Learning to trade in a new market is like learning to speak a new language. It's easier when you have a good vocabulary and understand some basic ideas and concepts. So let's start with the basics of forex trading.
What Am I Doing When I Trade Forex?
Forex is a commonly used abbreviation for "foreign exchange", and it is typically used to describe trading in the foreign exchange market by investors and speculators.
Imagine a situation where the U.S. dollar is expected to weaken in value relative to the euro. A forex trader in this situation will sell dollars and buy euros. If the euro strengthens, the purchasing power to buy dollars has now increased. The trader can now buy back more dollars than they had to begin with, making a profit.
This is similar to stock trading. Stock traders will buy a stock if they think its price will rise in the future and sell a stock if they think its price will fall in the future. Similarly, forex traders will buy a currency pair if they expect its exchange rate will rise in the future and sell a currency pair if they expect its exchange rate will fall in the future.
Forex Transaction: It's all in the Exchange
If you've ever traveled overseas, you've made a forex transaction. Take a trip to France and you convert your dollars
into euros. When you do this, the exchange rate between the two currencies—based on supply and demand-determines
how many euros you get for your dollars. And the exchange rate fluctuates continuously. A single dollar on
Monday could get you .70 euros. On Tuesday, .69 euros. This tiny change may not seem like a big deal.
But think of it on a bigger scale. A large international company may need to pay overseas employees.
Imagine what that could do to the bottom line if, like in the example above, simply exchanging one
currency for another costs you more depending on when you do it? These few pennies add up quickly.
In both cases, you—as a traveler or a business owner—may want to hold your money until the exchange rate is more favorable.
What Is An Exchange Rate?
The foreign exchange market is a global decentralized marketplace that determines the relative
values of different currencies. Unlike other markets, there is no centralized depository or
exchange where transactions are conducted. Instead, these transactions are conducted by
several market participants in several locations. It is rare that any two currencies will
be identical to one another in value, and it's also rare that any two currencies will maintain
the same relative value for more than a short period of time. In forex, the exchange rate
between two currencies constantly changes.
For example, on January 3, 2011, one euro was worth about $1.33. By May 3, 2011, one euro was worth about $1.48. The euro increased in value by about 10% relative to the U.S. dollar during this time.
Why Do Exchange Rates Change?
Currencies trade on an open market, just like stocks, bonds, computers, cars and many other goods and services. A currency's value fluctuates as its supply and demand fluctuates, just like anything else.
- An increase in supply or a decrease in demand for a currency can cause the value of that currency to fall.
- A decrease in the supply or an increase in demand for a currency can cause the value of that currency to rise.
A big benefit to forex trading is that you can buy or sell any currency pair, at any time subject
to available liquidity. So if you think the Eurozone is going to break apart, you can sell the euro
and buy the dollar (sell EUR/USD). If you think the price of gold is going to go up, and based on
historical correlation patterns, you think the value of gold affects the value of the Australian
dollar, you might decide to buy the Australian dollar and sell the U.S. dollar (buy AUD/USD).
This also means that there really is no such thing as a "bear market," in the traditional sense. You can make (or lose) money when the market is trending up or down.
Elements of a Forex Trade
How Do You Read A Quote?
Because you are always comparing one currency to another, forex is quoted in pairs. This may seem confusing at first, but it is actually pretty straightforward. For example, EUR/USD at 1.4022 shows how much one euro (EUR) is worth in U.S. dollars (USD).
What Is A Lot?
A lot is the smallest trade size available. FXCM accounts have a standard lot size of 1,000 units of currency. Account holders can, however, place trades of different sizes, as long as they are in increments of 1,000 units like 2,000; 3,000; 15,000; 112,000.
What Is A Pip?
A pip is the unit you count profit or loss in. Most currency pairs, except Japanese yen pairs, are quoted to four decimal places. This fourth spot after the decimal point (at one 100th of a cent) is typically what one watches to count "pips." Every point that place in the quote moves is 1 pip of movement. For example, if EUR/USD rises from 1.4022 to 1.4027, EUR/USD has risen 5 pips.
What Is Leverage/Margin?
As mentioned before, all trades are executed using borrowed money. This allows you to take advantage of leverage. Leverage of 50:1 allows you to trade with $1,000 in the market by setting aside approximately $20 as a security deposit. This means that you can take advantage of even the smallest movements in currencies by controlling more money in the market than you have in your account. On the other hand, leverage can significantly increase your losses. Trading foreign exchange with any level of leverage may not be suitable for all investors.
The specific amount that you are required to put aside to hold a position is referred to as your margin requirement. Margin can be thought of as a good faith deposit required to maintain open positions. This is not a fee or a transaction cost, it is simply a portion of your account equity set aside and allocated as a margin deposit. Learn more about FXCM's Margin Requirements.
Why Trade Forex?
Online forex trading has become very popular in the past decade.
Forex Never Sleeps
Trading goes on all around the world during different countries' business hours. You can, therefore, trade major currencies at any time, 24 hours per day, five days per week. Since there are no set exchange hours, it means that there is also something happening at almost any time of the day or night.1
Go Long or Short
Unlike many other financial markets, where it can be difficult to sell short, there are no limitations on shorting currencies subject to available liquidity. If you think a currency will go up, buy it. If you think it will fall, sell it. This means there is no such thing as a "bear market" in forex—you can make (or lose) money any time.
Because of the deep liquidity available in the forex market, you can trade forex with considerable leverage (up to 50:1). This can allow you to trade even the smallest moves in the market. Leverage is a double-edged sword, of course, as it can significantly increase your losses as well as your gains.
Because forex is a $5.3 trillion-a-day market, with most trading concentrated in only a few currencies, there are always a lot of people trading. This makes it typically very easy to get into and out of trades at any time, even in large sizes subject to available liquidity.
Low Trading Cost
FXCM's Standard accounts are made up of low, competitive commissions and super-tight spreads. You trade the direct quotes from our liquidity providers with no hidden markups. For beginners, FXCM also offers a Mini account with all-inclusive spreads.2
As the world becomes more and more global, investors hunt for opportunities anywhere they can. If you want to take a broad opinion and invest in another country (or sell it short!), forex is a way to gain exposure while avoiding vagaries such as foreign securities laws and financial statements in other languages.
How to Trade Forex
Opportunities in Forex: What's your Opinion?
Just like stocks, you can trade currency based on what you think its value is (or where it's headed). But the big difference with forex is that you can trade up or down just as easily. If you think a currency will increase in value, you can buy it. If you think it will decrease, you can sell it. With a market this large, finding a buyer when you're selling and a seller when you're buying is much easier than in other markets, subject to available liquidity.
Maybe you hear on the news that China is devaluing its currency to draw more foreign business into its country. If you think that trend will continue, you could make a forex trade by selling the Chinese currency against another currency, say, the US dollar. The more the Chinese currency devalues against the US dollar, the higher your profits. If the Chinese currency increases in value while you have your sell position open, then your losses increase and you'd want to get out of the trade.
Making a Trade: How to Buy and Sell Currency
You have an opinion. Now what? Open your free forex demo platform and trade your opinion.
All forex trades involve two currencies because you're betting on the value of a currency against another. Think of EUR/USD, the most-traded currency pair in the world. EUR, the first currency in the pair, is the base, and USD, the second, is the counter. When you see a price quoted on your platform, that price is how much one euro is worth in US dollars. You always see two prices because one is the buy price and one is the sell. The difference between the two is the spread. When you click buy or sell, you are buying or selling the first currency in the pair.
Let's say you think the euro will increase in value against the US dollar. Your pair is EUR/USD. Since the euro is first, if you think it will go up, you buy EUR/USD. If you think the euro will drop in value against the US dollar, you sell EUR/USD.
If the EUR/USD buy price is 0.70644 and the sell price is 0.70640, then the spread is 0.4 pips. If the trade moves in your favor (or against you), then, once you cover the spread, you could make a profit (or loss) on your trade.
Fractions of a Penny: Trading on Margin
If prices are quoted to the hundredths of cents, how can you see any significant return on your investment when you trade forex? The answer is leverage.
When you trade forex, you're effectively borrowing the first currency in the pair to buy or sell the second currency. With a $5-trillion-a-day market, the liquidity is so deep that liquidity providers—the big banks, basically—allow you to trade with leverage. To trade with leverage, you simply set aside the required margin for your trade size. If you're trading 50:1 leverage, for example, you can trade $1,000 in the market while only setting aside $20 in margin in your trading account. This gives you much more exposure, while keeping your capital investment down.
But leverage doesn't just increase your profit potential. It can also increase your losses, which can exceed deposited funds. When you're new to forex, you should always start trading small with lower leverage ratios, until you feel comfortable in the market.