What is Forex & How Does It Work?
Forex, also known as foreign exchange, FX, or currency trading, is a decentralized global market where all the world’s currencies trade. The forex market is the largest, most liquid market in the world with an average daily trading volume exceeding $5 trillion.
All the world’s combined stock markets don’t even come close to this. But what does that mean to you? Take a closer look at forex trading and you may find some exciting trading opportunities unavailable with other investments.
What is the Forex Market?
If you’ve ever traveled overseas, you’ve made a forex transaction. Take a trip to France and you convert your pounds into euros. When you do this, the forex exchange rate between the two currencies—based on supply and demand—determines how many euros you get for your pounds. And the exchange rate fluctuates continuously.
A single pound on Monday could get you 1.19 euros. On Tuesday, 1.20 euros. This tiny change may not seem like a big deal. But think of it on a bigger scale. A large international company may need to pay overseas employees. Imagine what that could do to the bottom line if, like in the example above, simply exchanging one currency for another cost you more depending on when you do it? These few pennies add up quickly. In both cases, you—as a traveler or a business owner—may want to hold your money until the forex exchange rate is more favorable.
There are several key differences between swapping currencies abroad and buying or selling forex.
Participating in the foreign exchange market is the easiest, most efficient way of exchanging currencies. You don’t have to stand in line at a currency dealer and pay undue premiums to trade monies. Instead, you simply need computing power, internet connectivity, and an FX broker to engage the world’s currency markets.
How Does Forex Trading Work?
On the foreign exchange market (forex), trade is conducted in an exclusively electronic format. Currency pairs are bought and sold 24 hours a day, 5 days a week by participants worldwide. Market participants engage the forex remotely, via internet connectivity.
Upon a trader sending a buy or sell order to the market, forex brokers facilitate the transaction by extending the margin. Accordingly, the trader is able to open new positions far in excess of capital on hand, with the goal of realizing profits from beneficial movements in price. To complete each forex trade, the market’s technological infrastructure matches contradictory orders from market makers, individual traders, and other liquidity providers.
How to Start Forex Trading?
All forex trades involve two currencies because you’re betting on the value of a currency against another. Think of EUR/USD, the most-traded currency pair in the world. EUR, the first currency in the pair, is the base, and USD, the second, is the counter. When you see a price quoted on your platform, that price is how much one euro is worth in US dollars. You always see two prices because one is the buy price and one is the sell. The difference between the two is the spread. When you click buy or sell, you are buying or selling the first currency in the pair.
Let’s say you think the euro will increase in value against the US dollar. Your pair is EUR/USD. Since the euro is first, and you think it will go up, you buy EUR/USD. If you think the euro will drop in value against the US dollar, you sell EUR/USD.
If the EUR/USD buy price is 0.70644 and the sell price is 0.70640, then the spread is 0.4 pips. If the trade moves in your favor (or against you), then, once you cover the spread, you could make a profit (or loss) on your trade.
Trading FX pairs in the contemporary forex marketplace is straightforward and user-friendly. Vast functionalities are readily available on the software trading platform designed to aid in analysis and trade execution. Some of the most powerful features are advanced charting applications, technical indicators and multiple order types. Whether you are an intraday scalper or long-term investor, modern platforms make it routine to conduct business with forex.
PROS AND CONS OF TRADING FOREX?
Like all markets, forex features a unique collection of pros and cons. For any aspiring currency market participant, it’s important to conduct adequate due diligence and decide if forex trading is a suitable endeavor.
Remote accessibility, limited capital requirements, and low operational costs are a few benefits that attract traders of all types to the foreign exchange markets. In addition, forex is the world’s largest marketplace, meaning that consistent depth and liquidity are all but assured. Factor in a diverse array of products, and retail traders enjoy a high degree of strategic freedom.
However, there are several pitfalls of which to be aware. First, the availability of enhanced leverage an abundance of trading options can seriously test one’s discipline. Also, pricing volatility can be swift and dramatic, posing the risk of rapid, significant loss. Lastly, past performance is not indicative of future results― forex trading is always changing, emphasizing the need for sound strategy and strong risk management.
Flexibility and diversity are perhaps the two biggest advantages to trading forex. The ability to open either a long or short position in the world’s leading major, minor or exotic currencies affords traders countless strategic options.
Forex Trading Platforms
The forex trading platform is the trader’s window to the world’s currency marketplace. To be effective, it’s imperative that your trading platform is up to the many challenges of the live market.
At FXCM, we offer a collection of robust software suites, each with unique features and functionalities. Our flagship platform Trading Station furnishes traders with the utmost in trade execution, technical analysis and accessibility. We also support the industry-standard Metatrader 4 (MT4) software, NinjaTrader, social trading-oriented Zulutrade, and assorted specialty platforms. No matter what your approach to forex trading may be, rest assured that FXCM has your trading needs covered. To check out our available platforms, please click here.
If prices are quoted to the hundredths of cents, how can you see any significant return on your investment when you trade forex? The answer is leverage.
WHAT IS LEVERAGE IN FOREX?
When you trade forex, you’re effectively borrowing the first currency in the pair to buy or sell the second currency. With a US$5-trillion-a-day market, the liquidity is so deep that liquidity providers—the big banks, basically—allow you to trade with leverage. To trade with leverage, you simply set aside the required margin for your trade size.
If you’re trading 200:1 leverage, for example, you can trade £2,000 in the market while only setting aside £10 in the margin in your trading account. For 50:1 leverage, the same trade size would still only require about £40 in the margin. This gives you much more exposure while keeping your capital investment down.
While it’s true that forex leverage is a great way to optimize your capital efficiency, it must be treated with respect. Ultra-low margin requirements give you the ability to assume large positions in the market with only a minimal capital outlay. This is a key element of posting extraordinary returns over the short, medium or long run.
However, in FX trading, leverage is the quintessential double-edged sword; it simultaneously boosts profit potential and assumed liability. During volatile periods, an unfortunate turn in price can generate losses in excess of deposited funds. The result can be a premature position liquidation, margin call or account closure.
If you’re new to forex trading, then it’s best to start small. Trading lower leverage ensures that you have enough capital to become experienced in the market. There’s plenty of time to implement higher degrees of leverage once you gain competency and security in the marketplace.
WHAT IS MARGIN IN FOREX?
Forex margin is a good-faith deposit made by the trader to the broker. It is the portion of the trading account allocated to servicing open positions in one or more currencies. Margin is a vital component to forex trading as it gives participants an ability to control positions much larger than their capital reserves.
It’s important to remember that margin requirements vary according to currency pair and market conditions. During times of extreme exchange rate volatility, margins typically grow as market conditions become unhinged. This occurs to protect both the trader and broker from unexpected, catastrophic losses.
At FXCM, clients enjoy minimal margin requirements and countless position sizing options. For major currency pairs, a 30:1 leverage restriction applies; for non-major currency pairs, a 20:1 limit applies. To view up-to-date margin requirements, click here.
WHAT ARE PIPS IN FOREX TRADING?
A point-in-percentage, or “pip,” is the minimum price movement that a currency pair can make. Pips are standardized units, which let traders quickly monitor the fluctuations of a currency pair’s exchange rate. A majority of forex pairs are quoted to the fourth decimal place, or 1/10,000, making a pip 0.0001.
To illustrate pip functionality, let’s take a look at the EUR/USD. The EUR/USD is quoted in terms of a 0.0001 pip; thus, for every 0.0001 movements in price, the trading account is credited or debited the pip’s value. Pip value is calculated by dividing one pip by the currency pair’s market price then multiplying by position size (micro, mini, standard lots). For pairs that feature the USD as the base currency, pip values are typical US$0.10 (micro), US$1.00 (mini), and US$10.00 (standard). So, for one standard lot of EUR/USD, each 0.0001 pip movement results in a US$10.00 credit or debit to the trading account.
Calculating your target forex pair’s pip value for a given trade can be complex. Key variables are evolving margin requirements, unique position sizes, and base currency. Fortunately, FXCM provides access to a pip calculator to help you stay on top of any trade’s liabilities.
HOW TO LEARN FOREX
In an atmosphere as dynamic as the forex market, proper training is important. Whether you are a seasoned market veteran or brand new to currency trading, being prepared is critical to producing consistent profits.
Of course, this is much easier said than done. To ensure that you have your best chance at forex success, it is imperative that your on-the-job training never stops. Developing solid trading habits, attending expert webinars, and continuing your market education are a few ways to remain competitive in the fast-paced forex environment.
If your goal is to become a consistently profitable forex trader, then your education will never stop. As the old adage goes, practice makes perfect; while perfection is often elusive for active traders, being prepared for every session should be routine.