What is Forex Trading? How to trade Forex

If you have been opportune to travel out of America to any other country, you have definitely engaged forex. Forex basically, means the exchange of foreign currency. Let’s say you travel out of America to Japan, you would have to convert your US dollars to Japanese yen at the airport or any exchange outfit. There are two types of people who make use of forex, regular travelers who have to change currencies across borders matters and investors who simply want to make gains on the value rise of currencies. Now that the basic idea about forex is addressed, let’s go further into the “juicy stuff.”

What is Forex?

Forex otherwise known as the foreign exchange market or currency market is a decentralized global market for trading currencies. Unlike the stock market which trades stocks over exchanges, forex is more over-the-counter (OTC) focused, and the currency exchange rates are determined by the fall or the rise of the market. Because of its across-borders nature, the forex is open 24hrs for trading. It can be said to be the largest market globally in terms of its trading volume.

What is Forex Trading? 

In the introduction, we stated that there are two types of people who use forex, travelers, and investors. The trading aspect of forex concerns the investors more than the regular traveler who just needs a currency exchange. Forex trading is the buying and selling of foreign currencies over the foreign exchange market. Forex trading is highly lucrative and beneficial for institutional or wealthy investors compared to average investors. For individual investors who would like to engage in forex trading, especially new investors, it is best to get proper education on how the market works as forex is highly speculative and complex. Most forex firms open dummy accounts for new-time investors to practice until they gain a good level of mastery. It is better to lose fake money in a dummy account than actual money in a real account.

Currencies are traded in pairs on forex—that is traders are either buying one currency and selling the other or vice versa. The most popular pairs of currencies are called the major pairs which are made up of highly traded currencies that are paired with US dollars. The major currencies are euro (EUR), U.S, dollar (USD), British pound (GBP), Canadian dollar (CAD), Australian dollar (AUD), Swiss franc (CHF), and Japanese yen (JPY).

How does forex trading differ from stock trading?

The major obvious difference is that one is concerned with trading currencies and the other, trading securities. Unlike the stock market which requires that all stocks be traded on a central exchange, forex trades are done over the counter (OTC) through forex brokers otherwise known as dealers. 

Understanding Forex:

Currency Pairs

Forex trades always work in pairs such as the EUR/USD. For every forex trade to be completed you must trade one currency for the other. The currency on the left is always the base currency and the one on the right is the counter currency. In the case of the euro and U.S dollar pair, the euro is always the base currency and the dollar the counter currency. For example, if you want to buy the USD and sell the EUR you will select the EUR/USD pair. If you want to buy the EUR and sell the USD, you will still select the EUR/USD pair. It is the base currency that is always either bought or sold. When trading in the EUR/USD pair, the euro is always the base currency.

Another reason for pairing currencies is so that investors can see the price of one currency in relation to the other currency. That way you can know the number of dollars it takes to buy a Japanese yen or any other currency of your choice. Rather than write out the currency titles in full, the forex makes use of symbols to represent each currency. You would always find currencies represented as such NZD (New Zealand dollar), GBP (British pound), AUD (Australian dollar), etc. The currency pairs usually have a market price which reveals how much it would cost the second currency to buy the first currency. For example, in the USD/JPY pair, the market price equals 109.57. That means, 1 US dollar equals 109.57 Japanese Yen. It is important to note that the prices are not fixed as they fluctuate daily or weekly or monthly as trades occur on the market.

Forex Lot

Forex trading is carried out using the lot. The Forex lot can be classified into three parts. A micro lot is made up of 1,000 units of currency, a mini lot has 10,000 units of currency, and a standard lot is made up of 100,000 units. One thing to note is that the higher the lot, the higher the risk rate. It is, therefore, best for investors to stick to a lot within their risk tolerance and capacity. For new investors or individual investors, the micro lot is preferable. 

Forex Quote

One secret to trading forex is the ability to read and understand forex quotes; this is the first step for most traders. Some part of the forex quote has been captured in the “forex pairs.” Forex quote is the technical representation of forex trade pairs on the market. The first thing to learn about the forex quote is the quote name which is usually represented by the currency symbol. The currency symbol is a combination of the country name and the local currency e.g, GBP= Great British Pound, JPY= Japanese Yen. In forex trading, all currencies quoted in pairs. By pairing currencies, traders are able to compare the value of one currency against another (to quote against). For example, USD/GBP is a currency pair where the value of the British Pound is expressed in relation to the US dollar (GBP is quoted against the USD). As explained before, the currency on the left (USD) is the base currency which’s value is 1, while the currency on the right (GBP) is the counter currency which’s value is expressed in relation to the base currency. In the foreign market, most currencies are quoted against the US dollar, though there are a few exceptions as in the EUR/USD pair where the US dollar is quoted against the euro.

After understanding the quote names and pairs, and how currencies are quoted against each other, the next detail to capture as a forex trader is the quote value. Understanding the quote value of forex means being able to read the price of a currency pair. The price of a currency pair is a major determiner in making forex trades. Low prices is probably a good sign not to sell a currency but good for buying, high prices would be favorable for selling and not buying. 

Example:

EUR/USD 1.2314/1.2315 (not actual value) where the euro is the base currency and the US dollar the counter currency which is quoted against the euro.

The first value 1.2314 is called the ‘bid price’ which is simply the market price of the currency—how much the market bids for a currency. While the second value 1.2315 is the ‘ask price’ which “indicates how much in US dollars the market is asking for a single euro.” 

Another thing to know about the quote value is that the bid price is usually lower than the ask price.

Still, on the forex quote, the difference between the bid price and the ask price is called ‘the spread’ which holds great importance in understanding the forex quote. The spread is being measured in points or pips—the fourth digit of a quote after the dot. When calculating the spread of the values in the above example, i.e., 1.2314/1.2315 the difference is 0.0001. The fourth digit in the calculation is ‘1’, therefore the spread is one pip.

Forex Pip

In continuation of the explanation from the forex quote, we would lay more emphasis on the pip. The pip is “the unit of measurement to express the change in value between two currencies.” The pip is the last decimal on a price quote which is mostly the fourth decimal, though some currencies like the Japanese yen mostly have only two decimal points. There are also currency pairs which are quoted in 3 and 5 decimal points, they are called fractional pips. The value of the pip increases based on the amount of the underlying currency.

Leverage

As a trusted trader, you can borrow more money above your account value from your broker to trade—this is called leverage. Leverage allows the trader to buy more currencies with less cash, and when the currency’s value increases the trader gains more return. Forex leverage is represented by digits such as 10:1, 20:1, 50:1. The digits on the left represent up to how many trades you can initiate beyond your account balance. On major pairs, moat brokers allow traders to make trades up to 50 times above their initial account balance; this is represented as thus 50:1. 

• 10:1 leverage is one-tenth of the trade value

• 20:1 leverage is one-twentieth of the trade value

• 50:1 leverage is one-fiftieth of the trade value.

Minimum Amount for Forex Day Trading

Many brokers require a minimum of $100 for a start while others go as low as $50; there is no fixed minimum account in forex. The $50 and $100 minimums are just suggestions of how low an investor can invest with, not necessarily making them the fixed amounts. Rather, when deciding how much to trade with, traders—especially new traders should consider the risks that come with trading forex. The higher the amount the higher the risk and responsibilities. It is advisable for day traders not to risk above 1% of their forex account unless they have considered the risks and counted the costs. The purpose of risking at least 1% of your total account per trade is for easy recovery. If your account balance is $1,000, risking $10 shouldn’t hurt much or $100 for a $10,000 account. 

On the flip side, there is also the part of gaining small amounts of money when the market is on the rise. Having a $100 account and risking 1% per trade also implies that when the market goes up you would be left with small returns. Higher amounts may attract higher risks, but they also attract higher returns if you bet correctly. $500 may seem like a better low-amount option to start with compared to $100 0r $50 as it provides more trading options and more trading returns compared to $100. Still, with $500 the returns you are most likely to get per day is between $5 to $15.

Even better is the $5,000 trading minimum which has a maximum risk of $50 (if you use the 1% rule). Trading with this amount can fetch you returns of $50 to $150 per day which is quite substantial compared to trading with lower amounts.

How is Forex Traded?

There are three major ways by which individuals, institutions, and corporations trade forex—the spot market, the forwards market, and the futures market.

 The spot market has always been the most traded forex market. This is as a result of its “underlying real assets that the forwards and futures markets are based on.” Contradicting its name, the futures market had more popularity in the past due to its availability to individual traders for a longer time. The introduction of electronic trading to the market gave rise and widespread to the spot market. The market has since produced a good number of forex brokers. More individual investors and speculators now prefer to use the spot market as technology has made trading and viewing a lot easier. The forwards and futures markets still have their benefits as they are mostly used by companies who hedge their forex risks out to a future date. Hedging forex is important to companies operating in foreign countries because they are more at risk due to fluctuations in currency values. The risk is as a result of buying and selling goods and services outside their local/domestic market. Hedging provides a way for these companies to fix a rate at which transactions will be completed. This means that “a trader can buy or sell currencies in the forward or swap markets in advance, which locks in an exchange rate.”

The forwards and futures markets do not trade real currencies, unlike the spot market. What they do is handle contracts that hold claims to a particular currency type, a particular price per unit, and a future date for settlement. In the forwards market, the contracts are traded over the counter between the parties involved on the basis of a mutual agreement. While in the futures market, contracts are bought or sold according to the standard size and future settlement date on public commodity markets which regulates the futures market. Futures contracts usually consist of delivery and settlement dates, minimum price increments, and the number of units traded.

Top Forex Brokers

In forex trading, the broker you use is as important as the trades you make. Forex trading has not been around for so long compared to other markets like stocks. Nevertheless, quite a few forex brokerage firms have emerged with the wide-spread of forex. There may be quite a number of forex brokers, but a key to successful trading is finding the right broker. Each trading platforms vary by their leverage maximums, costs, customer service, and the number of currency pairs they allow. Some platforms go as far as charging no commissions, but instead, get their fees off the bid-ask spread. Most trading platforms or forex brokers always open demo accounts for new traders to test their trading skills before opening an actual or real account. We have outlined some forex brokers that we think are the best in the market.

TD Ameritrade

Commissions: Spread markup

Currency pairs: 70+

Account minimum: $0

Ally Invest

Commissions: Spread markup

Currency pairs: 80

Account minimum: $250

Oanda

Commissions: Spread markup or commission accounts of $5 per 100,000 traded on each side

Currency pairs: 70+

Account minimum: $0

Forex.com

Commissions: Spread markup or commission account of $5 per 100,000 traded on each side

Currency pairs: 80+

Account minimum: $50

ATC Brokers

Commissions: Commission account of $0.60 for 10,000 traded & $6 for 100,000 traded on each side

Currency pairs: 38

Account minimum: $2,000

Conclusion

Forex is one of the most easily accessible financial markets due to having no fixed minimum trading amounts. It is yet one of the riskiest markets to trade. It offers lots of benefits to investors/traders such as high returns if traded well, however, before getting involved with forex it is best to properly understand how it works. Remember, learning and understanding the forex quote is key to successful trading.