A Beginner’s Guide to Forex Trading
What is forex trading?
Forex is a portmanteau of the words “foreign” and “exchange” and forex trading refers to the trading of foreign currencies through a brokerage. The broker gives you access to the forex market which comprises thousands of major banks, financial institutions and retail forex traders (i.e. individual traders). Forex brokers are basically a platform through which trading forex or the online trading of currencies takes place.
Generally, when exchanging currency for another, we are making a forex transaction. For example, sometimes we buy stuff from Amazon.co.uk, Amazon.de, or even Amazon.com according to which country’s prices are cheaper. Obviously, when ordering from each domain, the transaction would be charged in Pounds Sterling, Euro or US Dollars respectively.
This exchange also takes place when countries are importing or exporting their goods and need to pay each other or when we take a trip to a foreign country and we need to exchange our local currency with the one used at our destination. The largest volume of forex transactions, however, is speculative. Meaning the ones facilitated by forex brokers on the behalf of millions of forex traders globally.
The market that never sleeps
Due to this massive volume of transactions that take place daily, more than 5 trillion USD in daily transactions to put things to scale – the forex market is considered the largest and most liquid financial market in the world. The liquidity refers to the millions of buyers and sellers of currencies and this abundancy allows for rapid order execution almost 24/7 (explained in next paragraph). And since the forex market doesn’t actually have a central exchange like the stock markets, it never sleeps, allowing you to speculate on price movements around the clock and find matching buyers/sellers to take the opposite side of your trade virtually instantly.
The forex market is closed during the weekend since most of the world’s banks are closed as well. However, daily forex trading is split into four trading sessions, which conveniently overlap by a few hours before each session closes – so we can trade around the clock. The Sydney session opens on Sunday evening (or Monday morning for some of us) and then the market moves to Tokyo, London and finally New York. Obviously, depending on the time you wish to trade and the currency, you are likely to notice that there isn’t much happening in the market. But if you can trade during the overlap of two trading sessions i.e. when the London and New York markets are in session then you will enjoy a lot of trading volume which translates to better liquidity, higher volatility and therefore greater profit opportunities.
Trading currency pairs
We went through the basic forex trading terminology and how the market works. Now let’s look at how we trade currency pairs. Do note that it’s currency pairs and not just currencies because even though we are not physically exchanging currency for another when trading forex, we are still gauging a currency’s strength by comparing it to another.
Let’s consider that one EUR can currently be exchanged for around 1.50 USD. On your forex trading platform, this quote would show up as: EUR/USD – BID= 1.5034, ASK= 1.5038. In this example EUR is the base currency, the basis for our exchange and the USD is the quote currency. This basically signifies how much one EUR is worth in USD. You may be confused by the Bid and Ask prices in the example but it’s actually quite simple. They stand for the price you can buy or sell the currency pair. The Bid price is the value your broker will buy the base currency (EUR) for the counter currency (USD) and the Ask is the value your broker is willing to sell the base currency in exchange for the counter currency.
You can see there is a 4-pip difference between the two prices quoted above. Pip is a percentage in point and refers to the smallest move of a currency’s rate and also an easy way to calculate profits or losses when trading forex. In forex, the pip is always the fourth or second decimal in a pair’s quoted price. If we buy the aforementioned pair at the quoted Ask price (1.5038) and immediately sold it at the Bid (1.5034) we would actually lose 4 pips. The difference between the Bid and Ask price you are quoted is called the Spread and this is the commission charged by your broker for undertaking each transaction. So, in this case, we would have to wait for the Ask to move at least 4 pips before closing so we can break even. Each pip after that is profit in your trading wallet as long as you manage to close the position before the price starts moving the other way.
Timing is key when trading forex and you need to be aware of all the moving parts if you are going to survive for the long run. An invaluable tool that every forex trader should take advantage of in every single trade, for example, is the Stop loss and Take profit order.
Since the currency markets are so volatile where we often see 50-100 pip spikes in a matter of milliseconds. Therefore, it is crucial to be able to set a predetermined entry and exit point, right? This way, when we enter a trade, we don’t need to hover our finger over the trigger in order to manage to close the trade before the price moves against us. This is exactly what the Stop loss and Take profit orders are for.
A Take profit level attached to your order, for example, will close your position as soon as you reach the predetermined price set by you. If you are expecting a 10-pip uptrend or you are just aiming for a 10-pip profit on a particular trade, you can set your Take profit 10 pips above the Ask price where you entered and as soon as the price of the pair reaches that point, it will close the position automatically, granting you the profits before the price goes down. The Stop loss, on the other hand, is a safeguard. How many pips are you willing to risk in a trade? Place the Stop loss a few pips below the price you entered and you won’t need to worry about any sudden moves that could blow your account if the market moves against you and you weren’t fast enough to close the trade.
There are multiple ways you can protect your account if you are risk averse – and you should be. A solid strategy when you are just starting out is to first try trading on a demo account which is completely free and always is conscious of how much money you are risking per trade. A good rule is to never risk more than 2% of your account and that’s not even modest enough as in 5 bad trades you would already be down 10%.
The opportunities are endless and forex trading is a highly attractive market for investors but if you are aspiring to make it as a forex trader, you need to educate yourself, practice until you have a consistent strategy and always have strictly defined money management rules in place to protect your investment.