Forex market is one of the largest financial markets in the world. According to the statistics, its daily trading volume in 2019 has reached $6.6 trillion. Therefore, it’s not surprising that it continues to attract a growing number of traders worldwide.
Forex is suitable for both newbies and professionals, yet, as any other type of trading, it implies some risks. In this guide, we will look into key features of forex trading, its types, main definitions, benefits and challenges, everything you need to know to minimize trading mistakes and become potentially profitable.
What is Forex Trading?
Forex trading, also known as FX trading, is a way to exchange various currencies. Due to this particular function, it plays a key role in foreign trade and international business. FX trading always implies a currency pair, meaning that a trader buys one currency while selling another one at the same time. When an investor is going to buy a specific currency, expecting that its price will increase in the future, he is going long. Consequently, if he wants to sell the currency, predicting that its value will drop, he is going short.
When it comes to the forex or foreign exchange market, it stands out with the following features:
- It’s a 24-hour market that closes only for the weekend;
- The currency trading is conducted over the counter (OTC), so there is no physical building for this marketplace;
- It’s one of the most liquid markets to trade.
- It comes with leverage which makes it possible to enter the trade with a smaller amount of investment.
The key players in the forex market can be divided into five main groups:
- Commercial and investment banks. Not only do they operate as traders and customer representatives, but also form the trading channels for other market players.
- Central banks. They act on behalf of governments and trade to stabilize or improve the state of their national economy.
- Multinational companies. They use the FX market as a payment method while conducting international trades.
- Individual traders (dealers, speculators, brokers, etc.). In contrast to other market participants, they have a significantly lower presence in the foreign exchange market, yet it’s continuously increasing.
The History of Forex Market
Although currency exchange and trading date back to ancient times, the modern forex market is not here for long.
- To cut a long story short, the first crucial event in its history is related to Amsterdam. There in the 17th century was established the first forex market, which was operating between England and Holland.
- The next important step was related to the introduction of the Gold Standard in the 1870s. This monetary system implied that all the prices were fixed by gold. So, although paper money was also used it was just a representation of a specific amount of gold.
- In 1944 the Gold Standard was replaced by the Bretton Wood monetary system which came into full effect in 1958. It allowed currencies to fluctuate in a range of ±1%.
- And finally, the most crucial change happened in 1971. The US President Nixon closed the era of gold, which meant that from that moment and on there was no fixed exchange rate, currency value was defined by many different factors and couldn’t be counted just arithmetically. This is the moment when the forex market started to gain popularity.
What are currency pairs?
Currencies in the forex market are always traded in pairs. Each pair consists of two national currencies whose value is quoted against each other. All of them are represented by three letters: the first two stand for the name of the country while the third one indicates the name of the currency of that region. For example, USD consists of US and Dollar, GBP stands for Great Britain and pound sterling. USD is the most widespread currency in the forex market involved in the majority of fx trading. It is followed by EUR (European Union Euro), JPY (Japanese Yen), GBP, etc.
Types of Forex Currency Pairs
All currency pairs traded in forex can be divided into three main groups:
- Major pairs are the most popular ones to trade. They make up around 80% of all forex trading. The list of top five includes EUR/USD, which accounts for around 20% of all fx transactions, followed by USD/JPY, GBP/USD, AUD/USD, and USD/CAD.
- Minor pairs are the ones that are not traded against the USD. Some of the examples are GBP/JPY, EUR/GBP, and others.
- Exotic pairs have trading currencies from emerging economies. It can be EUR/TRY (Euro/Turkish Lira), USD/ZAR (US Dollar/ South African Rand), etc.
How Does Forex Trading Work?
Forex trading is conducted on the decentralized base 24 hours 5 days per week. The main feature that makes it different from investing in other types of securities is currency pairs. So, investors have to sell and buy currencies simultaneously.
When it comes to forex quotes like EUR/USD=1.1400, it’s necessary to understand that the base currency is on the left (in our case it’s EUR), the quote currency is on the right (USD). The equation means that 1 EUR is exchanged for 1.1400 US dollars.
Let’s consider it in the example: if a trader wants to buy 1000 euros, with such an exchange rate he should pay 1140 US dollars. In case the exchange rate rises to 1.1500, he can gain a profit of $100 by selling the euros. Thus, when expecting the base currency price to grow you can buy the pair or go long and, conversely, when expecting the base currency to drop you can sell it or go short.
Three Different Types of Forex Market
The majority of forex traders don’t want to take the delivery of the currency. They prefer to speculate and take advantage of market fluctuations. The forex market has three key types. Each of them has its defining characteristics and serves particular trading purposes.
- Spot market implies that the currencies are exchanged immediately (“on the spot”) or within a short period at a current exchange rate. This market type accounts for a great part of all currency trading and is usually used by commercial, investment, and central banks.
- Forward market suggests that a buyer and a seller agree on lot size and price to trade at a specific date in the future. It has such players as individuals, companies, etc., and is particularly popular for hedging purposes. Forward markets are not centralized, thus, more prone to counterparty risk.
- Futures market, as well as forward market, implies an agreement between the buyer and seller on a set amount and price of the currency to trade at a set date. However, it uses centralized exchanges, thus, helping its participants avoid counterparty risks and ensuring high asset liquidity.
What is a Leverage in Forex Trading?
Leverage in forex is a mechanism that allows speculators to enter the trade without paying the total amount of the underlying asset. They can invest just a part of it called margin. Leverage provides traders with great opportunities. It can significantly increase the profits, however, it can result in magnified losses as well, since all the calculations are based on the full size of the trade. Thus, when dealing with this instrument it’s crucial to have robust risk management and trading strategy.
What is a Margin in the Forex Market?
Margin is an initial investment that is necessary to open the trading position. It is usually a percentage of the total amount of the asset which can differ, depending on the broker and the trade size. For example, if the margin is 5% and the whole amount of the underlying asset is $20000, the trader has to pay only $20000*0.05=$1000 to enter the trade. However, it’s crucial to note that despite investing $1000, he still risks $20000.
What is a Spread in Forex Trading?
The spread is a small difference between the buying and selling price for every forex pair. For example, taking the EUR/USD pair, if the buying price is 1.14179 and the selling price is 1.14163, the spread will be 1.6 pips.
What is a Pip in the Forex Market?
A pip, also known as a percentage in point, is the smallest unit to measure the price movements in a forex pair. It usually refers to the fourth decimal place. Thus, if to compare the buying (1.14179) and selling price (1.14163) of the EUR/USD pair, the pip will be 1 (7-6=1).
However, there is an exception for currency pairs that are priced out to the second decimal. For example, in the EUR/JPY pair, the fluctuations in the second decimal will correspond to the number of pips.
What is a Lot in Forex Trading?
A lot is a unit helping to measure the amount of forex transactions. The standard size of the lot is 100 000 units of currency. However, there are smaller lots:
Mini - 10 000 units;
Micro - 1000 units;
Nano - 100 units.
When it comes to standard lot size, forex traders may not have $100 000 or 100 000 euros to speculate. This is when the use of leverage becomes particularly helpful.
What Moves Forex Markets?
Like any other market, forex is moved by demand and supply. There is a great variety of factors, influencing these forces. Here are the key ones.
- Economic factors. Economic policy, established by national governments and central banks, level of inflation, unemployment, etc. have a great impact on the currency price. Therefore, traders tend to opt for pairs supported by robust and stable economies.
- Political conditions. The political situation in the country is directly proportional to the attractiveness of its currency in the forex market. Thus, political uncertainty and instability can negatively impact the currency value and conversely.
- News. Positive news reports about the region’s economic and political situation can foster investments in its currency and enhance its positions in forex. Respectively, negative news can make the currency value decrease.
- Market sentiment. Traders’ expectations and beliefs can also impact the rise and fall of the currency demand. If many investors share the same sentiment, they may persuade others to follow their example.
How to Get Started With Forex Trading?
Forex trading is not much different from trading other assets. To start your fx experience you need to follow these steps.
1 ) Open the account. The first thing you need to do is to find a suitable platform to open a brokerage account. Naga is one of the leading fintech solutions, offering its traders a feature-rich and efficient ecosystem to manage their financial activities. It’s simple to get started with.
- Go to naga.com and press “sign up”.
- Fill in the registration form and get started with a demo account to check out how it operates.
- Go through the KYC (Know Your Customer) process, providing proof of your ID and adding information about your trading experience.
- Once the verification is finished, fund your account and start investing.
2 ) Broaden your knowledge. Forex is similar to other types of trading, yet it has its distinguishing features to pay attention to. Make sure you are aware of the forex key definitions, factors, influencing the currency price movements, news from the countries whose currency you are going to trade, etc. Not only will it give you more confidence but also it could protect you from some risks.
3 ) Choose your trading strategy. Once you understand forex basics, you can opt for a suitable trading strategy that will help you understand whether to sell or buy the currency pair at a specific time. Trading strategies can be developed manually or with the help of automation. In the first case, a trader himself conducts market analysis and tries to predict the price fluctuations. The automated method implies the algorithm that looks for and interprets the trading signs.
4 ) Get started. Don’t be in a rush and don’t succumb to your emotions. Gain some experience while trading small amounts and increase your investments when starting to feel more confident.
Pros and Cons of Forex Trading
Before getting started with trading on the foreign exchange market, it’s reasonable to consider some of its merits and drawbacks.
Forex Trading Advantages
- High Liquidity. Forex is one of the largest financial markets worldwide. Thus, it has a lot of demand, which results in the most liquidity.
- Accessibility. The forex market is easy to get started with even for beginners. Due to the leverage, it’s not necessary to make a huge initial investment to enter the trade.
- Trading time. Forex market operates 24-hours 5 days per week. It provides traders with amplified opportunities to mitigate risks and increase profits.
- Low transaction costs. Not only does forex come with the leverage but also offers investors much lower transaction costs in contrast to other financial markets.
Forex Trading Disadvantages
- Volatility. It’s a double-edged sword. On the one hand, it offers traders great opportunities to enlarge their potential profits. But, on the other hand, it means that the market can suddenly turn in the opposite direction, bringing significant losses.
- Leverage. It can also be considered either as a merit or a drawback. Despite giving the speculators a chance to enter the market without huge initial investments, it involves the risk of increased losses.
- Low transparency. Due to its decentralized nature, the forex market is less regulated, thus, lacks transparency compared to centralized financial markets.
Forex trading is gaining growing popularity worldwide. It’s not complicated to get started with, however, it requires some time, knowledge, and experience to become successful.
If you decided to try it out, make sure you have chosen a trustworthy platform with a great package of trading tools. Opting for Naga will allow you to easily dive into forex trading details while taking advantage of its customizable tools, high level of transparency, and seamless security.