low and your high of the day, plus the current bid and offer price. You can click on one of those and get into a trade very quickly. You can see the order ticket there. So you’ve got the order ticket for pound-Aussie; probably tell by the accent that I follow this one quite a fair bit. And then you’ve got underneath that your sort of stop loss. I’ve got a guaranteed stop loss order on that screen at the moment, just in case that price moves against me, I’m guaranteed to get out at 50 points below the current price. So that gives me that protection. But from a trader’s perspective, there’s three sort of areas there, or four potentially, that you can look at. You’ve got your Reuters newsfeed on the left-hand side, which’ll update me on things that are happening on the FX markets. You’ve got the charts. I’ve got two intervals there on the pound-Aussie. I’ve got a long-term interval, showing me the general change over a longer period of time, and then I’ve got a shorter-term interval of one hour there. And you can see the volatility. You can see that huge, big U-turn that happened after a particular tweet went out recently. And that’s the opportunity that clients are looking for, and that volatility. And then on the right-hand side, you’ve got the economic calendar, and I constantly have this open on my platform. It’s showing me all the different events that are happening globally. I can filter that to be just on US markets, for example, or UK markets, if I’m trading one of those currency pairs. And then you can see the trend as to how those announcements have been coming out in the past, on the right there.

Oh, so that’s above expectations or below expectations.

And then you’ve got a forecast, as well as you get real-time announcements pop up on your screen. You also get countdown timers, so you know, if you want to be aware of the event prior to it happening so you can set up your trades, you can get triggers for notifications prior.

And also, just looking at the [GBP] ticket as well, just on FX costs, you know, how a broker would charge for… you can see the estimated cost, can you, and is that spread cost or…?

No, that’s your margin. So you’ve got estimated margin down the bottom, so that shows you that for the £1 point I’m doing on this spread bet trade, that’s the amount of margin that I’d need to put up. But then there’s also the estimated cost, and that’s related to the guaranteed stop loss order. So putting on a guaranteed stop loss order is a bit like insurance. You pay a small premium. However, if you don’t use the guaranteed stop loss order, so you get out of that trade early, you’ll get 100 per cent of that money back. So it’s there, it’s a great tool to use.

Because obviously, you have overnight financing.

Yes, we do. So that won’t be on this but we’ve got a product overview that you’ll be able to see all the different costs and when they’re charged on that.

And then also, in the middle top right, you have client sentiment of forex positions.

Yeah, so that’s a general market watch list that I’ve got created there, showing me some of the major indices and FX pairs, and this is what we call the analytics view; it’s showing you the performance for the day, a mini chart, basically showing you the performance over two days, so you can get a feel for has the market just gone down today or has it been a general trend. And then you’ve got the client sentiments, so it’s showing you what clients are currently long and short. So quite often, you’ll start to see those move, and they’re updated every minute, so you can get a really good feel as to if there’s any momentum one way or the other in regards to how other traders are looking at the market.

Okay, interesting. Right, and just moving on to the pros and cons of FX trading. Everybody has exposure to forex in one way or another. You know, there are forex brokers opening up almost on a daily basis. So let’s just quickly talk about the pros and cons, because it’s important to be balanced. So what are the main benefits of forex trading? You know, what, as an individual, be it a private client, semi-professional, professional, you know, what can you get out of forex trading and also, what’s the downside or the risks?

I think it’s really important to cover both. You know, the FX market’s an exciting market. It can be volatile, which then creates opportunity. And the costs involved in FX trading are quite considerably smaller than some other markets; because of that liquidity, your spread costs are a lot lower. It’s a 24-hour market. So there’s always opportunity. So unlike other markets, which can close off at the end of the day, FX provides you with an opportunity to trade at any hour of the day. So some opportunities there, plus you can exposure to different currency pairs. You know, we’ve got 330-odd different currency pairs that you can trade. So you’ve got a varied opportunity base.

But the risks, again, the leverage side of things, you know, it is a double-edged sword in the sense that you can amplify your profits but also amplify your losses. And with FX trading, it’s got the lowest margin requirements, so you’re looking at a leverage of 30:1 or 3.33 margin requirement. So you’re only putting even a smaller amount of money, compared to the total notional value. So yes, that can amplify those profits, but you’ve just got to be careful on the losses side.

So they’re the main pros and cons, I would say, of what FX trading is. So you know, the other one, I guess, on the FX market is as we talked about before, is the unknown, you know, that can actually move the markets quite quickly. Quite often with equities, you’ve got a fairly structured corporate calendar that tells you when dividends are going to be paid, things are going to happen. You do get those shock announcements every so often, but we with the FX market, you know, somebody can come out and say something and they can move very, very quickly.

And moving on, just tapping into your experience, you know, having been in the forex markets for a while, of all the clients you’ve seen, what would you say are the top three mistakes that people do when they lose money? Whether you know, they come into the market with unreasonable expectations or they’re just not managing their account properly. What’s the sort of top three mistakes that you’ve seen, and what can people do to avoid them?

I think with the FX market, because there is so much opportunities all the time, I think the number one for this particular market by itself is definitely overtrading. There are a lot of people that will trade, constantly get in and out of the market because it’ll move so quickly, 50, 60 points within five/ten minutes. So they’ll see this opportunity, they’ll get in without doing the necessary research to sort of understand why it’s moving the way it is. With FX as well, I have a strong feeling that it’s both a technical and fundamental trade. It’s not just one or the other. So actually getting a bit of a feel and doing your research in regards to, you know, what the technical side of things like key levels, resistance support levels, and also what are the fundamentals and how they both combine to create a trading opportunity. But then the other one is trading too much, like as in the size of your trades, because you obviously see this opportunity and you think well, if I do a bigger trade, I’ll make more money. You really should sit within the boundaries of what your account is. So there’s some basic techniques out there that you only risk two per cent of your money on any one trade so that you’re not overexposed in the markets. You can push that up to five per cent if you’ve got a smaller account.

So those sorts of things are probably the key mistakes. And then the other one is literally leaving what I call a naked trade. You’ve got a market order out there, you haven’t protected it with a stop loss, which you know, considering the volatility, it’s really important to make sure that you do.

Interesting. Alright, well brilliant. Ryan, thank you very much for your time.

No problem.

And thank you very much for watching our Good Money Guide TV section on forex brokers.

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