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Among the top forex pairs traded in 2022, the U.S. dollar dominated the list, with the euro-U.S. dollar (EUR/USD) pair accounting for nearly 23% of the average daily turnover in April 2022.
How do you start trading forex? What are the advantages and disadvantages of forex trading?
This article discusses how forex trading works, the types of currencies you can trade and the factors influencing the forex market.
When looking for an online broker, consider one that offers trading opportunities for forex and other financial instruments like shares, commodities, and cryptocurrencies.
The Foreign Exchange Market: What Forex Trading Is and How It Works
The forex market, also called the FX market, is a global marketplace to buy and sell various currencies.
Forex’s worldwide reach across trade, commerce and finance makes this market the world’s largest and most liquid.
Whenever you trade currencies, you usually exchange them in pairs. For example, the EUR/USD (euro and U.S. dollar) pair trades the euro against the U.S. dollar.
What Is Trading?
Trading in the financial markets involves buying and selling an asset to make a profit. You can trade on a centralised exchange or over-the-counter (OTC).
An exchange is a place where you trade various financial instruments like securities, commodities and derivatives.
Meanwhile, an OTC transaction trades securities through a broker-dealer network instead of a centralised exchange.
So, in the EUR/USD trading strategy, you can profit by buying and selling the euro currency against the U.S. dollar in the foreign exchange market.
What Are Foreign Exchange Markets?
Forex is a decentralised global market for trading currencies and it operates 24 hours a day, five days a week. This highly liquid market comprises banks, hedge funds, commercial companies and individual investors in every time zone.
Instead of one central exchange, financial centres around the world, such as those in New York, London, and Hong Kong, act as foreign exchange trading hubs.
What Are the Benefits of Forex Trading?
Trading forex provides the following advantages:
- Trading on margin using leverage (enables you to open positions worth more than your deposit)
- Quick price reaction due to breaking news and economic announcements
- The ability to go long (buying the asset before selling) and short (selling an asset you don’t own yet)
- High liquidity levels to help keep forex trading costs low
What Pros and Cons Does Forex Trading Have?
Like other financial instruments, forex has benefits and risks that you should consider before you start trading forex.
- High liquidity: The large volume of daily trades makes buying and selling currencies easy due to high demand.
- Low cost: You don’t need a large amount of capital to start forex trading. You can use leverage to boost investment opportunities.
Leverage is like a loan that lets you borrow money from a broker so that you can trade larger amounts of assets.
- Large international market: Forex trading is a vast global market, giving you plenty of trading opportunities worldwide.
- Trading time: Forex trading runs for 24 hours a day, unlike other markets with limited weekly trading hours.
- Leverage risk: Using leverage to trade large amounts of currency can increase the possibility of you losing money if a currency drops in value.
- High volatility: Currencies constantly fluctuate in value and can be very unpredictable.
- Exchange rate risk: Fluctuations in the exchange rate can affect your earnings when you convert back into the currency in which you take your profits.
- Selling limits: Some countries implement trading limits on how much currency you can exchange at a specific price at different times.
Why Do People Trade Forex?
Your reason for trading forex can vary from other traders. The following sections expound on why people choose to trade forex.
Speculating on Currencies Strengthening or Weakening
Traders speculate (buy an asset hoping its value will rise) on forex to profit from one currency’s strengthening or weakening against another. For example, in a GBP/USD (British pound and U.S. dollar) pair, you can buy the pound if you believe it will rise in value against the dollar.
Hedging With Forex
Hedging helps you mitigate risk exposure by letting you open positions that will likely profit if your other positions decline in value. This way, the gains will help offset some or all losses.
For example, you can go short on GBP/USD when you have a long EUR/USD position to hedge against potential declines in the pound or euro’s value.
Seize Opportunity 24 Hours a Day
The global network of markets and banks allow the forex market to exchange currencies constantly throughout the day. The time differences between these markets in the U.S., Europe, and Asia enable the forex market to operate 24 hours daily.
What Influences the Foreign Exchange Markets?
Numerous factors can affect price movement in the forex market. Significant factors include interest rates, inflation, debt, economic performance and even political instability.
Political Instability and Economic Performance
Countries with robust economic performance and stable politics, will likely appeal more to foreign investors. However, countries with more economic or political risks, such as recessions or wars, can discourage investors and adversely affect that country’s currency.
Central banks control interest rates to manage inflation in the country.
For instance, the central bank can increase interest rates to help lower inflation and stop spending and lending. This way, the value of money in the country rises as there’s less money available in the economy.
Inflation rates often move with interest rates and can influence a nation’s foreign exchange rates.
Rising inflation rates can adversely affect a currency’s value. High inflation rates can lead to an increase in the price of goods, causing the currency to depreciate and discouraging spending.
On the other hand, low inflation rates may contribute to a currency’s value appreciation.
Terms of Trade
A country’s terms of trade represent the ratio of export prices to import prices. If your country’s export prices rise and import prices fall, the terms of trade improve in your country’s favour.
This situation can help increase your nation’s revenue. In turn, your country’s demand for the currency will likely increase, which can help improve your currency’s value.
A nation’s debt can have a significant influence on the currency price. Countries with large debts relative to their gross domestic product (GDP) will likely be less attractive to foreign investors.
GDP is the total value of a nation’s goods and services produced within a particular period.
If your country doesn’t have foreign investments, it will likely struggle to build its foreign capital. This situation can lead to higher inflation rates that can cause currency depreciation.
Beginners’ Guide to Forex: “How Can I Get Started Trading FX?”
Trading forex isn’t only about exchanging one currency for another. It’s also about understanding how currency pairs work and what makes currency prices move. The following sections discuss these concepts to help you make informed decisions when trading forex.
Forex Trading Essentials for Beginners
If you’re new to forex trading, learning about the essentials is necessary to help you build a solid foundation in the foreign currency market. The sections below explore these essentials.
What Is a Forex Pair?
A forex pair consists of two currencies that you trade against each other. The most traded currency pairs include the following:
- EUR/USD: Euro vs. U.S. dollar
- USD/JPY: U.S. dollar vs. Japanese yen
- GBP/USD: British pound vs. U.S. dollar
- AUD/USD: Australian dollar vs. U.S. dollar
- USD/CAD: U.S. dollar vs. Canadian dollar
- USD/CNY: U.S. dollar vs. Chinese yuan
- USD/CHF: U.S. dollar vs Swiss franc
What Are the Base and Quote Currencies?
A forex pair consists of a base and a quote currency.
- Base currency: This currency is on the left side of a forex pair. The base is always equal to one.
- Quote currency: This currency is on the right side of a pair and shows how much of this currency will cost to buy one unit of the base currency.
For example, the EUR/USD pair’s exchange rate as of June 5, 2023, closed at 1.0700, meaning €1 was equal to $1.07.
What Is a Pip in Forex?
A pip in forex typically refers to a one-digit movement in a currency pair’s fourth decimal place.
If a GBP/USD pair moves from $1.2423 to $1.2424, it has moved by one pip.
One exception is when you trade pairs with the Japanese yen because a pip in such pairs is a change to the second decimal place.
So, for pairs with a yen-denominated currency, a pip in JPY is 0.01. For all other pairs, it’s 0.0001 of the counter or quote currency.
What Is a Lot in Forex Trading?
Currencies trade in lots, which are currency batches standardised for forex trades. Lots tend to be large because forex price movements are usually small.
One standard lot consists of 100,000 units of the base currency. Meanwhile, a mini-lot has 10,000 units and a micro-lot represents 1,000.
Learn How Currency Markets Work: How Currencies Are Traded
After knowing the basic terms like forex pairs, base and quote currencies, pips and lots, it’s time to learn how forex markets work, discussed in the sections below.
What Moves the Forex Market?
The forex market is where currencies from different countries get traded. Predicting the exchange rate can be challenging because many forces, like inflation, trade deficits and surpluses and politics worldwide, can influence price movements.
Central banks control a currency’s supply and announce measures that can significantly impact that currency’s price.
For example, the central bank can implement quantitative easing, which involves injecting more money into an economy to increase supply but cause the currency’s price to fall.
Investors and commercial banks tend to put their capital into economies with a positive and robust outlook.
If positive news in a country hits the markets, that event can drive investment and help increase demand for that nation’s currency. On the other hand, negative news can cause currency demand to fall.
Market sentiment often reacts to news and can be essential in driving currency prices.
Suppose you believe a currency is trending towards a specific direction. You can trade accordingly to help increase or decrease demand based on that currency’s movement.
Discover How to Trade Forex: Ways to Trade Forex
Once you learn how forex trading works, you can choose between different currency pairs and trade them anytime during the day.
Select a Currency Pair
When choosing a currency pair, research to determine which pairs you’re comfortable with in order to trade. If you’re a beginner, choose pairs with relatively stable performance.
For example, you can choose forex pairs consisting of these currencies:
- U.S. dollar
- Japanese yen
- British pound
- Swiss franc
- Canadian dollar
- Australian dollar
- South African rand
What Does It Mean When You Buy or Sell a Currency Pair?
When you buy a currency pair, you expect the base currency to strengthen relative to the quote currency, which leads to a price increase.
On the other hand, selling a currency pair means you expect the base to weaken against the quote, causing the price to fall.
“When Should I Buy?”
After you analyse the market and believe that a specific base currency’s value will increase, you can buy or open a long position with that currency.
“When Should I Sell?”
If you think your chosen base currency will decrease in value soon, you can go short or sell that currency.
When Can Currencies Be Traded?
The table below lists the different forex markets and their trading hours based on Eastern Standard Time (EST):
Decide Whether to Buy or Sell
After choosing a currency pair to trade, you must decide whether to sell or buy a currency based on your analysis and depending on your trading goals.
Suppose you aim to sell a currency pair after its price increases by 10 pips from your initial purchase price. Once you hit your desired price level, you can exit your position and take the profit.
Choose How to Trade
You can trade currencies by buying and owning that asset until it’s time to sell it.
Other trading strategies you can use to buy and sell currencies include the following:
- Trend trading: You use technical indicators to identify whether the forex market is in an uptrend (bullish), downtrend (bearish), or sideways trend.
Technical indicators are pattern-based signals produced by an asset’s price and volume.
- Trend reversal trading: You focus on the turnaround in a currency pair’s price movement, such as when a bullish trend turns bearish or vice versa.
- Range trading: This method works on the principle that the market moves consistently between two price levels for a specific period without significant upward or downward progress.
Open Your First Trade
The right online trading platform should allow you to search for currency pairs you want to trade so you can start buying and selling forex.
If you’re unsure how to start trading, consider opening a demo account. This way, you can practise trading by using strategies and indicators to help you make informed trading decisions.
Monitor Your Position
After entering a position, monitor your FX trade to understand how your forex pair’s price moves to help you decide whether to sell later or hold.
Close Your Trade and Take Your Profit or Loss
After your traded currency hits a specific price and you want to exit your position, execute a trade opposite to the one you opened. Then take the profit or loss resulting from the transaction.
What Fees and Costs Do You Need to Pay When Currency Trading?
The costs and fees you pay to trade currency vary between forex brokers. These costs include the following:
- Spreads (the difference between an asset’s buy and sell rates)
- Overnight fees like swaps or overnight financing costs
- Storage or holding fees
- Custodial fees (small annualised charges deducted monthly)
What Are Margin and Leverage in FX Trading?
Margin is the initial deposit you must commit to open and maintain a leveraged position.
Suppose you want to buy a currency pair worth $10,000, but it requires a 2% margin to open. You must deposit at least $200 to execute that order ($10,000 trade value x 2% margin = $200).
What Is a Spread in Forex?
The forex trading spread, also called the bid-ask or buy-sell spread, is the difference between a currency pair’s buy and sell price.
When trading forex pairs, the buy price is usually above the market price. Meanwhile, the selling price is often set below the market price.
Fundamental analysis looks into why a forex market reacts the way it does. Forex and currencies are affected by many reasons, including a country’s economic strength, political and social factors and market sentiment.
News and Economic Data
News and reports indicating strong economic activity can make investors and banks want to consider buying that country’s currency and hope their capital will appreciate. Demand for that country’s currency can increase as the positive economic outlook encourages additional investment.
Central Bank and Government Policy
Central banks determine a country’s monetary policy, including interest rates and money supply. These banks’ policy types and tools can influence the currency’s supply and demand.
Furthermore, a government’s fiscal policy through taxes or spending can help grow or slow the country’s economy and affect exchange rates.
As a forex trader, you use technical analysis to study trends and price action on the charts. These movements can help you identify supply and demand levels and potential buy and sell signals.
Technical analysis can help you interpret patterns in charts so that you can determine the right time and price level to enter and exit a position in the market.
A candlestick chart displays an asset’s high to low range using vertical lines to show the opening and closing prices.
A candlestick pattern consists of a “body” indicating the opening and closing prices and the candle “wicks” showing the high and low prices.
Most charting software allows the change of colours of candlesticks. Each colour represents a unique meaning.
If the candlestick’s body is green, the currency pair has closed at a higher price than it opened. If the candlestick is red, the closing price is lower than the opening.
Like a candlestick chart, a bar chart shows the high, opening, closing and low prices for a specific period.
The vertical bar indicates the highest and lowest traded prices. To the left of the bar is a horizontal mark that indicates the opening price, and the mark on the right is the closing price.
If you’re a beginner, you may find a line chart as the simplest among the other charts. This chart shows a line connecting one closing price to the next.
You can use this chart to identify a currency pair’s price movement through a specific period and determine currency patterns.
Forex Trading Strategies
You can use various trading strategies to help guide your buying and selling activities. Your ability to follow a strategy to decide what actions to take makes the difference between informed trading and guesswork.
You can create strategies by adopting others’ trading methods or tailor these systems to meet your needs.
A currency trading strategy usually incorporates technical indicators and forex signals to help you determine entry and exit points in a given market.
What Is a Forex Currency Trader?
Forex traders or speculators take positions on the foreign exchange market and anticipate currency price movement to profit from the changes in currency demand.
As a forex trader, you can execute trades as an individual investor, on behalf of clients, or for financial institutions. You rely on massive amounts of data and a mix of analysis tools to predict currency price movements and make profitable trades.
How to Become a Forex Currency Trader
Most entry-level forex trader positions in financial institutions may require a bachelor’s degree, such as in business administration, mathematics, economics, statistics or finance. Still, forex traders can come from different backgrounds.
As a forex trader, you can work solo or for a financial organisation like brokerages, hedge funds and institutional investors like investment management firms, multinational corporations, investment banks or central banks.
“Is a Forex Trading Career Right for Me?”
You may have a good chance to succeed in a forex trading career if you have the following:
- Strong mathematical skills
- Problem-solving and analytical abilities
- Technical and fundamental analysis skills
- Strategic thinking and planning skills
- Meticulous record-keeping skill
- Self-directed learning skill
To excel as a forex trader, you must also be comfortable in a high- stakes environment and prepared to handle various risk levels.
Other Possible Career Tracks in Finance
If you want career options in other financial roles other than a forex trader, consider the following fields:
- Private equity
- Risk analysis and management
- Portfolio management
What Is a Forex Chart?
Forex charts are price charts showing the current and past performance of currency pairs.
A price chart can help you see price actions over several time frames. It also helps you use various analysis tools and indicators to find patterns that can assist you in making trading decisions.
World’s Major Currencies
Countries have their own currencies that vary in value against other currencies. This difference and frequent price movement are where you can find profit opportunities through forex trading.
Currency Code Examples
The currencies you trade are usually represented by three-letter codes. Examples of these currency codes are as follows:
- AUD: Australian dollar
- CHF: Swiss franc
- CNY: Chinese yuan (renminbi)
- EUR: Euro
- GBP: British pound (sterling)
- JPY: Japanese yen
- NZD: New Zealand dollar
- USD: U.S. dollar
Understanding Currency Pairs
Forex market transactions involve the simultaneous buying and selling of two currencies in a currency pair. You can profit from this trade by correctly forecasting a currency pair’s price movements.
Suppose you want to trade a USD/CAD pair whose bid (buy) price is 1.3438 and the ask (sell) price is 1.3440. These figures indicate how much Canadian dollars you need to trade one U.S. dollar.
For this example, the bid-ask spread is two pips (1.3440 – 1.3438 = 0.0002 = 2 pips).
As defined earlier, the base currency is the first currency in a forex pair and represents how much of the quote currency you need to exchange one base currency unit.
If you want to trade a currency pair by buying the base currency, you must pay an amount equal to the counter currency (also called “quote currency”) for each base unit.
Using the previous section’s example, you can buy $1 in a USD/CAD pair by paying the bid price of 1.3438 Canadian dollars. Similarly, you can sell $1 and receive 1.3440 in Canadian dollars.
Major Currency Pairs
Many traders perceive major currency pairs as the primary drivers of forex market activities. These pairs account for over 80% of daily forex trade volume.
Major currency pairs typically have high liquidity and lower spreads. They are less prone to slippage due to their association with stable, well-managed economies.
Slippage is the tendency of an asset’s expected price to differ from the price at which the trade executes.
Four major pairs dominate the market, namely:
Some major currencies fall under commodity pairs, which are forex pairs from countries with significant commodity reserves. These pairs include the following:
Cross Currency Pairs
Cross currency pairs are those that don’t include the U.S. dollar. Some of the most commonly traded crosses are from minor pairs and are less liquid than the major ones. Common crosses include:
Exotic Currency Pairs
Exotic pairs consist of currencies from emerging economies paired with a major currency.
These pairs are traditionally riskier to trade because they’re less liquid and more volatile than majors and crosses. Exotic pairs are usually associated with countries whose economies are more susceptible to sudden political shifts and financial developments.
As you continue trading forex, you’ll encounter many terms unfamiliar to other non-traders. Examples include:
- Bid-ask spread
- Currency or forex pairs
These terms are defined throughout this article to help you become familiar with their meanings and lessen confusion.
Even if your currency pair increases in value by 50 pips, your trade won’t earn much if you only work with a few hundred units of currency.
Suppose you buy a forex pair, whose quote currency is in USD, for 1.3000. And then, it increases by 20 pips to 1.3020 (1.3000 + 20 pips or 0.0020 = 1.3020). If you buy 500 units, your profit is only $1 (0.0020 x 500 = $1).
For this reason, many forex traders buy and sell currencies in lots to take advantage of relatively small price moves.
Using the example above, a standard lot of 100,000 units can help bring a $200 profit from a 20-pip increase (0.0020 x 100,000 = $200).
How Much Money Is Traded Daily on the Forex Market?
A 2019 Triennial Central Bank Survey mentioned that forex is the world’s largest financial market, with a daily trade volume of $6.6 trillion, larger than the stock market.
Is Forex Trading Income Taxable?
Taxes on forex trading can vary by country. For example, if you’re in the United Kingdom, your profits are subject to corporation tax. For earnings of £50,000 or more, you’ll need to pay income tax at 20%.
In the United States, income from forex trading can fall under Internal Revenue Code (IRC) Section 988 or 1256 contracts.
The 988 contract applies to most spot traders and allows them to deduct all losses from forex trading for the year.
Meanwhile, a 1256 contract is mainly for forex futures (contracts to sell or buy an asset at a specific price and time) taxed under the 60/40 rule. This rule states that 60% of gains are treated as long-term gains and 40% as short-term.
How Is the Forex Market Regulated?
Although the forex market is decentralised, it is still regulated by various authorities based on the country or region these markets are based.
For example, in the U.K., the Financial Conduct Authority (FCA) implements the regulations.
In the U.S., regulatory bodies include the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC).
What Are Forex Trading’s Potential Risks?
Forex trading doesn’t guarantee that you’ll consistently profit from buying and selling currencies. You can still lose your entire capital, especially when you use leverage, because profits and losses depend on your traded position’s total value.
While market volatility provides profit opportunities through price movements, it can result in a gap risk.
Gap risk is when a stock’s price falls substantially from one trade to another due to volatility.
One adverse effect of gap risk is that your stop-loss orders may execute at unfavourable prices.
- What is a forex online broker?
A forex broker traditionally trades currencies on your behalf. Nowadays, many online forex brokers offer trading platforms allowing you to buy and sell currencies yourself.
- Is forex trading profitable?
You can make huge profits in forex trading if you’re an exceptionally skilled trader or a hedge fund with substantial capital.
At the same time, forex trading may not be for everyone. It can be challenging for the average retail trader due to its significant loss potential.
- Is forex good for beginners?
Whether forex trading is good for beginners depends on an individual’s financial condition, goals and investing experience.
Trading is risky whether you’re a beginner or an experienced trader. So, exercise caution, especially if you’re a beginner, because the reality is that forex traders can also lose huge amounts of money.
- Is trading forex a good idea?
Trading currencies can be a good idea if you like to trade anytime you want, considering the forex market operates 24 hours daily.
Forex can also work for you if you prefer a high-risk environment where you can take advantage of a large market with high liquidity, volatility, volume, and leverage.
- Is forex trading similar to currency trading? Is there a difference between currency trading and forex trading?
Forex trading is similar to currency trading because these terms involve exchanging one currency for another to profit from the currency’s fluctuating price movements.
- How do I earn money from forex trading?
You can earn from forex trading by correctly predicting a pair’s price movements and opening a position that you believe will profit.
Suppose a country’s central bank adjusts its interest rate, which may cause that nation’s currency to decline in value. You can go short and profit from a weaker currency.
- What are gaps in forex trading?
Gaps are market periods with sharp upward or downward movements but with little or no trading. Such events result in gaps in the price pattern.
- Can forex trading be a full-time job?
If you have the time and financial resources, you can engage in forex trading as a full-time job. The forex market operates 24 hours daily, giving you more opportunities to trade full-time.
- What are margin rates for forex?
Forex margin rates can vary based on your broker and the currency pair being traded. Some currencies’ margin rates are as low as 0.20%, while others have 5%.
- Can I trade on forex from home?
Yes, you can trade forex and derivatives from home through an online forex broker.
- How many currency pairs does the forex market have?
The forex market has numerous currency pairs categorised into major, minor, and exotic currencies.
Most online brokers offer trading for currency pairs, including EUR/USD, GBP/USD, and USD/JPY.
- Are forex trading and FX trading the same thing?
FX trading is a shortened version of forex trading. Thus, both terms are the same.
- Leading forex currency pairs in April 2022, by share of daily average turnover
- Red Candlestick Definition, What It Tells You, How to Use It
- Bar Chart: Definition, How Analysts Use Them, and Example
- What Is Forex Trading? A Beginner’s Guide
- Exchanges: Explanation, Types and Examples
- Over-the-Counter (OTC): Trading and Security Types Defined
- What Is a Forex Currency Trader?
- Gross Domestic Product
- What Is Standard Lot? Definition in Forex and Calculating Lots
- Quote Currency in Forex: Meaning and Examples
- Major Pairs: Definition in Forex Trading and How to Trade
- Commodity Pairs: Currency Correlations Explained
- Forex Market: Who Trades Currencies and Why
- How Forex Trades Are Taxed
- Gap Risk
- Can Forex Trading Make You Rich?