What is Forex Trading?
Without getting too technical, forex is what we call foreign exchange. The exchange of one currency to another and/or vice versa. By extension, forex trading is the trading of these currencies and playing around with their exchange rates (the cost of making a currency exchange) in order to make a profit.
You probably already dabbled in foreign exchange when taking a vacation abroad. For example, when I flew over to Mumbai last year, I had to exchange my Rand for some Indian Rupees. Obviously, this doesn’t happen on a one-to-one basis. You aren’t getting one Rupee for every Rand your exchange. Instead, thanks to the exchange rate between the two currencies and any other fees incurred, I received approximately five Rupees for each Rand in my possession in this transaction. This exchange rate sometimes can either be favorable or not so favorable and it’s quite a fluid beast, going up and down every second.
The Forex Market
This brings us to the Forex Market. Imagine a decentralized network of international banks, retail traders (small fish like you and me) and a range of other financial institutions – trading forex between each other in order to make a profit off of the constant valuing or devaluing of a currency against another and their exchange rate.
Yes, the Forex Market isn’t a brick and mortar shop like your post office where you can just waltz into and make an exchange. As such, it enjoys the advantage of running almost 24/7. This is possible due to the fact that there are multiple trading sessions in different countries like Sydney, Tokyo, London the US. The trading hours of these different markets overlap and therefore you can trade from the market open on Sunday evening and up to Friday evening. Also, some trading hours are more volatile and suited to different trading strategies. And what’s more, when you are trading, you don’t actually buy Euros and sell them for Dollars. This all happens with the help of a trusty forex broker, who acts as an intermediary for your trades, buying and selling the selected currencies on your behalf. Essentially, when making a trade, you are taking a (hopefully) calculated guess that the value of the currency you are “buying” will rise – always in relation to the currency you are “selling”. Because, trades always take place in pairs and when you have a feeling that the USD value will increase, you should also be thinking the currency it will rise up against.
The Forex Pairs (Majors, Minors and Exotics)
We established that what you are actually trading in forex is currencies which come in pairs. These pairs are categorized into different categories according to how popular they are or how widely they are traded. The Major leagues are, to no one’s surprise, the ones with the US Dollar or USD. Let’s see some examples.
EUR/USD (Euro/US Dollar)
USD/JPY (Euro/Japanese Yen)
GBP/USD (British Pound/US Dollar)
USD/CHF (US Dollar/Swiss franc)
The next category of pairs is the minors which are the ones that don’t include the USD. These cover most other currencies but we’ll list some of them below.
EUR/AUD (Euro/Australian dollar)
EUR/GBP (Euro/British pound)
GBP/JPY (British pound/Japanese yen)
CHF/JPY (Swiss franc/Japanese yen)
Then, we got the exotics which consist of a major currency and one of a developing economy like the South African rand or the Mexican peso.
Some of the most popular exotics are these:
USD/HKD (US dollar/Hong Kong dollar)
JPY/NOK (Japanese yen/Norwegian krone)
EUR/TRY (Euro/Turkish lira)
NZD/SGD (New Zealand dollar/Singaporean dollar)
Now, you are maybe wondering about the order of each currency in the pair and if there is a reason they are reflected in this way. And you would be correct in thinking so.
Actually, the first currency in the pair is called the base while the second is called the quote. So, in the EUR/USD pair for example, the EUR is the base and the USD is the quote currency. This ties in with the Bid and Ask price which you will find on your trading platform.
The Bid price is how much the market is willing to buy the said pair while the Ask price is the price the pair is currently selling at. Therefore, if you are buying the EUR/USD at 1.3356 (the Ask price), you are selling US dollars in order to buy Euros at the aforementioned exchange rate. This exchange rate denotes the amount of USD you need for 1 EUR. The exchange rate, depending on your broker, can have 4 or 5 decimal points and the fourth one is called the pip short for the price in point.
The difference between the Ask and the Bid price is what we refer to as the Spread and naturally, it’s also measured in pips. The Spread is the fee you pay your broker for executing a trade for you. It’s also worthy to note here that you will find much better spreads or lower fees when you trade the major forex pairs due to their high liquidity.
So, when the exchange rate of a currency moves it is measured in pips. Going back to our example, if we are buying the EUR/USD at 1.3356 which means we believe the EUR will appreciate against the USD and the exchange rate goes up at 1.3360, you already made 4 pips in profit as long as you exit the trade before the price moves down again.
It’s pretty clear that the Forex Market is driven by the price of all these different economies. Sometimes, however, it is also greatly affected by the investors’ sentiment and forex trading itself. When a country is doing well, its economy goes up and the value of its currency increases. If the market thinks an economy is doing well, it might start buying or trading that currency creating an upsurge in its price as well.
Some forex traders believe that financial reports about a countries GDP and economic indicators like the Non-farm Payroll are key market movers and can interpret whether the statements are positive or negative for the value of the country’s economy. A big number of traders wait for the release of these figures in order to enter a trade where the market experiences high volatility and therefore bigger movements and higher pip values to snatch.
This birds-eye view of a country’s economy and its growth is called Fundamental Analysis. Forex trading, however, takes place on a platform with a bunch of price charts and it was inevitable for some analysts to try and find patterns in the price movements based on historical data. This is how Technical Analysis was born and with it a great range of technical indicators which help predict price movements in the Forex Market directly on the chart.
Technical analysis is a very popular tool for many due to the fact that it eliminates unnecessary distractions and focuses solely on the currency’s price.
These two schools of thought don’t have to be mutually exclusive though. You can use both as a tool to identify opportunities in the market and create a solid forex trading strategy that enjoys the best of both worlds.
Risk and Benefits
Trading in the Forex Market has many advantages. The high liquidity and the pooling of funds of all the traders and financial institutions being one of them as it makes finding people to cover the opposite side of your trade very easy and most importantly fast. Actually, this is why it stands as the largest financial market in the world with more than USD 5 trillion in daily transactions.
Each trader can find a strategy that suits his trading style and schedule. With many opening and closing positions instantly a few times a day while others go for long-term weekly trades waiting for the interest to go up.
Forex trading inherently doesn’t come without its drawbacks and risks, however. You are investing your hard-earned money after all and if you are not careful many forex brokers warn that your losses might even exceed your initial capital. This makes it essential for you to start educating yourself before jumping in. Not only learning about forex trading and the market in general but also choosing a trusted, regulated broker so you know you are protected regardless of any profits or losses.
A recommended step for all beginner traders is signing up for a demo account with their broker of choice so they can test and develop their trading strategy and find ways to minimize their exposure to risk.
Join CM Trading today and enjoy the best trading experience you can get!