What is Forex Trading?

by Andrew McGuinness  //  dec. 29, 2017

20 mins read

What is forex and how does it work?

The global, decentralized market for currency trading is called foreign exchange market, or simply forex. This is where the exchange rate is determined, based on supply and demand.

The foreign exchange market is the largest and most liquid market in the world with an average daily trading volume of more than $5 trillion. It is open twenty-four hours a day, five days a week.

The entire forex market works through financial institutions and operates on several levels. Financial institutions that deal with large quantities of forex trading are called dealers, who are often large banks. This market where the currency exchange is executed is known as the interbank market.

The largest foreign exchange market participants are:

  • Commercial companies. These market participants engage for commercial reasons, either to purchase/sell goods overseas or to hedge their position against currency exchange losses.
  • Commercial banks. These participants engage in variety of ways; they assist commercial companies in their international goods exchange, give credits to companies, governments, or funds.
  • Central banks. The main goal for central banks is to carry out their monetary policy. This means acquiring foreign currency or assets as reserves, purchasing/selling other currencies to impact their own currency’s price, or printing money.
  • Investment firms. These market participants engage in the forex market to invest in other countries or in those countries’ currencies for carry trading, to acquire government bonds, or to acquire foreign companies.
  • Retail traders. These are speculators that mostly exchange currencies on a daily basis without a long-term goal.
  • Forex brokers. These market participants act as an intermediary between retail traders and the interbank market for a fee.

A brief history of forex trading

The beginnings of the modern foreign exchange market can be found back in the 1944 when the Bretton Woods system was set. During the time, a method of fixed exchange rates was introduced, where members were required to establish a parity with their national currencies to a reserve currency, which at the time was the U.S. dollar. The U.S. dollar, on the other hand, was backed by gold (at $35/ounce), making the currency as good as gold. The U.S. dollar became the world currency. At this time, two large financial agencies were created – the International Monetary Fund (IMF), and the International Bank for Reconstruction and Development (IBRD).

Thirty years later, after the Vietnam War, the United States had a growing public debt and negative balance payments, as well as monetary inflation. The attempts to defend the U.S. dollar at a fixed peg of $35/ounce became impossible. By 1970 The U.S. dollar gold coverage had dropped to 22% and countries lost fait in the United States’ ability to maintain the dollar as a reserve currency. U.S. President Richard Nixon withdrew U.S. dollar to gold convertibility. This came to be known as the Nixon Shock and caused all major economic powers to float their currencies and begin intervening in the exchange rate that keeps going even today.

What is the retail forex market?

This is a small segment of the forex market where individual traders speculate on price movements between different currencies. In retail forex market, forex brokers act as intermediaries between the retail traders and the dealers on the interbank market.

How to start trading forex?

Today, every person with a computer and access to internet can trade on the forex market. First step is to open an account with a forex broker, fund the account, and start trading.

What is a forex broker?

A forex broker gives retail traders access to the interbank market. This is achieved by setting up trading accounts with the broker and then access the market through their trading platforms. Most of the forex trading is executed through the spot market, but some brokers act as dealers and take the opposite side of the trade to provide trading liquidity.

Forex brokers make profit through the bid/ask spread (a Dealing Desk broker), or if they pass the order to the market without taking the opposite side (a No Dealing Desk broker), they usually charge a small fee.

Based on their trading model, forex brokers can be:

  • Electronic Communications Network (ECN) brokers. This is means the broker gives the trader a direct access to the interbank market. ECN accounts are No Dealing Desk and typically have lower spreads.
  • Straight Through Processing (STP) brokers. This model is also considered a No Dealing Desk as every trade is processed directly to the liquidity providers. This model has higher liquidity.
  • Direct Market Access (DMA) brokers. This trading model matches client’s orders with dealing prices offered by market makers, banks, or other liquidity providers. This model can be both Dealing Desk and No Dealing Desk, depending on the broker.
  • Market Maker brokers. These are typically Dealing Desk brokers who make their profit by quoting bid/ask spread to their clients. They are also known as B-Book brokers. Market makers can sometimes manipulate their quoted price, depending on their market view, but they can also increase spread to execute stop loss orders.
  • Hybrid brokers. These brokers combine the previously mentioned models by making each account type use one trading model.

Are all forex brokers regulated?

Due to being decentralized with no central exchange or clearing house, the forex market is prone to fraud and manipulation. Because of that, some governments have tried to regulate forex brokers to ensure fair business behavior through government or independent supervisors.

For a broker to be regulated by a certain body, they have to be registered in that country. This means that the broker may be subject to recurring audits and evaluations. Some of those regulators are:

Popular trading platforms

Some brokers offer their own proprietary trading platforms, while others offer the option to connect third-party trading and charting software. Popular trading platforms are:

  • Metatrader 4 (MT4). This is the most popular and most widely-used charting software by retail traders. Every broker offers this platform to their clients for free. MT4 is mostly used by traders who use automated trading software, and it is available to desktop and mobile devices.
  • NinjaTrader. This platform has basically the same charting options as Metatrader 4. It is free for trading simulation, but for live trading, the developers charge fees.
  • Trading Station. This is a proprietary platform by the broker FXCM. It has the same options as all other charting software, except it has a small market for automated trading compared to MT4, and is free to use with FXCM broker.
  • CQG FX. This is a charting platform that has all the standard options as other charting software, plus it has more chart types available (Renko, Heikin-Ashi, sub-minute bars, and many others). It also has Excel integration. CQG FX has a 14-day free trial.
  • MultiCharts. Except the standard options, this platform offers high-definition charting, real-time market scanner, not only for forex, but for other financial instruments, as well. It has a 30-day free demo.
  • MotiveWave. This is a similar platform to MultiCharts, as it offers trading on other instruments as well as currencies. It offers support for 4k displays, high-quality pattern scanner, advanced volume tools, and much more. It has a 14-day free trial.
  • JForex. This is a java-based proprietary platform from Dukascopy broker. It has all the options as the other charting software, plus for those familiar with coding on java programming language, creating automated systems would be easy. This is a free platform to use.

How to buy and sell currencies?

The concept of trading on the retail market revolves around buying one currency and selling another at the same time. That is why trading in forex is done with currency pairs.

If we take the most-trader pair EUR/USD for example, EUR is called the base currency and USD is called the counter.

In order to profit from increase in price of the euro against the U.S. dollar the trading position is: buy EUR/USD. This means that the trader buys EUR and sells USD.

To profit from decrease in price of the euro against the U.S. dollar, the position is: sell EUR/USD. This means that the trader sells EUR and buys USD.

Another term for buy and sell is going long and short.

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Most liquid and most traded pairs are:

  • EUR/USD
  • GBP/USD
  • USD/JPY
  • AUD/USD
  • USD/CAD
  • USD/CHF
  • AUD/JPY

What is leverage in forex trading?

Since price movements in forex are relatively small (measured in cents), the possibility to earn a decent profit with an account of $500 is very low. That is why forex brokers borrow money to traders in what is called a margin account; In this case, the amount of $500 is called margin, or the collateral, that the broker keeps in case the trader suffers losses. The ability to control large amount of (borrowed) money using a small amount of money owned is called leverage. Leverage can reach up to 500 times the size of the account, which means a $500 account can control $250,000 and turn small movements in price into a large amount of money, either in losses or in gains.

Forex money management

The use of leverage in forex makes it equally important for profit and for losses. With proper money management trading risks can be limited to a small percentage of the account. Most common risk per trade is 2 percent, but for aggressive traders, 5 percent should be more than enough. Anything above that makes it difficult to recover losses should they occur.

What is a Lot in forex trading?

Lot is the number of currency units that a trader buys or sells. Standard lot in forex trading is 1.0, which is equal to 100,000 currency units ($100,000 U.S. dollars, for example).

Lot name

Number of units

Lot size in forex

Standard

100,000

1.0

Mini

10,000

0.1

Micro

1,000

0.01

Nano

100

0.001

What is a Pip in forex trading?

The smallest measure of change in the currency price is called a pip (Price in Percentage). For example, if the current price of EUR/USD is 1.0000 and after a moment it moves to 1.0001 it means that the price moved by 1 pip.

When trading with a standard lot, this change would be equal to $10. If the lot size was mini, the change of one pip would be equal to $1.

Today, most brokers offer trading to the fifth decimal point (1/10 of a pip), which is called a pipette.

What is technical analysis?

The study of historical price action and the attempt to forecast the future price action by the use of technical studies, price charts, indicators, and other analysis tools is known as technical analysis. With the help of technical analysis, a trader can identify trends, support/resistance zones, and trading opportunities. This is a great tool for determining entry and exit points in any currency pair.

Most common technical analysis elements are:

  • Price chart
  • Candlestick patterns
  • Indicators

What is fundamental analysis?

The process of analyzing macroeconomic data, along with political and social events, is called fundamental analysis. The main focus in fundamental analysis are economic indicators such as:

  • Interest rates
  • Employment
  • Inflation

Some traders refer to fundamental analysis as trading the news.

Fundamental analysis provides insight on how the price of a certain currency pair may react due to certain economic event. This can be a report from a central bank on U.S. home sales, for example, or the change of monetary policy by the Swiss National Bank, or any other similar event.

When this data is released, investors and speculators often react, thus changing the price of a certain currency pair. Sometimes, the price can change before the news is released, based on anticipation of the upcoming data. These speculations can be sometimes priced in, hours or days before the news is released. Currency pairs are known to move by hundreds of pips just moments before release, thus creating a high-volatility and increase in spread and slippage.

Common trading strategies

There are several key elements that the trader must overcome in order to be successful. Selecting the best trading strategy according to the trader’s needs is one of them.

  • Scalping. This is a strategy where the goal is to capture small number of pips, many times a day. This is a high-frequency trading and having a good internet connection is of utmost importance. For this strategy to work, the trader has to select the most liquid pairs like EUR/USD, GBP/USD, and USD/JPY, which have low spreads, and then to trade on calm, non-volatile markets. Scalpers usually trade the Asian session due to low volatility, and they avoid trading near high-impact news.
  • Day trading. This is a strategy where the trader opens and closes positions in one day, but unlike scalping, in day trading the goal is to capture larger number of pips. For this strategy, the trader has to be aware of the economic news as things may change fast.
  • Swing trading. This is a long-term trading strategy where trades may last for days. The name implies swinging with the price, which means buying low and selling high in an uptrend, and selling high and buying low in a downtrend.
  • Position trading. This is a trading strategy that can last for months. For position trading, the trader enters a position (let say buy EUR/USD), and holds it for as long as the price goes in their favor. It is a common practice to open more positions in the direction of the trend.
  • Martingale trading. This strategy is based on the probability theory where for every losing trade (let say 0.1 lot), the trader opens another trade with double the lot (0.2 lot). If the second trade is profitable, the trader recovers all losses from the first trade and earns a profit. If the trade ends in losses, the trader opens another position with double the lot from the second position (0.4 lots). This process is repeated as long as the trader ends up in profit or destroys the account. This strategy can be used by day traders, swing traders, and even position traders, but it is highly-dangerous and it can wipe out any account.
  • Hedging. This is a strategy where the trader holds two opposite positions at the same time (for example, buy 0.1 lots EUR/USD and sell 0.1 lots EUR/USD). Hedging can also be achieved by holding positions in highly-corelated pairs.

Automated trading

A computer program that creates and executes trading orders without human intervention is known as automated trading program. Since 2014, more than 70 percent of all stocks traded on U.S. stock exchanges were executed through automated trading programs. These programs are designed to take human emotion out of the trading process and input computer logic. In forex, this type of trading is achieved mostly through the use of Expert Advisors (EAs).

EAs come in many varieties, depending on the strategy they use, but we can roughly divide them in these categories:

  • Martingale
  • Grid-trading
  • Hedging
  • Breakout
  • Scalping
  • Trend-following
  • News trading

It is common practice in today’s EAs to use a combination of these strategies for better performance.

What is the advantage of trading forex vs trading stocks?

Many traders have switched from trading stocks to trading forex because of the opportunities the currency markets give. The main advantages are:

  • 24-hour market, 5 days a week. The trading hours give flexibility to traders worldwide to customize their own trading schedule.
  • High liquidity. The forex market liquidity is measured in trillions, while the stock market in billions. This means that a trader can open/close large positions and have them executed in an instant. It also means that if someone wants to influence the price of a currency and manipulate the market, they would have to use an incredible amount of money, which makes it unfeasible.
  • Higher potential profit/loss. Forex brokers offer higher leverage and that can increase the trader’s profit potential, but also their losses.
  • Simplicity. Eight currency pairs make up 70 percent of all the trading volume. It is enough for a trader to learn these pairs and trade, whereas in the stock market there are thousands of companies to trade.

Risks of forex trading

The foreign exchange market has a high profit potential. Despite that, there are some risks to consider.

  • High leverage. Having the ability to control $100,000 with only $500, makes it easy to make large profit from every currency move; it also makes it easy to suffer large losses and wipe the account.
  • Interest rate differential. Long-term traders who hold positions for months are mostly affected by the interest rate differential. If a trader holds a currency with lower interest rate against a currency with a high interest rate, the trader will be forced to pay the difference every day in what is called a swap.
  • Unregulated forex brokers. Selecting a suspicious forex broker without a regulation may cause the loss of the entire account, either by the broker’s malpractice, fraud, or insolvency.
  • Central bank involvement. Central banks are active participants in the forex market, but there are some cases when they can influence an exchange rate to such extent that many people could end up losing their accounts. Such event happened in 2015 when the Swiss National Bank removed the peg with the euro and the EUR/CHF exchange rate crashed by more than a thousand pips in minutes, jumping over stop losses. It made many accounts end up with negative balance, and many brokers insolvent.

Conclusion

Forex trading is the most liquid market in the world. With the access to internet and the use of forex brokers, retail traders can get the chance to participate and earn money. And even though this can be a highly-profitable activity, it can also be risky. To be a successful trader, one has to understand how the market works, to understand fundamental and technical analysis, and above all to have a good money management plan.





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