What is Forex trading?
Forex, also known as Forex trading or Foreign exchange, is converting one currency to another currency. Forex is considered one of the most actively traded markets globally, with a daily trading volume of more than $5 trillion.
If you want to trade with Forex, you should always trade with two currencies or currency pairs by selling one currency and simultaneously purchasing another currency. Some of the most frequently traded Forex pairs are EUR/USD (here EUR is the base currency and USD is the quote currency) GBP/EUR, AUD/USD, and GBP/USD.
Every currency pair is listed as a three-letter code, where the first two letters are denoted for the region, and the last one denotes the currency itself. For example, if we take USD, the US stands for the United States, and D stands for the US dollar. If we take JPY, JP stands for Japanese, and Y stands for Yen. If you take the USD/JPY pair, you need to buy the US dollar by simultaneously selling the Japanese Yen.
The History of Forex
- On the contrary, compared to stock markets where we can trace their origins back to centuries, the forex market we have today is a new market, which means people are taking one currency and converting it into another currency pairs for financial advantage. Moreover, forex is the major reason why countries started minting currencies.
- The forex markets what we have today is a result of modern invention. Several major currencies were allowed to float against each other after the end of the Bretton woods system in 1971. Since the value of individual currencies varies, there came the need for Forex services and also for trading.
- Some of the investment and commercial banks conduct trading in forex markets on behalf of the clients. Yet, there are several opportunities for trading with a currency over other currency pairs like EUR/USD, which are used by experienced and individual traders.
Important features of Forex trading
Let us discuss few important features of Forex Trading –
- The most popular Forex instrument across the world is currency spot trading, which comprises more than one-third of the entire activity. It was calculated that spot FX trading roughly generates about $1.5 trillion in a day in trading volume, making it the largest and most liquidated markets around the globe.
- Furthermore, forex markets function 24 hours a day, and it also offers the best forex brokers where the users can trade currencies anytime during the day. It also offers a convenient time for the adjustments to be made whenever and wherever it is needed.
- A foreign exchange market involves the trading of several currencies around the world, like EUR/USD, and it is the most liquid financial market across the world. The first currency that appears in the currency pair is the base currency, and the second pair is called the quote currency or counter currency.
- The users in the forex market are free to buy and sell currency anytime as per their convenience. They can exchange currencies free of charge without the price of the currency that is being traded, which might get affected.
- The investors in the forex market can have full access to the market information and data; also, they can monitor various country’s currencies, price fluctuations, easily through real-time portfolio and also through account tracking.
- When compared to other markets, the forex market has a low trade cost, and there are no commissions that are involved in the Investments. Since it involves low cost, and the losses are minimum, which makes it possible for small traders and investors to make huge profits when they trade in this market.
- We can say that the forex market is where dynamic changes take place and the value of currency changes every hour or second. Because of the changing demand and supply, the value of the currency changes, and it also helps us to know the exchange rate. Because of its fastest movements, this market is considered as the perfect market for trading.
- The US dollar is considered as one of the most dominant currencies in the forex market. The US dollar is always paired with almost all the country’s currency, and it is traded in the foreign exchange market. Similarly, the British pound is also considered as the most predominant currency.
- A long position is executed in a trade when the trader anticipates the asset to increase in its value. In simple words, we can say that when the trader places a buy order like USD/JPY, they will hold a long position for USD(Base currency) expecting it will appreciate against the Japanese Yen (quote currency).
- In certain countries, like South Africa Forex trading is legal, if the trader adhere to money laundering laws, and they should declare their profits to SARS (South African Revenue Service)
Why should you trade Forex?
Since foreign exchange is considered as one of the most traded markets offering several benefits for its users. Let us see a few reasons about why you should trade in the forex market-
- Exposure to several markets
By trading in the forex market, it allows users to easily gain good exposure to several markets around the world. Even though most of the trading is done on the world’s major currency like EUR/USD, and the users can also have access to developing markets like Polish Zloty (PLN) and Mexican Peso (MXN).
- 24×5 trading
When compared to other markets, the foreign exchange market does not have any limitation, where the trading does not need to stop at a particular time. Since it is traded across the globe, Forex trading markets are open 24 hours a day and for five days a week, so the trader can trade as per their convenience.
- No hidden costs or commissions
When you trade in the forex market, the cost of trading is already included in the spread where the trader need not fear that there are hidden charges and commissions. They can trade confidently, and they can also have an idea about how much it costs to trade.
- Trading with Leverage
Forex can be traded with a certain degree of leverage, which allows the trader to take a position in the trading market by having a fraction of capital that is needed by the trader. Even though leverage might increase the trader’s gains, it can also lead to huge losses. Hence the trader must understand the risk of trading by using a margin.
- Trade opportunities in all types of markets
When compared to other markets, we can say that the forex market provides the users with a unique feature of the trading in both rising and falling markets. Unlike other markets, there are no additional costs or restrictions involved for short selling.
- Liquid Market
Foreign exchange market turnover is roughly around $5.1 trillion, and it is considered as one of the most liquidated markets around the world. Besides, this liquidity always increases prices, and just like other markets, the users can respond immediately to the fluctuations in the currency when they occur anytime in a day or a week.
Types of Forex pairs
There are four types of Forex pairs that are described below –
- Major Pairs:- There are several major pairs that make up 80% of Forex trade around the world, which includes GBP/USD, USD/CHF, EUR/USD, AUD/USD and USD/JPY.
- Minor Pairs:- Some of the less frequently traded minor pairs that also features along with major currencies instead of US dollar, these are EUR/CHF, GBP/JPY, and EUR/GBP
- Exotic pairs:- One of the major currency against one currency from a developing or a small economy this includes- GBP/MXN, USD/PLN, EUR/CZK
- Regional Pairs:- Regional pairs are classified by pairs according to the region like Australasia or Scandinavia. Some of them include AUD/NZD, AUD/SGD, EUR/NOK
Pros and Cons of Forex trading
Let us discuss a few pros and cons of Forex trading –
Even though there are several risks because of Forex trading, there are also a few pros that make Forex trading profitable and desirable. Some of them are –
- The forex market is considered as one of the most accessible markets for users. The users can register for a Forex account within 1 to 3 days, and they can start to trade with a minimum amount of £50.
- Almost all forex brokers allow auto trading in the forex markets, and they offer access to news real-time market prices, technical analysis, tools, price charts, and trade strategies through their online platforms.
- When compared to other types of trading that offer limited time for its trade process, the Forex market is open 24×5, which means the users can proceed with the Forex trading as per their convenient schedules.
- Several trading platforms offer access to leverage, which makes a lot of difference between small profits and bigger ones. The availability of leverage in the forex market is one of the most advantageous features offered when compared to other markets.
- The foreign exchange market is considered as the fastest moving market and offers liquidity. The above-mentioned characteristics, combined with the higher leverage that is offered to the users, implies that the users might book good profits in the forex market while they are trading in other markets.
- Regarding short selling that is available in some markets, it would require exposure to risk and borrowing of assets that sometimes short positions might be called off. But short selling in currencies is a much simpler process, and the currency can be purchased and sold in pairs, which means when a trader buys one currency, they are selling another one.
- Sometimes the trading cost of Forex is determined by the bid-ask spread, which means the difference between buying and selling prices that are published by the brokers in the current situation. This is one of the most advantageous features that makes Forex trading more transparent.
- Users from other markets should need to keep a tab on their short term, and long term activities on trading for tax reporting since foreign exchange trading is subjected to simple tax rules that make easier tax calculations.
- Furthermore, Foreign exchange trading can be used in automated trading as well. Besides, users can also set up automated trades, stop-loss, programming entry, and they can also limit prices in advance when they are making a trade or give a set of instructions to the platform to trade on specific price moments or as per their trading strategies.
- An experienced trader who has a well-developed automated trading strategy can take advantage of daily swings that happen in the foreign exchange market without depleting their money or mental ability that affects the trades to keep up with the latest trends that happen in the market.
Let’s discuss some of the cons of forex trading-
- Forex market traders sometimes can face adverse trading conditions, which makes successful trades more challenging, which might have appeared as a successful trade in the beginning.
- Sometimes the market shows volatility, and when the forex market is affected by it, and Forex traders who are expecting short term profits might be exposed to extreme volatility, which is unexpected, that makes their trading unprofitable.
- Over US$ 5 trillion are daily traded on the global forex market. Major forex market trading is done by some of the major players like hedge funds, large financial institutions, and banks.
- The foreign exchange market is considered as over the counter(OTC) market, which means the trades are not executed on a centralized exchange, and insights about the regulations are restricted. Moreover, the users need to research and investigate the trading practices before they proceed with signing up for an account. Also, the country of residence plays an important part in operating the Forex trading, and they should analyze the forex broker before proceeding.
- The stocks and bonds regularly offer interest and dividend payments, which enhances the long-term value of an asset, but the main objective of Forex trading is to obtain capital gains from appreciation of the currency in a currency pair.
Benefits of Forex trading
Let us discuss a few benefits of trading in Forex –
- Forex trading is considered as one of the largest financial markets offering a wide range of assets and also trading major currencies with over $4 trillion in US dollars on an average exchange per day. Users from all over the world are purchasing and selling the currency pairs like EUR/USD and several others as per their convenience hours, which makes Forex a global marketplace and which has plenty of scope for arriving profitable trades.
- One of the most advantageous features of Forex trading is accessibility. When compared to other trading markets, it is very easy to enter trading, and it does not require a huge investment to start Forex trading.
- The convenient working hours of the forex market is also considered as an advantageous feature of Forex trading. The trading takes place over the counter(OTC), which implies the transactions are carried out directly between the trading parties, and it is facilitated by a foreign exchange broker.
- Trading in the foreign exchange market does not require huge investment for entering into trades, and it also offers low transaction costs, when the trader starts trading. Moreover, the brokers make money through spread that is measured in pips and is included in the currency pairs price.
- One of the best reasons to trade forex is the availability of leverage, which is one of the most important features which allows the trader to open a high position. Even though the trader has a small amount of capital, several Forex brokers allow the retail trader to borrow against for a much higher stake. This is similar to placing a deposit for a mortgage when you are dealing with the property.
- In trading terminology, the term liquidity refers to the ease at which the asset can be purchased or sold with little effect on the value of the assets. To summarize, the forex market operates 24hours and five days a week; and it operates in different time zones like London, New York, Sydney, and Tokyo, and the trader can trade as per their convenience. It is considered as one of the most liquidated markets around the globe.
- Contrary to other trading markets such as stocks and shares, it is considered as a relatively new concept, and it has gained momentum. It has quickly adapted itself to the technological improvements around the trading world.
How does Forex Trading work?
- Forex trading takes place among the two parties in the OTC market. This implies that there is no centralized exchange such as the stock market and the forex is run by a worldwide network of banks and other financial institutions.
- Forex transactions are spread over four important Forex trading centers in different time zones like London, Sydney, New York, and Tokyo because there is no centralized location. The trader can trade on the Forex 24 hours a day, five days a week, as per their convenience.
- Some users speculate on Foreign exchange prices on base currency or quote currency, and they do not take delivery of the foreign currency, rather few traders will forecast the exchange rate to take advantage of market price movements. One of the best ways to proceed is by trading derivatives like rolling a spot Forex contract that is offered by several brokers.
- Trading derivatives permits the traders to speculate on the asset’s price movements even though the trader need not take ownership of the asset.
Different Types of Forex Market
There are three ways where corporations, individuals, and institutions place trades on Forex. They are the spot market, forwards market, and the futures market. Forex trading on the spot market has been considered as the largest market because of the underlying real asset, where the forwards and futures markets are based on. Earlier, futures markets were most popular for the traders because it was used by the individual investors for longer periods.
- Spot Market
- The spot forex market can be described as the physical exchange of currency pairs that take place at the precise point when the exchange is settled, which is on the spot for a short period. Moreover, derivatives that are based on the spot forex market are provided over the counter by the dealers.
- When the traders refer to the foreign exchange market, it is presumed that they are referring to the spot market. Forwards and futures markets are very popular with companies who need to hedge their forex risks to a specified date in the future.
- A spot market is a place where the currency is purchased as the base or quote currency and sold as per the current price. This price is determined by supply and demand, which is determined by economic performance, current exchange rate, ongoing political situations, as well as the future performance of the currency pair.
- When a deal is finalized by a broker, it is known as a spot deal. It can be described as a bilateral transaction where one party delivers on the agreed currency amount to the other party and receives a certain amount of other currency at the agreed exchange rate value.
- When the short position is closed, the settlement offer is in cash, even though the spot market deals with present transactions, and it takes more than two days for settlement.
- Forward Markets
- A forward forex market is a contract where one party agrees to purchase or sell a certain amount of a currency at a certain price, and it is to be settled at a future set date or within a range of future dates.
- When compared to the spot market, the futures and the forward markets do not transact actual currencies. Rather, they deal with contracts that claim a certain type of currency, a certain price for the unit, and also the future date for settlement.
- Considering the forwards market, the contracts are purchased and sold over the counter(OTC) among both the parties who determine the terms of the contract between themselves.
- Futures Markets
The futures forex market can be defined as an exchange-traded contract to purchase or sell a given set of currency with a set price and a date in the future. Concerning the futures market, futures contracts are purchased and sold based on a standard size and a settlement date on commodities markets like the Chicago mercantile exchange.
Forex Trading Software
- Forex trading software can be explained as a set of computer programs that are used by the foreign exchange traders to trade the market. They come in several forms and each one of them provides several tools and features to the traders.
- Top Forex trading software offers a complete set of tools that permit the forex trader to open various positions in the market, analyze them, and execute them through social trading platforms. They also offer the appropriate forex news and they automatically execute Forex trades when a certain specific set of conditions are met.
- Forex trading platforms can be described as a set of forex programs which represents the link between the trader and the broker and also offers direct access to the foreign exchange market. If there are no Foreign exchange trading platforms, the traders will find it difficult to trade in the market.
Types of Forex software
Similar to other businesses, Forex trading software can be divided as per the tools and features they provide for traders. Given below are the few types of forex software-
- Trading platforms are the most important forex programs which allow a trader to open trades, modify and close the positions like MetaTrader 4. They also offer advanced charting tools, Technical Analysis, and a wide range of market orders, which also feature in the forex trading platform.
- The social trading platform adds a new social dimension for trading Forex. Several platforms that use MetaTrader 4 allow traders to copy or follow the other trader’s strategy, or they can chat with them to get an idea that can help the trader when they are trading.
- Automated Forex trading platforms are a small set of programs that usually runs inside the trading platform. Usually, they analyze the market movements, and also they make independent trading decisions; this implies that no input is required from the trader’s side, and these automated trading programs will open, modify and close the positions on behalf of the trader. Even though it sounds so easy, there are several dangers involved in this type of trading.
Forex for Speculation
Speculation in the forex includes purchasing and selling of currency with the main aim of making a profit. The term speculation is applied because of the uncertainty that is involved and no one can say whether the financial markets will go up or down. The trader needs to assess the situation on their own and place trades. Some of the factors like trade flows, Exchange rate, economic strength, Geopolitical risk, and tourism affect supply and demand for the currency, which in turn creates volatility in the foreign exchange market.
Why should you Trade Currencies?
To trade in Forex or in stocks using leverage is based on which asset the trader is interested in trading, either in currencies or in shares. Some of the reasons why the traders prefer Forex trading then stock trading are discussed below –
- Forex trading offers a wide range of currencies, and it operates in different time zones like London, New York, Sydney, and Tokyo. The market opening hours of the stock market are restricted to exchange opening hours, whereas the foreign exchange market is open 24 hours a day and five days a week.
- The foreign exchange market offers higher liquidity, and the daily turnover averages to $5 trillion, instead, there are comparatively few users who trade per day on the stock market.
- When the trader is considering to trade either in the foreign exchange or the stock market, they should consider the financial goals and the threats involved.
- Before the internet, Forex currency trading was considered very difficult for individual investors; and the currency traders consisted mainly of large multinational corporations, high net worth individuals, or the hedge funds because trading in Forex requires huge capital.
- With the advent of the internet, individual traders have emerged, and it provided easy access to forex, which is done either through brokers or banks by making it a secondary market. Besides, several online brokers and dealers provide very high leverage to several traders who can control a large volume of trades with the very meager account balance.
- Some of the worldwide supervisory, regulatory bodies of Forex set new standards for all the Forex brokers who come under their jurisdiction. They should comply with some of these standards, which include being licensed and registered with the regulatory body, and should undergo regular audits, communicate certain changes of service to their customers, and several more. This is also to ensure that forex currency trading is fair and ethical for those who are all involved.
- The foreign exchange market is considered as the biggest and most liquidated markets around the world. The market’s scope and its size offer unique challenges about market regulation.
- The Foreign exchange market does not have any centralized body which governs the Forex trading market; rather, many independent and governmental bodies supervise foreign exchange trading across the world.
- Few of the most popular and recognized global Forex regulators are the FCA from the UK, NFA from the United States, and CySEC in Cyprus. Additionally, several Forex regulatory bodies are established by national governments, and few brokers find the necessity to acquire the memberships from cross-border entities and professionals.
- Further, Forex brokers in UK who are operating in the European Union should comply with MiFID (markets in financial instruments directive), which is a European Union-wide regulation; which ensures regulation for investment services over 30 member states of the European economic area.
Risks involved in Forex Trading
There are several risks involved when you are trading in the FX markets. The trader can suffer additional risks if they are trading in less popular and less liquid currency pairs. They should be careful about not getting into a situation where there are unstable transactions because of poorly managed margin accounts, or they might have chosen a non-reputable broker or a less trustworthy exchange. Some of the major risks involved in Forex trading are given below –
- The major threat is the exchange risk, which is caused by the changes in the currency value. This is based on a continuous effect on the volatile shifts in global demand and supply balance. For a limited period, the trader might enjoy the position, which offers more profits; the position might radically change if the price changes. It can be quite substantial, and it depends upon the market perception that which way the currency will move at any given time around the world.
- The next is the interest rate risk, which is often referred to as the profit and loss that is generated by fluctuations in the spread and the amount which mismatches and maturity gaps among the transactions that are given in the foreign exchange book. This threat is inevitable to currency swaps, futures, and options. To minimize this, a trader should place a limit on the total size of mismatches.
- The next type is a credit risk, which refers to an outstanding currency position, which may or may not is repaid as agreed earlier because of the involuntary or voluntary action of the other party. Besides, credit risk is usually concerned with large banks and corporations, and for the individual trader, who is trading on margin credit risk, it is substantially very low.
- The next type of risk is the country risk and liquidity risk. The liquidity of over the counter(OTC) Forex is generally much greater than exchange-traded currency futures outside of European and US trading hours. Several countries have imposed several trading limits and restrictions on the amount by which a specific price of a foreign exchange rate varies during a specific period. This restricts the trades from being executed during that period. These restrictions might prevent a trader from liquidating unfavorable positions and, in turn, might lead to substantial losses in the trader’s account.
- The next type of risk is the leverage or marginal risk. Trade collateral or low margin deposits are required in Forex, and the margin policies allow a higher degree of leverage. As per this, a small price movement in the contract would result in instant and substantial losses in the amount invested.
- The next type of risk is the transaction risk. Some of the errors in communication, confirmation, and handling of the trader’s orders would result in unforeseen losses. The trader’s records would be restricted in seeking compensation, which has resulted in the losses in the trader’s account.
- The next type of risk is the risk of ruin. Even though the trader might have anticipated a long-term view of the market, which might be correct, yet the trader would not have anticipated financially short term losses, and they might have closed out a position due to loss because of unable to meet a Margin Call or to sustain these positions. Although the trader’s view of the market is correct, because of the market fluctuations, the currency position would turn around, and it might lead to profits when it had been held for a longer time. If the users are insufficient with the capital, they might end up in losses.
Limitations of Forex Trading
Let us discuss few limitations concerning Forex trading –
- The major disadvantageous features of the FX market is it is decentralized. Because of its decentralized nature, the forex market is dominated by the brokers. If the trader is trading for the first time, they need to speculate against experienced professionals.
- The determination of the price of the foreign currency pairs is believed to be a complex process because of its complex price determination process. Moreover, the fluctuations in the exchange rate are highly influenced by several reasons and other factors. The economy influences the rate of currency pair, and international politics also plays an important role, which creates uncertainty in the price.
- Even though several educational resources and materials are available free of cost, it does have risks. If the trader trades in the stock market, they get assistance from portfolio managers, relationship managers, and expert advisors. When compared to this, foreign exchange traders do not have any assistance, and they need to deal on their own.
- Forex market is influenced by high market volatility, which can be both advantageous and a disadvantageous feature. Some of the factors like change in the economy, global policies drastically change the price, and forecasting makes it highly difficult for the users to judge the foreign exchange market and to invest their money.
- The major disadvantageous feature of the forex market is there is a lot of scam going on in the market, and the trader should be very careful about choosing a reliable and trustworthy broker who offers good returns and does not cheat.
To conclude, the forex market is considered as the largest market across the globe, and several users are taking keen interest to trade in the forex market. However, the user should consider taking into account that before they proceed with trading, they should research the forex broker and check about its regulatory status. If they meet all the specified standards in Forex, the trader should analyze which trading strategy suits best for their trading needs. One of the best ways to trade forex is to opt for the demo mode, get familiar with the trading, and then proceed with a real account.
1. Is Forex trading illegal?
Ans. No, Forex trading is not considered as an illegal activity, and there are several myths among Forex traders that forex trading is banned in the United States. The trader should analyze the laws about that country and should trade as per the specified limits described by the laws of that country.
2. How do I start trading Forex?
Ans. The first step is to use a demo mode and familiarize themselves with trade terminologies until they make good profits by using a demo account. Several people start trading in the forex market, and within a short period, they lose a lot of money.
3. Can I trade Forex with $100?
Ans. Most of the forex brokers will allow their customers to open an account with a minimum deposit of $100. The trader should learn about the various topics about Forex trading, and they should practice in a demo mode before adding real money into their account.
4. How much do Forex traders make?
Ans. Forex traders make quite an amount of money and also their ability to take risk per trade. If the trader is ready to risk $1,000, then they can make $20,000 for a year on an average. More the risk could be the profit, and it might also lead to huge losses if there are volatility and fluctuations in the market.