Written by Brenda Nakalema

Introduction to Forex Trading

You might be one of the people that yearns to earn extra money trading forex, and asks themselves the question, …

You might be one of the people that yearns to earn extra money trading forex, and asks themselves the question, “what is forex trading and how does it work?” With this article, we hope to demystify the world of trading currencies,so that in time you too might consider yourself a ‘pro-trader’.

Forex is a word that combines foreign currency and exchange. Foreign exchange is the process of exchanging one currency for another as done by forex traders. Forex trading is essentially a network of buyers and sellers who transfer different currencies between each other at a pre-determined price.

Despite the fact that foreign exchange is typically undertaken for practical purposes, i.e. to facilitate changing of currency during travel or to make payments, the activity is also sometimes undertaken with the aim of earning a profit. The amount of currency converted on any day can result in volatile price movements of certain highly traded currencies. The price volatility makes forex trading so attractive for certain forex traders, the extreme inherent risks, and the potential for high profits.

What is the forex market?

The forex exchange market is the financial market where currencies are traded. The trade of currencies is important because it facilitates the exchange of goods and services within and across borders. For foreign trade and business to occur, currencies have to switch hands as a representation of value.

This is also true in the case of international travel; An American tourist, for instance, cannot use U.S dollars when travelling to China; he or she must change their dollars into Chinese currency in order to pay for goods and services once in China.

Unlike other international financial markets such as the stock market, the forex market doesn’t have a central marketplace. The market remains operational 24 hours a day, five days a week, and currencies are traded across borders in the major financial centres of Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo and Zurich- essentially almost every time zone. Trading of international currencies is conducted over the counter (OTC), which means that all trades are executed via computer networks among forex traders worldwide instead of one centralized exchange. What this means is that when the trading day comes to an end in the U.S, the forex market reopens in Tokyo and Hong Kong.

An overarching view of Forex Markets

The Forex market is the virtual world where currencies are continuously traded; it is the only market that runs seven days a week at all hours of the day. Previously, the market was dominated mainly by institutional firms and large banks that were the only institutions with the means and the permission to trade large volumes of foreign currency. However, in recent years the market has taken on a more retail outlook, with forex traders and investors of all sizes taking part in the lucrative market.

Most investors and forex traders consider the forex market quite risky because it doesn’t have the same regulatory oversight that other markets have; currencies are traded in OTC markets in which disclosures are not mandatory. Large liquidity pools from institutional firms are commonplace in the market.

Types of forex markets

Spot Market

The spot market is where the largest forex trades are executed because it is where trades in the biggest underlying asset- forwards and futures markets- are conducted. In the past, trading volumes in the forwards and futures markets were larger than those of spot markets; however, the growth and development in technology, electronic trading and increase in the number of forex brokers influenced the growth of the spot market.

The spot market is the forex market where currencies are bought and sold based on their trading price. It is calculated based on a wide range of factors like current interest rates, economic performance, the influence of both local and international political forces, as well as the perception of future performance of one currency against another. The forces of demand and supply determine the price. The deal finally reached after all this has gone into play is known as a spot deal. It is a bilateral transaction where one party delivers an agreed-upon currency amount at the agreed-upon exchange rate value. After a deal is struck, the settlement is made in cash. Although the spot market is typically known as one that deals with transactions in the current time (as opposed to the future), these trades usually take two days to be completed.

Forwards and Futures Markets

A forward contract is an agreement struck between two parties agreeing to buy a currency at a future date and at a pre-determined price in the Over-the-counter markets. A futures contract is a standardized agreement that exists between two parties to take delivery of a currency at a future date and pre-determined price. Futures contracts are traded on exchanges and not over the counter like in the case of forwards contracts.

In the forwards markets, contracts are bought and sold OTC between two parties, with the price being pre-determined and noted within the agreement between the two parties. In the futures market, futures contracts are traded based upon a pre-determined standard size and a settlement date on one of the public commodities markets, like the Chicago Mercantile Exchange (CME) is handled therein.

Within the United States, the futures market is regulated by the National Futures Association (NFA). Futures contracts have specific details, such as; the number of units being traded, delivery and settlement dates, and minimum price increments that are non-negotiable. In this case, the exchange also performs a counterparty’s role to the trader, thereby providing clearance and settlement services.

The contracts, once finalized, are binding and usually settled in cash at the exchange in question upon expiry; however, they can also be traded before they expire. When conducting their trades, traders are protected from risk by the currency forwards and futures markets. Typically, big international corporations use such markets to hedge (protect) against exchange rate fluctuations in the future.

Uses of Forex Markets

Hedging trades

Companies that participate in international trade are frequently at risk of loss due to the currency fluctuations when they buy or sell goods and services. Forex markets provide the opportunity for companies to hedge currency risk by fixing the rate at which the transaction will be completed.

A trader would typically buy or sell currencies in the forward or swap market in advance to take advantage of this. This would essentially complete the transaction at a pre-determined rate. For instance, if a company plans to sell the U.S made umbrellas in Europe when the exchange rate between the two currencies Euro and the dollar (EUR/ USD), is 1 euro to $1 at parity. Supposing the umbrellas cost $100 to manufacture, and the U.S Company plans to sell them for 150 euros, the company would stand a chance to make a $50 profit per sale because the EUR/USD exchange rate is the same. Now supposing the value of the U.S dollar begins to rise compared to the Euro to the point where the EUR/USD stands at 0.80, meaning it would cost $0.80 to buy 1 Euro.

The company would now face a severe problem because although it still costs the company $100 to make the umbrellas, it would only be able to sell the product at about 150 Euros. When translated back to USD, it would only amount to $120; therefore, the company would lose potential profit as a result of the stronger dollar.

The company could have reduced its risk by selling the Euro and buying the U.S dollar when they were equal through short selling. With this strategy, if the U.S dollar rose in value, then profits made from the trade would offset the lowered profit from the sale of umbrellas. If the U.S dollar dropped in value, the more favourable exchange rate would increase the profit from the sale of blenders, which would offset the losses in the trade.

The currency futures market is known for this type of hedging. The trader’s inherent advantage is that futures contracts are standardized and cleared by a central authority. However, currency futures might lack the liquidity of forwards markets, which are decentralized and exist within the interbank system throughout the world.

Speculation

Forex markets experience constant volatility as a result of factors such as interest rates, trade flows, tourism, economic strength and geopolitical risk affecting the demand and supply for currencies. Because of these price fluctuations, intelligent traders are able to benefit from the changes in one currency’s value compared to another. A prediction of a drop in currency value of one currency also means a strengthening in another currency because currencies are traded in pairs.

How to trade forex for beginners

For many the lure to trade forex lies in the question of whether or not forex trading is profitable. The simple answer, yes. However a disclaimer must be put in place, because while trading can be lucrative, it is anything but simple. As far as the world of trading goes, currency trading remains a riskier and more complex way to make money. The interbank market has different degrees of regulation, and for the most part, forex markets are not standardized. In certain parts of the world, the forex markets are entirely unregulated.

The interbank market is a network of banks trading with each other worldwide. The onus was on the banks to determine and undertake sovereign as well as credit risk; therefore, they established internal processes to keep themselves safe. The industry imposes regulations such as these to protect each participating bank.

The market pricing mechanism is based on supply and demand as a result of the fact that each participating bank provides offers and bids for a particular currency. The presence of large trade flows within the system makes it challenging for rogue traders to influence the price of a currency maliciously. This helps create a level of transparency in the market for investors to access through interbank dealing easily.

Many smaller traders conduct their trades through small and somewhat unregulated forex dealers/ brokers, which frequently re-quote prices and might even trade against their own customers.

How to start trading forex

Learn everything you can about forex: Forex trading involves highly specialized knowledge and therefore requires time and patience if one is to get really good at it. For instance, the leverage ratio is much higher in forex trading than in equity trading, plus the elements that drive currency price movements are different from those of equity markets. Luckily for all rookies out there, there are several online courses that teach forex trading for beginners.

Create a brokerage account: You will need a brokerage account before you can start forex trading. Instead of charging commissions, forex brokers make money through spreads (also known as pips) between the selling and buying prices.

If you are a beginner in the trade, it might be a good idea to start off with a micro forex trading account with low capital requirements. Such accounts have different trading limits and permit brokers to limit their trades to amounts as low as 1,000 units of a currency- a standard account lot is typically 100,000 units.

Develop your trading strategy: Forex trading is unpredictable due to the various forces that influence the prices of different currencies. For this reason, an intelligent trader must develop a strategy that takes their finances and lifestyle into account. A good trading strategy considers the amount of money you’re willing to risk on a trade and the amount you’re willing to lose.

Always know your numbers: As soon as you start trading, keep close watch over your trading positions at the end of the day. Most trading software is programmed to keep daily accounting of your trades. Be certain that you do not have any pending positions to be filled out and that your account has sufficient money to make future trades.

Don’t get emotional: Like most forms of trading, forex trading is highly risky and packed with ups and downs. At any given point in time, it can be difficult to predict whether you’ll be making losses or smiling all the way to the bank. As a rookie trader, you must always remember to maintain a stable emotional state regardless of what the market is doing.

Forex terminology you should know

Forex Account: A forex account is an account used to make currency trades. Forex accounts depend on the lot size; there can be three types of accounts.

Micro forex accounts: These forex accounts allow you to trade up to $1000 worth of currencies in one lot.

Mini forex accounts: These forex accounts allow you to trade up to $10,000 worth of currencies in one lot.

Standard forex accounts: These forex accounts allow you to trade up to $100,000 worth of currencies in one lot.

Ask: Also known as an offer, it is the lowest price at which a trader is willing to buy a particular currency. For example, supposing you place an ask price of $1.3556 for GBP, then that figure is the lowest you are willing to pay for a pound in USD.

Bid: This is the price at which you are willing to sell a currency. A market maker in a specific currency is responsible for putting out bids in response to buyer demand.

Bear market: A bear market is where prices decline among currencies. These signal a downward trend in the market and are typically the result of depressions, financial crises or catastrophic events.

Bull market: A bull market is one in which prices increase for all currencies. These signify an uptrend in the market as a result of excellent economic performance.

Contract difference: A contract difference is a derivative that enables traders to speculate on price fluctuations for currencies without actually owning the underlying asset. For instance, a trader can bet that the price of a currency pair will increase and therefore purchase CFDs for that pair, while a trader believing the opposite will opt to sell CFDs for that pair.

Leverage: Leverage is defined as the use of borrowed capital to increase returns. The forex market is known for high leverages that traders use to boost their positions.

Lot size: Currencies in the forex markets are typically traded in standard sizes known as lots. There are four common lot sizes, i.e. standard, mini, micro and nano. Standard lot sizes are made up of 100,000 units of currency. Mini lot sizes are made up of 10,000 units of currency, and micro lot sizes are made up of 1000 units of currency.

Margin: Margin refers to the cash set aside in an account for a currency trade. Margin money acts as the broker’s assurance that the trader will remain solvent and be able to meet any monetary obligations regardless of which direction the trade goes.

Pip: A pip is a percentage point, also known as a price interest point. The minimum price move is equal to four decimal points made in currency markets. One pip is the equivalent of 0.0001. One hundred pips are the equivalent of 1 cent, and 10,000 pips are $1. Pip value can vary depending on the standard lot size offered by a broker, and in a standard lot of $100,000, each pip would carry a value of $10.

Spread: A spread is the difference between the bid (sell) and ask (buy) price for any given currency. Because forex traders do not charge commissions, they make their money through spreads. The size of a spread can be influenced by any number of factors, including demand for the currency, size of the trade, currency volatility and others.

Although not for the weak at heart, the forex market is still one of the most exciting and lucrative ways to make money. Its flexibility and ease of entry, allows for every rookie to start small and then work their way to the big bucks. With this introduction, you too can determine with whether currency trading is really for you.