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What is Forex Trading?

FX Scouts By Jeffrey Cammack Updated: September 6th, 2019

Forex trading is the trading currency CFDs for profit.  Private Forex traders, known as retail traders, speculate on the values of currencies.  The goal is to predict if a currency value will increase or decrease over time in relation to a second currency.

What is Forex Trading

[toc]The Forex market is an open market and the largest financial market in the world; measured in trading volume. The foreign exchange spot and OTC derivatives markets averaged $5.1 trillion per day according to the Triennial Central Bank Survey 2016 – this was slightly down from $5.3 trillion per day in April 2013.  The initial results for the 2019 survey are due in September 2019.

A financial institution with suitable credentials will be able to open and close trading positions on behalf of clients, but many different players partake in the trading of currencies.

While the Forex market moves in tiny increments, economic news like economic reports or interest rate changes causes more significant changes in the currency value.  As traders attempt to buy and sell a currency pair at different prices to generate a profit, a trader can thus only make a profit from a market that has this volatility over shorter periods.

Retail traders make up a minimal amount of the volume traded on the market.  Retail traders represented only 5.5% of the Forex exchange trade volume in 2016.   The most substantial amount is being invested by the banks, where the three leading players were  Citi 12.9%, JP Morgan 8.8%, UBS 8.8% (Reuters).

How to Learn Forex Trading?

Most Forex traders jump right in and figure it out using a free play-money account called a demo account. Opening a demo account makes the free educational resources available, along with industry analysis tools and commentary.

Trading Forex and CFDs is not suitable for all investors and comes with a high risk of losing money rapidly due to leverage. 75-90% of retail investors lose money trading these products. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Traders often get into trading through two distinct avenues.  There are a set of traders that enjoy following news, and understand how the news events affect global economics and currency values.  These news readers have an advantage in fundamental analysis and are very effective day traders and scalpers.

The other trader is more of a mathematician who has an interest in math, numbers, charts and patterns.  The technical traders trade almost entirely based on market data, trends and patterns, and enjoy the deeply involved strategies and focus needed to execute on them.

Only once a trader has figured out how to identify market opportunities, will they be able to learn to trade and perfect that style of trading.

Is Forex Trading profitable?

Forex trading can be profitable if you have the skill to learn more trades than you lose. Change in currency value is tiny in comparison to other financial markets like stock exchanges.  Unless you are bank investing millions of dollars in a single trade, you are not going to see any significant profits that would justify the time spent and exposed risk.  For this reason, CFD traders use leverage.

Leverage as a way to amplify trading profits by borrowing money from a liquidity provider so that a trader can hold a more substantial position.  When using leverage, the trading account balance must be able to cover for any losses for the amount of leverage you are using, so leverage increases your exposure to risk.

Having leverage available to a trader can make Forex trading extremely profitable as long as the trader wins more trades than they lose.  There are very few traders who are good enough to be able to leave their job to become day traders, but there are enough traders who make an extra bit of money to pay for a holiday every year.

Risk in Forex Trading

CFD trading is a high-risk activity (MoneySmart AU – pdf – Page 12), that involves investment risk, counterparty risk, and client money risk.

The volatility of the financial markets creates investment risk as markets can move in any direction without notice.  It is especially surprising when markets move sharply in a direction that was never anticipated.  Numerous factors affect market volatility, and there are a lot of big banks that have the capital to move markets for them to make a profit.

Trading any speculative CFD product exposes traders to a great deal of risk.  As a general rule, traders should never trade with money than they can not afford to lose where traders need to maintain a healthy win-loss ratio, and never put more than 2% of the account balance into any single trade.

Counterparty and client money risk can be minimised by trading with regulated Forex brokers. Regulated Forex brokers are required to follow strict processes for client fund handling and resolution processes.  In general, the more regulators a broker has, the lower counterparty and client money risk a client will be exposed to.  Regulation is central to how we review brokers, and regulation details are often made clear on individual broker websites.

Best Forex Trading Brokers

Broker Min. Deposit Min. Spread
FXTM $5 0.0 pips Visit Website Read Review
eToro $200 2.0 pips Visit Website Read Review
AvaTrade $100 0.7 pips Visit Website Read Review
HotForex $100 0.0 pips Visit Website Read Review
XM $5 0.0 pips Visit Website Read Review
Markets.com $100 0.9 pips Visit Website Read Review
easyMarkets $100 1.8 pips Visit Website Read Review
GKFX Prime $5 0.0 pips Visit Website Read Review
FBS $5 0.0 pips Visit Website Read Review
HYCM $100 0.2 pips Visit Website Read Review
Pepperstone $200 0.01 pips Visit Website Read Review

Broker Types

Forex brokers have different business models which will affect client profits.  Some brokers will trade against their client base (Market Makers) by becoming a counterparty to trades, as a way for them to offer immediate liquidity, while other brokers will execute trades on the Interbank market (Direct Market Access) with existing levels of liquidity.

Market Makers: These are the brokers that take the counterparty to your trade, and thus make the market.  Market makers are usually identified by having wider spreads than their DMA counterparts.

Direct Market Access (DMA):  There are two different broker types in the DMA category.  ECN brokers STP brokers, or a combination of the two.

ECN brokers offer traders a connection to the interbank market, which means that the broker does not get involved in the trade.   The broker has no direct conflict of interest, but should there be liquidity to execute the trade, the trader should expect slippage.

The ECN/STP brokers also get their rates directly from the interbank market, but in the case that there is no liquidity, the broker can offer the liquidity to the trader by becoming a Dealing Desk and becoming a counterparty to the trade.   This means that there can be a conflict of interest from the broker, but not to the extent you would expect from a pure Dealing Desk broker.

Forex Trading Vocabulary

Forex Currency Pairs

Currencies are always traded in pairs as the value of a currency can only increase or decrease in relation to another.  When we trade Forex, we are either buying or selling one of the currencies in the pair, in a process that is known as going long or going short.

For the case of simplicity and standardisation, all currencies have a 3-letter code to represent them.  The first two letters are made up of the country, and the third is the currency.

For example, the USD is the United States Dollar, and the Malaysian Ringgit is the MYR.

 

Below is an example of a pair, including the United States Dollar and the Malaysian Ringgit.  This is how you will see it on your trading platform.

Majors, Minors, Exotics

Currency pairs are grouped into three categories called the Majors, the Minors, and the Exotics.    For more on what currency pairs you should trade and which to avoid, read our article here.

The Majors Pairs

These are a group of 7 currency pairs that are a combination of USD with another major currency.  They are:

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

The Minors Pairs

These are the group of currencies that do not contain the USD but contain two currencies from strong economies.  These could be:

  • EUR/GBP
  • GBP/JPY
  • CHF/CAD

The Exotics Pairs

These are pairs made up of one currency from a developed economy and one from an emerging economy.  These pairs are not commonly traded, so expect a lack of liquidity and slippage if trading them – as well as crazy high spreads.  Some examples are:

  • USD/MYR
  • GBP/ZAR
  • AUD/THB

Pips & Spread

The smallest change in the value of a currency is called a pip.  In the example below, we have the USD/EUR pair that has a current value of 0.8106.  A single pip is the movement of the 4th decimal place.  Should the value of the pair increase to 0.8107, it would be an increase of 1 pip, and should it drop to 0.8105, it would be a decrease in value of 1 pip.

 

The red numbers next to the value of the currency are the daily change.  So far today, the USD/EUR pair is down 15 pips. 

Lots & Portion Size

Upon opening a position, the trader needs to decide the size of the trade.  This is called portion size and it is measured in lots.  A standard lot is the largest measure of portion size and it can be broken down into smaller portions.  They are:

  • Mini Lots – 10% the size of the Standard lot
  • Micro Lots – 10% of a Mini lot and 1% of a Standard lot
  • Nano Lot – 10% of a Micro lot and 0.1% of a Standard lot.

Should you choose to open a trading account with a minimal amount of funds, you will be trading Mirco and Nano lots and trading Mini lots, and Standard lots will take more investment capital.

Long & Short

At the same time a Forex trader opens a position, they indicate the direction of the trade.  A CFD trade can be profitable for a trader in both an increasing or decreasing market, as long as the trader speculates on the direction correctly at the time of opening the trade.

Going long is where the trader expects the currency pair will increase in value.  In this case, the trader is buying the first currency in the pair.  Going short is the opposite, and is a bet against the market and should the value of the currency pair devalue, the trader will profit.

Forex Trading Strategy

Trading Trends

One of the main principles of Forex trading is to trade with the trend.  If the market is going in a specific direction, it is fair to assume that the market will continue moving in that direction until something happens.  There are two main trends you will hear people talk about in the market – a bearish trend and a bullish trend.

Bearish Trend

A bearish trend is a prevailing downward trend.  This means that the overall trend needs to be down regardless of any upward movements against the overall trend.  Below is an example of this bearish trend.

Bullish Trend

A bullish trend is where the prevailing trend is an upward one, regardless of any smaller movements that go against the general upward trend.

Market Analysis

Some traders prefer finding trading opportunities from news events, while others prefer technical trading which involves chart analysis.  Every trader needs to analyse the news and markets to find upcoming trading opportunities.  As you get into trading, you will need to find out the kind of trader you are – here are some brief examples of how these traders might do analysis and what they may find.

Fundamental Analysis:  Traders doing fundamental analysis will be looking for major news events that are going to affect the value of either of the currencies in a currency pair.

An example:  During the day, the United States government is going to release a report called the Housing Price Index, which is an estimation of the value of single-family house prices.  Housing is an essential component of the US economy, and should the House Price Index increase, this will create a bullish environment for traders.  Should the index fall, it could create a bearish market.

Traders will have done analysis before the release of this report and opened a position prior to when the news is released.  Should the predicted outcome of the report be correct, traders will profit from the market volatility created.

Technical Analysis:  Traders doing technical analysis to look for opportunities to trade, will spend their time analysing chart patterns with the help of indicators and other trading tools.

An example: A trader will be watching a moving average indicator over two different time periods.  When the long-term indicator starts dropping below the shorter-term indicator, this could signal that the market is losing momentum and could be pivoting and head in the opposite direction.  This would encourage a trader to either sell or buy.

Sentiment Analysis:  This is where traders will try and get an understanding of the collective feeling of future value.  It is often displayed in a widget in the trading platform for each pair.

Pepperstone Sentiment Analysis Example

Pepperstone: Sentiment Analysis Example – AUDCAD 2019

An example:  There are tools out there that give traders a collected view of what all the traders in the world feel about specific pairs based on their trading.  Certain patterns and behaviour of these indicators will give conclusions about what might be happening in the market to others – which can then be traded for profit.

How to Open Your First Trade?

To open a trade, we need to:

  1. Choose the currency pair

Example: We buy the EUR/GBP because we believe the value of the EUR is going to increase against the pound after the British Prime Minister meets with the European Government to discuss Brexit conditions.  Rumour has it that the Europeans will not like the British proposal, so we want to trade this volatility.

  1. Select the portion size

Example: We choose to invest 150 EUR in the trade and decide to use 1:100 leverage.  This means that we will be using our 150 EUR to buy 15,000 EUR of investment.

  1. Chose the direction

Example: Since believing the EUR will increase in value against the GBP, we will go long and buy EUR, knowing that when the value of the GBP drops we will exit the trade with more GBP than we started with.

  1. Close the position

Example: We open the trade when the rate is EUR/GBP is 0.8750, and just as we expect the Euro gains on the GBP.  We exit the trade at a rate of 0.8900.  This is a change of 0.015 (or 15 pips).  0.015 of our original investment of 15,000 EUR is 225 EUR profit.

Conclusion

Forex trading, a form of CFD trading, is the trading of currency pairs where the trader does not take ownership of the asset.  Instead, the trader is speculating on the future value of currencies.  Due to the speculative nature of Forex trading, there is a high level of risk involved.  Forex traders are always working to control the risk their account balance is exposed too, and the larger the win to loss ratio is, the more profit a Forex trader will make.

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Trading Forex and CFDs is not suitable for all investors and comes with a high risk of losing money rapidly due to leverage. 75-90% of retail investors lose money trading these products. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.