The word ‘Forex’ is ‘foreign currency’ and ‘exchange’ merged together. The term denotes currency conversion and the gigantic global market where it takes place. According to the latest figures from the Bank of International Settlements, its daily volume reaches 5.1 trillion US dollars. Discover the fundamentals of Forex trading for beginners in our comprehensive guide.
Forex is the largest and most liquid financial market worldwide. Given the scope of international trade and tourism, this is hardly surprising. Currencies are exchanged for three major reasons:
- commerce (imports and exports),
- trading (speculation on trends), and
- traveling (buying currency to make payments in the destination country).
Participants also hedge against interest rate risks or buy currencies for diversification purposes. The FX system comprises a spot market and markets for related derivatives (futures, forwards, options, and currency swaps).
Fundamentals of Forex Trading for Beginners
There are 7.5 billion people on the planet, and currency exchange is important for all of them. Those who never travel still use its results when they buy imported goods. International trade concerns all of us, at least indirectly. For example, Americans purchase French wine from a company that pays its supplier in euros. The importer converts euros into dollars all the time.
The same is true for tourists. To travel across Japan, a resident of the European Union converts euros to yen. When abroad, we have to pay in the currency of the other nation. But how to trade in Forex?
The Nature of Rates
Every course of online Forex trading for beginners starts with how exchange rates are formed. Currencies are valued against one another. For example, one of the most liquid instruments, EUR/USD, reflects the value of 1 euro in US dollars.
Forex is an over-the-counter market – a system without a physical center. This market is electronic, so buyers and sellers connect through the Internet using sophisticated software. Of course, you can still exchange cash at a local bank office, but most of the operations are conducted online. The absence of a centralized exchange is a unique feature.
Currencies are traded 24 hours a day, 5 days a week, across time zones. Trading begins in Sydney and ends in New York. Other major centers are Paris, London, Frankfurt, Hong Kong, Singapore, and Tokyo. When sessions overlap, the market sees the biggest volumes of trading. Currency exchange rates are changing all the time, and Forex never stands still.
How Forex Appeared
Forex is a relatively young market. In the most basic definition of currency conversion, it has existed since ancient times. Humans have been exchanging currencies for centuries.
However, not until the 1970s had the market started taking its present shape. The Bretton Woods agreement had connected the values of currencies to the US dollar. The replacement of the gold standard was an event whose value may not be underestimated. When the system collapsed, majors started floating freely.
Today, the largest share of the volume is generated by commercial and investment banks, hedge funds, and other large players. Retail Forex, where individuals speculate on the rates, has existed since the 1990s. The market’s opportunities are used by traders and investors. At present, the terms FX, forex, foreign-exchange market, and currency market are used interchangeably. So, how to trade currency today?
Spot vs. Forwards vs. Futures
Each dimension of Forex gives participants a specific opportunity to make a profit. Most trades occur in the so-called spot market, which contains the underlying assets for derivatives. Once the leading venue, the futures market is now incomparable to the spot market in terms of size. With the advent of electronic trading and FX brokerage, it became secondary.
The spot market is what most people mean when they use the term ‘Forex.’ Futures and forwards are most popular with corporations that hedge their currency-related risks. These instruments allow them to secure a certain price for a specific date in the future.
In the spot market, traders and investors can buy and sell currencies at current prices. These are defined by market forces (supply and demand) that are based on myriad factors. Interest rates set by central banks, import and export flows, unemployment, geopolitics, and even expectations of political changes may affect the market.
Deals on these current-price markets are cash-settled. ‘Spot deals’ are defined as bilateral transactions. One party delivers an agreed currency amount to the other party and gets a certain amount of another currency in return. Spot deals are defined as transactions in the present, rather than in the future. However, actual settlement occurs two days after the closing of the position.
Futures and Forwards
These markets are drastically different from spot deals. They are focused on contracts, not actual currencies. These instruments are, in essence, claims to a certain currency at a certain price per unit with a future settlement date.
The forwards market is completely over-the-counter. Here, two parties of a contract buy and sell currencies remotely. They also set the terms between themselves.
The futures market is different. Standard-size contracts with fixed dates are traded via public commodities markets. These contracts include peculiar details like:
- how many units are being bought or sold,
- when they are going to be delivered,
- what are the lowest price increments, and
- when settlement will take place.
All of these aspects are known in advance and are not subject to alteration. Futures are traded on platforms like the Chicago Mercantile Exchange. The role of the exchanges is to provide clearance and settlement to the parties. In the United States, the market is regulated by the National Futures Association. It makes sure all market participants follow strict rules.
Futures contracts are always binding. This means the parties have fixed obligations they have to fulfill. Typically, settlement occurs on the exchange on the expiry date. In addition, these contracts may be traded before expiry.
Both markets may be used for protection against currency exchange risks. As a rule, large global firms use these derivatives to hedge against future volatility. At the same time, futures and forwards are also traded by speculators – those who profit from short-term changes in prices.
How to Trade Currency for Hedging
Companies engaged in global business may lose money due to fluctuations in currency exchange rates. When a manufacturer buys raw materials abroad, they need to pay in the suppliers’ currency. Revenue of exporters also depends on the value of the importing nation’s currencies. The global currency market offers a convenient way of protection against such risks. Corporate participants may secure a certain price for their future transactions.
For this purpose, traders may purchase or sell currencies in the swap or forwards markets. This is done beforehand, and the exchange rate is thereby locked.
Example: Export to Europe
Suppose a US-based charcoal grill producer wants to export to Europe. The ideal conditions for them are when the two currencies, the US dollar and the euro, are at parity (€1 to $1).
The grill costs 80 dollars to make, and the distributor is planning to price it at 120 euros. This will allow them to compete with rival products manufactured in the EU. In theory, such conditions should provide the company with $40 in profit (given the expected exchange rate). However, the rate is always changing. The currency market is never static. So, what happens if the dollar suddenly surges against the other currency?
Suppose the exchange rate is now 0.75, so 1 euro costs 0.75 dollars. The company may not raise its retail price accordingly, as this would make the product less competitive. Therefore, it has to still sell the grills at €120 per unit. Following the strengthening of the dollar, this now gives only $90 (€120 X 0.75 = $90). However, the grill still costs $80 to make, so the changes in the exchange rate will eat at the profit margin. The stronger the US dollar – the lower the revenue.
The grill manufacturer could have protected itself by taking action in the currency market. It could have sold its euros in exchange for dollars while the currencies were at parity. Subsequently, when the dollar gained value, the trade would bring a profit that could compensate for the meager revenue from EU sales. On the other hand, if the opposite was observed, and the dollar became cheaper, the company would gain a higher profit from its business in Europe. This would offset the loss made through trading.
This sort of hedging is possible in the Forex futures market. As the contracts are standardized, and a central authority clears them, the advantages for the trader are clear. However, there is one downside. Sometimes, futures are less liquid than forwards, so they are harder to trade. Forwards are bought and sold on a global decentralized market that operates based on interbank rates.
How to Trade in Forex
All traders aim to profit by buying and selling currencies. Their activity depends on factors that affect the rates. These range from tourism to interest rates to geopolitics. All factors that can affect supply and demand for currencies have significance. Every day, the market sees volatility caused by such changes. To understand how to trade in currency, you need to understand these fundamentals.
Thus, as any currency may rise or fall against another, traders have an opportunity to monetize their speculative skills. The pair-based nature of trading means the strengthening of one element comes with the weakening of the other. The goal is to predict in which direction the rates will move and open long or short positions accordingly. For example, consider someone who speculates on the rate of exchange between the US and the Australian dollar. How to trade in the forex market with this instrument?
If the price for AUD/USD stands at 0.75, they can purchase 1 Australian dollar for 75 US cents. Now, imagine that the Federal Reserve increases the interest rate, thereby boosting the demand for the US dollar globally. This will lead to a lower exchange rate for AUD/USD, as the quote currency will strengthen.
If the trader can anticipate such changes, they short sell their Australian dollars for American dollars. The subsequent rise results in profit. For instance, the exchange rate may drop to 0.50, so selling the AUD before it drops will bring monetary gain.
Read more about: Forex Robots: Do You Really Need Them?
Currencies as Assets
All currencies may also be seen as a separate class of assets. Aside from changes in exchange rates, you may benefit from the difference in the interest rates for two currencies.
This arrangement is known as carry trade. You may purchase a currency with a higher interest rate and sell (short) the one with the lower interest rate. Before the global crisis of 2008, shorting Japanese yen for British pounds was a very common practice. The difference between the rates was large, and the activity would bring substantial profit.
Ease of Online Trading
In the pre-internet days, buying and selling currencies was a hassle. This was largely done by multinationals, hedge funds, and extremely wealthy individuals, as Forex trading required gigantic initial investment.
After the advent of the Internet, the retail segment emerged. Now, individuals could become retail Forex traders and gain access through banks or brokers. Thanks to leverage, brokerage firms can boost their clients’ buying power, allowing them to trade with more than they deposit. The ratio may be spectacular – for instance, 1:1,000.
Intricacies of Forex Market Pricing
The global interbank market is made up of institutions that trade with one another. The parties can determine acceptable risks and control them via internal procedures. The industry imposes regulations that protect every participant.
In this segment of the market, pricing is determined by the participants. It is based on supply and demand worldwide. Due to the significant size of trade flows in the system, it is challenging for any trader to influence the price of a currency. The interbank market provides investors with transparency.
In comparison, retail traders, the participants we mostly hear about, deal with relatively modest volumes. They may also work through under-regulated intermediaries. Some of these brokers may manipulate prices and even trade against their clients. This is a possibility in the so-called ‘dealing desk’ or ‘market maker’ model. The provider uses its own pricing instead of giving access to real-time quotes.
Government and industry regulation is still limited or absent in many countries. Therefore, most small traders need to check their broker’s background to see if it is a regulated entity. Generally, oversight from US and UK-based organizations is the most preferable.
It is vital to check any client protection guarantees in the event of the company’s insolvency. For example, negative balance protection means that clients may never lose more than their positive balance, even in the case of leveraged trades.
Benefits and Risks of Trading in 2020
Due to its colossal size and easy online access, the Forex market attracts retail traders around the world. It offers the most liquidity, which means that buyers and sellers have no problem connecting to one another. You may easily enter and exit a position in any of the major currencies.
Brokers allow instant execution and charge tight spreads for many instruments. Another important advantage is that the currency market rarely sleeps. It is active around the clock 5 and a half days a week. Trading does not close at night.
In addition, brokers, dealers, and banks offer impressive leverage. Traders are able to manage large volumes without a significant investment of their own. This system increases potential profits. However, trading on margin also magnifies typical Forex risks. A single bad decision can wipe out your account. Caution is paramount.
Risk is an organic part of trading. At the moment, the FX market still lacks regulation in many countries. In Nigeria, for example, there are no applicable legal frameworks.
Accurate prediction is not always easy. Currency rates are affected by myriad fundamental factors. The trader must be well-versed in economic indicators and interconnections between national financial systems. Although some traders prefer to rely on technical indicators, they also need to be aware of all such factors.
Best Forex Trading Platform for Beginners
What software is the best for retail traders? Some brokers recommend universal systems, while others invest in proprietary solutions. For example, Olymp Trade MT4 platform has its own platform available as desktop software and a smartphone app.
The best Forex trading platform for beginners is user-friendly systems. They have charting tools, news updates, and other features for technical and fundamental analysis. There is also a free and unlimited demo mode, so novices can practice.
The Bottom Line
These are the essentials of how to trade in the currency market. Today, individuals with very limited funds may gain access to day trading or swing trading. Thanks to leverage, their volumes are boosted by large brokers. On the other hand, investors focused on the long term use larger volumes and carry trade opportunities for monetary gain. To succeed, retail Forex traders should have a good understanding of macroeconomics, as well as technical indicators.