What is Forex?

Forex Trading is the trading currencies on an open and international market.  Forex traders, often known as retail traders, speculate on the values of currencies, where they try to predict if a currency value will increase or decrease over time in relation to a second currency.

In trading the market, Forex traders first chose the amount they want to trade, the currencies they want to speculate on, and the approximate time frame they wish to keep the trade open for.  This request is passed forward to the market by a third party often referred to as a broker.

Example Forex Brokers

The Forex market is an open market and the largest financial market in the world; measured in trading volume.  A financial institution with the correct credentials will be able open and close trading positions on behalf of clients, but there are many different players who partake in the trading of currencies.

While the Forex market moves in very small increments, economic news like tax increases or interest rate rises can affect the values of currencies even more.  Forex traders only can make money in a market that has this volatility and change, so traders will always stay ahead of major news events to make a profit.

Forex brokers representing retail traders make up a very small amount of the money that is represented on the market – the largest amount is being invested by the banks.  The banks are continually investing and creating their own volatility in the markets, and it is all this volatility that small Forex traders try to profit from.

How to Learn Forex Trading?

There is no single way that Forex traders start.  There are two main types of traders, and I think each one might gain an interest in trading from two different directions.

There are a set of traders that really enjoy the news, and really 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 the mathematician who has an interest in math and numbers.  The technical traders trade almost entirely based on market data and trends, and really enjoy the deeply complex strategies and focus needed to execute on them.

These trading strategies are not mutually exclusive, so each trader needs to understand a little about fundamental and technical trading.  But more on this later.

Is Forex Trading profitable?

Change in currency values on the Forex market is very small in comparison to other financial markets like stock exchanges.  And so, unless you are bank investing millions of dollars in a single trade, you are not going to see any significant profits that would make trading worth the time and risk.  That is why retail traders use something called leverage.

Leverage is used by traders as a way to amplify their profits in trading.  It means that a liquidity provider, usually a 3rd party, will lend you additional money so that you can hold a larger position.    When using leverage, you must be able to cover for any losses on your trading account for the amount of leverage you are using, so leverage increases your exposure to risk.

But 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 and be 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

The nature of the financial markets is that they are volatile and can move without notice.  They can go in any direction, and they can especially go in a direction you had never anticipated.  There are a lot of factors that affect the markets, and there are a lot of big banks that have the capital to move markets for them to make a profit.

If you are thinking trading Forex, you should know that trading in any CFD-like product which is speculative in nature expose you to a great deal of risk.  As a general rule, you should never trade with money that you cannot afford to lose.  And as a second rule, you should expect to lose some of your trades.  You just have to maintain a healthy win-loss ratio and you should never put more than 2% of your capital into a single trade.

In Forex trading you can mitigate your exposure to risk, but you can never get away from it.  Expect losses.  Expect gains.  And expect to be surprised.

Bearish vs. Bullish Trends

One of the main principles of Forex trading is to trade with the trend.  If the market is going in a certain 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.

Long & Short

When Forex traders speculate on currencies and open a position, they do so in a way that they indicate which way they believe the market will go.  A trade can be profitable for a trader both in a bullish and a bearish market, as long as the trader indicates if they are going long or short when executing the trade.

Going Long is where the trader believes that the currency pair will increase in value.  They believe that the market is bullish.  In this case, the trader is buying the first currency in the pair.

Going Short is different.  It is a bet against the market and should the value of the currency pair devalue.  In this case, the trader is buying the second currency in the pair, and should it increase in value while the first currency falls, the trader makes a profit.

Forex Currency Pairs

Currencies are always traded in pairs.  This is because a value of a currency can only increase or decrease in relation to another.  And when we trade forex, we are either buying or selling one of the currencies in the pair.

For the case of simplicity and standardization, 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.  They are 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 can make 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 is the daily change.  We can see that so far today, the USD/EUR pair is down 15 pips. 

Lots & Portion Size

When you place a trade, you will not only need to choose a currency pair, but also 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 very small amount of funds, it would be the Mirco and Nano lots that you would be trading.  Trading Mini lots and Standard lots will take more investment capital. 

Analysis in Forex Trading

We discussed earlier that traders are different.  Some prefer trading from news events and others rather trade from watching indicators in the financial data.  Every trader needs to do analysis in an effort 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 how the US housing market is going.  Housing is an important component of the US economy and so should the House Price Index increase, this will usually create a bullish environment for traders.  Should the index fall, it could create a bearish environment.

As a fundamental trader, you will have done your analysis prior to the release of this report so that you have opened your position when the news is released, and you make a profit from the volatility it creates.

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

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

Sentiment Analysis:  Traders doing this form of trading are rarer than the two previous ones.  This is because sentiment analysis is hard and often misunderstood.

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

There is no really good introduction example of sentiment analysis, so I feel it best that we leave this for now and address in future in a separate article.

Brokers & Broker Types

All forex brokers were not created equal.  There are different business models when operating a forex broker, where brokers will trade against their own client base as a way for them to offer liquidity on the pairs they want to trade instantly, but in doing so they take the counterparty to the trade.  Here are some brief explanations, but for more detailed descriptions read more here.

Market Makers or Dealing Desks:  These are the brokers that take the counterparty to your trade.  They are usually identified by requiring higher minimum deposits and they have wider spreads.

Non-Dealing Desks:  There are two different broker types in the Non-Dealing Desk category.  ECN brokers and ECN/STP brokers.

ECN brokers offer traders a direct link to the interbank market which means that broker does not get involved in the trade.   The broker, in this case, has no conflict of interest, but it does mean that if there is no liquidity, then 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 is able to 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.

How to Open Your First Trade?

Now that we have a good understanding of what Forex is, and how the Forex market work, we can think about how to open your first trade.

  1. Choose the currency pair you want to trade

Example:  Let’s trade 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.  Rumor has it, that the Europeans will not like the British proposal, so we want to trade this volatility.

  1. Select the amount we want to invest.

Keeping with our 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.  (We calculated this by Investment Capital x Leverage)

  1. Chose the direction you believe the market is going to move in.

As discussed in step 1, we believe the EUR will become more valuable against the GBP, so we will go long and buy EUR, knowing that when the value of the GBP will drop, and we will exit the trade with a greater number of GBP than we started with.

  1. Close the deal when you feel it is time.

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 is the trading of currency pairs where the trader does not take ownership of the asset, but rather is speculating on the future value of currencies.  Because Forex trading is speculative, there is risk involved and trading in any CFDs is a risky business.  Forex traders are always working to control the risk they expose themselves too, and the large the win to loss ratio is, the more profit a Forex trader will make.