Forex Trading Explained: A Primer

What is Foreign Exchange Trading?

The trading of foreign exchange, commonly known as “Forex” or “FX”, is the exchange of one currency for another at an agreed-upon price.

Forex trading means buying one currency and selling another at the same time, and this is why forex trading is expressed in terms of currency pairs.

You buy dollars for pounds; you sell roubles for South African Rand – by definition, you cannot buy or sell a given currency without acquiring another one.

The value of currencies changes constantly, due to events in:

  • World politics

  • Macroeconomics, and

  • World business.

The common goal of forex traders is to profit from these changes in the value of one currency against another - by actively speculating on which way currency prices are likely to turn in the future.

 

How does the Forex Market Function?

The global forex market is very different from those of stock markets.

There are no local forex markets: Currencies are traded in one single global forex market that operates 24 hours a day, from 10 p.m. GMT on Sunday to 10 p.m. GMT on Friday.

There are, however, local market hours that have an effect on trading, even if trading does not cease when these market close – for example, the London Forex Market opens at 8:00 a.m. GMT on Monday and closes that evening at 5:00 p.m. GMT. Trading in the British pound goes on without the slightest interruption after 5:00 p.m. GMT.

But there is a great deal more trading in the British pound during the opening hours of the London market, and there are specific trading patterns observable during open market hours.

 

How are Currencies Priced?

When the price of a currency is quoted, it is quoted in terms of a pair with another currency.

All forex is quoted in terms of one currency versus another.

The base currency is the currency on the left of the currency pair and the counter currency is on the right.

This is critical, because no currency has any kind of “absolute” value if it is trade on the international Forex market.

Nothing is pegged to gold, or to some other fixed determination of worth. Every currency on the market “floats” with respect to all the others.

So, for example, in GBP/USD, GBP is the ‘base’ currency and USD the ‘counter’ currency.

Forex price movements are triggered by currencies either:

  • appreciating in value (strengthening), or

  • depreciating in value (weakening).

If the price of GBP/USD for example were to fall, this would indicate that the counter currency (US dollars) was appreciating, whilst the base currency (British pounds) was depreciating.

 

Types of Currency Pairs

The most traded currency pairs in the world are called the Majors. They are:

  • EUR/USD

  • USD/JPY

  • GBP/USD

  • AUD/USD

  • USD/CHF, and

  • USD/CAD.

These are by far the most liquid currency pairs, and they account for about 85 per cent of all forex trading.

The pair USD-EUR is not traded for historical reasons. Some pairs have nicknames, which are useful to learn for understanding trading discussion.

The GBP/USD pairing is known by traders as ‘the cable’ – at one time an undersea cable connected the trading floors in London and New York to synchronise trading in this currency pair. 

Origins of some other nicknames for pairs are more obscure, but the:

  • EUR/USD is sometimes called ‘the Chunnel’,

  • EUR/GBP is occasionally referred to as the ‘Loonie’, and

  • USD/CAD is (rarely) referred to as the ‘The Funds’.

 

What are PIPS?

A PIP is an acronym for percentage in point.

This percentage in point represents the smallest value of measurement for currencies on the forex market.

Unlike dollars and cents which are calculated up to two decimal places, the currencies on the forex market are calculated up to the fourth decimal point.

The smallest move that a PIP can have is .0001, which represents 1/100th or commonly referred to as 1 basis point.

The one exception to the fourth decimal point is the Japanese Yen, which is only calculated up to two decimal places.

 

What is The Spread?

PIPs are calculated in terms of currency pairs.  Unlike stocks or futures which trade solely based on their own evaluation, the forex market compares the value of two currencies to arrive at a Bid and an Ask price, which is expressed in terms of PIPs.

So, for example, if the USD/CHF is worth 1.15351, then that means that $1 US Dollar is worth 1.1531 Swiss Francs.

But the price is different for the bid and for the asking. So, if the price of the EUR/USD forex pair moved from 1.33800 to 1.33920, it is said to have climbed by 12 ‘pips’ (92-80=12).

To show the BID/ASK prices, another example would be EUR/USD dealing at 1.33800/1.33808 (in this case the spread is 0.8 pips or 0.00008). The exceptions to this are the JPY pairs which are quoted to just 2 decimal places.

A USD/JPY price of 97.41/97.44 displays a 3 pip 'spread'.

 

How is Leverage Implemented in Forex?

The use of leverage is a key aspect of Forex trading.

Forex trading contracts are very large, but brokers permit their clients to access small parts of them using leverage.

When an investor first opens up an account with a broker, one of the first options to be chosen is the level of leverage obtained.

Usually, the amount of leverage provided is either 50:1, 100:1 or 200:1, depending on the broker and the size of the position the investor is trading.

Leverage of 200:1 is usually used for positions of $50,000 or less. Many traders have “mini-accounts,” so that, to trade $100,000 of currency, with a margin of 1%, an investor will only have to deposit $1,000 into his or her margin account.

The leverage provided on a trade like this is 100:1. Leverage of this size is significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage provided by the futures market.

This would ordinarily seem terribly risky, but traders are never asked to “cover their margins” in forex trading.

Currency prices usually change by less than 1% in a given day. Should a major shift take place, the broker has an automatic “stop” in place that will prevent your account from losing more than the cash or credit it has in place.

This is why it is difficult to trade forex with less than US$10,000 (or the equivalent) on hand even in a mini-account – a sizable shift in the value of one currency can devour all the money in an account in a matter of seconds.

To avoid such losses, forex traders usually implement a strict trading style that includes the use of stop and limit orders.

 

What is Stop Loss?

Forex trading is terribly rapid. In the space of nano-seconds, millions can change hands – this doesn’t just happen once in a while, it happens every day.

Every forex trader knows this, and uses the protection of stop losses so that a major shift in the value of a given currency against expectations doesn’t cost all the money in the account.

Once a trade is set in motion you cannot stop it, except to close the trade. You may not even be able to click the mouse quickly enough to keep from racking up huge losses.

A stop loss closes a trade automatically when the currency falls to given level. Similarly a stop loss can close a trade when a currency rises in value if you have bet on its going lower.

 

What is a Limit-Order?

A limit order allows an investor to set the minimum or maximum price at which they would like to buy or sell before making a trade.

What is a Take-Profit Order?

A take-profit order allows an investor to set the closing price of a trade before making the trade.

What is a Trailing Stop Loss Order?

A Trailing Stop Loss permits you to protect your account balance while locking in profit.

In a trade that, for example, is long on a certain currency, you may set your stop loss at a certain point. Suppose the currency pair moves higher? The Trailing Stop loss will also move higher, remaining at the distance you specify below the current value of the pair, so that you can protect your account while getting the value of the trade.

Let’s take the example of trade in which USD/JPY starts at 0 (this is hypothetical). You set your Trailing Stop Loss at -150. Now USD/JPY moves up to 200. Your Trailing Stop Loss Moves up to 50. Your profit of 150 is protected by the stop loss. Now the pair moves higher, to 400. Your Trailing Stop Loss moves to 250. Each time your profit is locked in.

Suppose the pair suddenly drops back to 0? Your trade is stopped out at 250, and you have gained 250. But, you must remember that the Trailing Stop Loss will close your trade, regardless of conditions.

This is not always desirable (sometimes, in certain complex trading movements, a move lower is expected followed by a move higher. Using a Trailing Stop Loss bars your access to this kind of trading strategy).

 

Can You Trade Forex for A Living?

It is possible to make a regular income out of forex trading. To do so, however, means putting a substantial amount of capital on the market, and trading it regularly.

Forex trading has one great advantage: Many brokers do not charge commission.

The cost of a trade is taken out in the spread, and, once a trade becomes profitable, the payment to the broker is already made. Apart from a small annual fee, it is thus possible to limit actual costs of trading. 

However, forex is not a get-rich-quick investment. It is, on the contrary, a demanding and time-intensive form of trading. The forex market is unforgiving: As seasoned forex traders often say: ‘Always remember, the market will hurt you if it you give it the opportunity.

To make a living at trading forex, you must learn to understand how the market works, gain serious experience at trading, and learn an in-depth proven strategy. If you are willing to spend the time to do this, and you are prepared to spend at least five to seven hours a day trading, then it is possible to make a living at the game.

Becoming a consistently profitable trader requires serious discipline, but it can be done and there are a happy few who achieve this.

Most forex traders anticipate earning 10-15 percent per month on their capital. In order to do this, however, you must make a fairly substantial initial investment. It is possible to begin trading with as little as $500, but you cannot really follow the movements of the market with so little invested. 

Normally, one should start with a minimum of US$10,000, or the equivalent. It is possible to begin with as little as US$5,000, or the equivalent, but it is a painful start.

Having a reasonable amount to work with allows you to avoid having to risk too much on any one trade. But you need to have enough money at your disposal to take a large enough position on a trade to make a reasonable amount of money.

Don’t quit your day job right away! Focus on building a consistently profitable track record and self-confidence and the money will follow. Forex trading is about consistency and security.

Good trading will lead to expanded trading. Good trading takes place one trade at a time. Trade the short-term – 15-minutes, an hour, the daily charts. Look for well-defined positions; take the advantage; clear out fast. The full-time trader is, above all, a trader who manages risk.

 

Is Forex a Safe Investment?

Trading Forex is not, strictly speaking, an “investment,” in the sense that investing in a bond or a stock is.

When you trade forex, you put your money at risk in an investment strategy. However, the risk can be managed with a prudent trading strategy.

As in all investment strategies, there is a ratio of risk versus return. Risk is high in forex trading, but it can be managed. 

The high level of risk stems from the number of forces that affect the global forex market.

One can understand the technical reasons for a move in a given currency, but that move may go the opposite way due to a political or even a climate event. A storm, a plane crash, an election – all of these may change the rules about what happens to your trade.

And this is why a good trader starts the day by studying the calendar of events on forex websites, and by reading the news carefully. Even then, stuff happens. That’s what the stop loss is for.

So traders manage the risk when they put money on the forex market. They make use of the limit order and the stop loss.

They watch for patterns of trading, so that they can predict market action. Technical trading is all about this kind of pattern-spotting, and, in orderly trading – and there is orderly trading on many markets when events do not intervene – it’s possible to follow, for example, a Fibonacci retracement, to let it take its course, and to take advantage of it.

Orderly trading takes place most of the time, and, as a result, putting money on the forex market is safe if you understand what you are doing. A disciplined, well-educated trader is a safe trader.

 

What about Demo Trading?

Many forex trading sites offer demo trading to get you started.

There is nothing wrong with this. The intention is to give you a chance to get to know how the site works. Every trading site has some symbols and indicators that are special to the site itself, and each site has a few idiosyncrasies, so working on the demo site for a bit helps you to get the basics down.

You should, however, be careful to not assume that trading on the demo site is in any way practice for trading with your own money. Why not? It is simply too easy to make dangerous decisions with symbolic money on a demo site that you would not (or, at least, should not) dare to make when trading with your own funds.

On a demo site, you just let a trade hang in there until it goes bad. You wouldn’t take such a risk if you knew it might cost you a great deal of cash. 

Doing symbolic trading induces bad habits, and takes the emotional edge off trading. Don’t make the mistake of using it instead of the real thing. Real forex trading is very tough, and it’s just not the same when there is no risk.

 

How do Forex Traders Make Money?

A forex trade works like this: You purchase 10,000 euros when the pair is quoted at EUR/USD = 1.1800. The value of the euro rises, and the pair is worth 1.2500. You earn $700.

What might make you think that the euro will rise against the dollar? There might be the obvious reason that the European Central Bank has announced that it intends to raise interest rates, but that doesn’t happen very often.

What usually happens is that the euro falls to a point, and then stops falling. It reaches what traders call a “support floor,” a point at which traders think the price is low enough.

When a currency hits a support floor, it often climbs back from it to a new level, as part of a trading pattern. Traders will have observed the drop to the support floor, will begin acquiring the euro at that point, and the currency will rise to its new level until it hits “resistance,” the point at which there is a kind of consensus that the price is high enough.

The trick, in any trading strategy, is to buy at the support floor, and sell at the resistance.

Traders judge these from experience, long-observed trading patterns, and a wealth of other formulas that they apply. 

Traders also use a number of different indicators, usually available on most trading platforms, to help in making judgements. These indicators can be plugged into the charts on which you make your trades.

Successful forex trading is based on strategies.  When you first learn to trade forex, you have to learn about the different strategies, and choose the ones that you find most useful. Obviously, one of the things traders think about the most is when to enter and when to exit.

Experience counts for a lot. Observing a single currency pair over a few months, one begins to spot regular patterns apart from those that one reads about in the manuals. It is this combination of experience and learning that makes a consistent trader. 

Once you have discovered patterns that repeat themselves, once you have a good sense of the market for a given currency pair and you know what to expect it might do, you will find that you begin making money consistently on the forex market.

If you remain prudent, cautious, disciplined, and if you adhere to what you have learned, you will continue to make money.

Proceed with caution, but don’t be afraid. Control the risks as much as possible. You will lose on some trades. It is important to accept that, and move on.

Psychologists tell us that it is very hard to accept losing on a trade, but it is important not to try to salvage a bad trade – that is a sure way to lose a lot of money.

Take your small loss and make a new trade. And keep going.