Forex basics every beginner should know - Traders Union

What is the Forex market?

The foreign exchange market, or Forex, is an international and decentralized trading market where participants purchase and sell currencies at prices they mutually agreed upon. It enables individuals, businesses, and central banks to exchange one form of currency for another for a variety of purposes. Although some exchanges are made for practical reasons, many traders focus on capitalizing on the fluctuating prices of currencies.

The massive daily trading volume can cause dramatic price shifts, making Forex an appealing market for those seeking significant returns but also introducing higher risk levels. Unlike other markets, spot Forex transactions don't occur on an exchange, but rather between parties via an over-the-counter (OTC) market. Forex markets are accessible 24 hours a day, enabling traders to participate in currency transactions across different time zones. They are mainly divided into three types: spot, forward, and futures.

In Forex trading, participants buy or sell pairs of currencies based on their expectations of the pair's future performance. Each currency pair includes a base currency and a quoted currency, and the price reflects the value of one unit of the base currency relative to the quoted currency. Traders forecast exchange rates by examining the market and leveraging price movements. They can choose to buy (go long) or sell (go short) a currency pair based on their predictions.

How does the Forex market work?

Trading in the Forex market is comparable to transacting with various securities, such as stocks. However, the primary distinction is that Forex trades occur in pairs, like AUD/CAD (Australian dollar/Canadian dollar) or CHF/JPY (Swiss franc/Japanese yen). When engaging in a Forex trade, one currency is sold while another is purchased. Profits are made if the bought currency appreciates relative to the sold currency.

For instance, imagine the exchange rate between the Australian dollar and the Canadian dollar is 1.25 to 1. If you purchase 1,500 Australian dollars, you would spend $1,875 Canadian dollars. If the exchange rate later shifts to 1.35 to 1, selling those Australian dollars would yield $2,025, resulting in a profit of $150.

The role of leverage

In the Forex market, using leverage is a common practice. It allows traders to trade in multiples of their capital. For example, some Forex traders might use a 30:1 leverage, enabling them to buy $30,000 of foreign currencies with just $1,000, as the brokerage firm lends them the remaining funds. Some firms may even permit leverage up to 500:1.

Leverage can amplify gains and losses in any investment, including the Forex market. If you buy $30,000 in currency and it increases by 10%, you'll earn a $3,000 profit. With a 30:1 leverage and an investment of $1,000, this equates to a 300% gain.

However, leverage can also work against you. Using the 30:1 leverage example, if your $30,000 drops by 10% to $27,000, you'd not only lose your entire $1,000 investment, but you'd also need to repay the loan to the brokerage firm.

Types of Forex markets

The Forex market is divided into three distinct categories, each with its unique characteristics and methods of operation:

Spot Forex Market: In this market, the actual exchange of a currency pair occurs at the precise moment the transaction is executed, also known as 'on the spot.' The settlement of the trade typically takes place instantly or within a brief time frame. The spot market is the most common and popular Forex market due to its immediacy and relatively straightforward nature.

Forward Forex Market: This market involves a contractual agreement to purchase or sell a predetermined quantity of a currency at a set price on a specified future date or within a range of future dates. The forward market allows participants to hedge against potential fluctuations in exchange rates by locking in a rate for a future transaction. Unlike the spot market, the forward market does not involve the immediate exchange of currencies, making it suitable for those who wish to mitigate currency risk.

Futures Forex Market: Similar to the forward market, the futures market involves a contractual agreement to buy or sell a specified amount of a currency at a predetermined price on a set future date. However, unlike forward contracts, futures contracts are legally binding and are typically traded on regulated exchanges. Futures contracts are standardized, meaning they have specific contract sizes, settlement dates, and other terms. The futures market is often used by traders and investors for speculation, risk management, and hedging purposes, as it offers transparency and the ability to trade on margin.

Each type of Forex market serves different purposes and caters to various trading strategies, allowing market participants to choose the market that best suits their needs and objectives.

How to start trading Forex?

Experts have highlighted key steps for anyone who wants to start trading Forex:

Learn what influences the market

To begin your journey in currency trading, the initial step is to acquaint yourself with the market and its distinct aspects. While the foreign exchange market shares similarities with stock trading, the driving forces behind currency fluctuations are unique.

For instance, global political situations can have a considerable impact on the Forex market. Even minor incidents can trigger a chain reaction affecting currency values. Although politics also affect stock markets, the effect is more pronounced for currencies. As a newcomer to Forex trading, it is crucial to examine and comprehend the diverse factors shaping the market.

Additionally, it's essential to be aware that currencies are traded in pairs, not in isolation. Some of the most commonly traded currency pairs worldwide include USD/CHF, EUR/AUD, GBP/JPY, and AUD/CAD. Gaining insights into how these pairs function and what influences their movements is vital.

Opt for a trustworthy broker

Picking the appropriate Forex broker is as crucial as mastering currency trading. Not every broker offers consistent service quality or dependability. Allocate time to investigate different brokers providing Forex trading services.

An exemplary Forex broker should have a seamless account creation process, a user-friendly trading platform, outstanding customer support, and affordable transaction fees. Also, when assessing brokers, examine their frequency of downtime. Prefer brokers with minimal downtime since Forex trading is volatile and requires swift trade executions and responses.

Set your financial aspirations and benchmarks

After opening a Forex trading account with a reliable broker, outline your financial ambitions and benchmarks. Consider what you aim to accomplish through currency trading. Establish benchmarks for each trade or specific periods before engaging in actual currency transactions.

Defining these targets enables you to develop a trading strategy, ultimately enhancing your trading proficiency. Without clear goals or benchmarks, it becomes increasingly difficult for beginners to identify appropriate entry and exit points, leaving them susceptible to market turbulence and adverse movements.

Hone your skills through simulated trading

Once you've outlined your financial benchmarks, participate in simulated trading. Simulated trading allows you to trade currencies in a virtual setting using demo accounts and fictitious funds. Various online resources replicate real-time trading environments, enabling you to practice without risking real money.

Through extensive simulated trading, you can become familiar with currency trading and explore new tactics and strategies. This learning process can offer valuable perspectives on how to approach Forex trading in real-time.

Proceed cautiously and manage trades prudently

After mastering simulated currency trading, transition to real trading carefully. Remember that the Forex market is notoriously volatile and can experience significant price swings. Begin by using only a small portion of your total investment amount.

Forex trading primarily relies on leverage, allowing you to hold sizable positions by depositing minimal amounts of money. While high leverage can result in increased profits during favorable trades, it can also lead to considerable losses if the trade doesn't go as expected. Start gradually and incrementally increase your investment amount as you gain confidence and expertise.

Basic Forex terminology

Currency

Currency refers to a nation's circulating medium of exchange, including banknotes and coins. The Forex market facilitates the trading of various national currencies against each other. The value of a currency is dictated by supply and demand forces, and traders seek to capitalize on fluctuations in these values.

Currency Pair

A currency pair consists of two currencies: a base currency and a quote currency. The base currency's value is expressed concerning the quoted currency. Currency pairs are the primary instruments traded on the Forex market, with traders buying and selling them to benefit from exchange rate shifts.

Major Pairs

Major pairs involve the US dollar as either the base or quote currency and one of the other seven significant currencies: the Euro, Canadian dollar, British pound, Swiss franc, Japanese yen, Australian dollar, and New Zealand dollar. These pairs are the most traded on the Forex market, offering low transaction costs and high liquidity.

Cross Pairs and Exotic Pairs

Cross pairs exclude the US dollar, such as the EUR/GBP or AUD/JPY. Exotic pairs involve one major currency and a less commonly traded currency, like the Mexican peso, Turkish lira, or Czech koruna. Exotic pairs generally exhibit higher volatility and lower liquidity than major pairs.

Bid/Ask Price

The bid price is the amount traders are prepared to pay for a currency pair, while the ask price is the amount they are willing to sell it for. The bid/ask spread is the gap between these prices, signifying the trading cost on the Forex market.

Exchange Rate

The exchange rate is the value of one currency in relation to another. Exchange rates are expressed as bid and ask prices, representing the prices at which traders are willing to buy or sell a currency pair.

Spread

The spread denotes the difference between a currency pair's bid and ask prices. As the trading cost on the Forex market, it's essential for traders to consider the spread as it can affect their overall profits.

Pip

A pip is the smallest unit used to express changes in exchange rates. For most currency pairs, one pip corresponds to a shift in the fourth decimal place of the exchange rate. For instance, a movement from 1.1000 to 1.1005 in the AUD/JPY pair constitutes a change of 5 pips.

Pipette

A pipette is one-tenth of a pip and is used to measure the spread between bid and ask prices on the Forex market.

Going Long/Short

In Forex trading, going long means purchasing a currency pair in anticipation of its value rising, while going short signifies selling a currency pair, expecting its value to fall. Traders aim to profit from exchange rate fluctuations by going long or short.

How to read Forex pairs

To understand and trade in the Forex market, it's crucial to learn how to read currency pairs. A currency pair consists of two currencies: a base currency and a quote currency. The base currency's value is expressed in terms of the quote currency. Here's a step-by-step guide to help you read Forex pairs.

Identify the base and quote currency:

In a currency pair, the base currency is listed first, followed by the quote currency. For example, in the AUD/GBP pair, AUD is the base currency, and GBP is the quote currency. The pair signifies the amount of quote currency required to purchase one unit of the base currency.

Understand the exchange rate:

The exchange rate represents the value of one currency in relation to another. For instance, if the exchange rate for EUR/USD is 1.2000, it means you need 1.20 US dollars to buy one euro. Exchange rates fluctuate continuously due to factors such as economic indicators, geopolitical events, and market sentiment.

Interpret the bid and ask prices:

Forex quotes usually display two prices: the bid price and the ask price. The bid price is the highest price at which buyers are willing to purchase the currency pair, while the ask price is the lowest price at which sellers are ready to sell the pair. The difference between these two prices is called the spread, which serves as the transaction cost for trading.

For example, if the EUR/USD pair has a bid price of 1.1995 and an ask price of 1.2000, this means you can buy the pair at 1.2000 and sell it at 1.1995. The spread in this case is 5 pips (0.0005).

Calculate profit or loss using pips:

A pip is the smallest price movement in the Forex market, typically representing a change in the fourth decimal place of the exchange rate (0.0001). Some brokers also quote prices to the fifth decimal place (pipettes), offering more precision.

If you bought the EUR/USD pair at 1.2000 and sold it at 1.2050, the difference is 50 pips (1.2050 - 1.2000). To calculate your profit or loss, you need to consider the position size (number of units) and the pip value. If you traded 10,000 units (a mini lot) and the value of one pip for this lot size is $1, your profit would be $50 (50 pips x $1).

Forex trading tips for beginners

Here are some expert Forex trading tips for beginners:

Begin with small investments and learn progressively:

As a beginner in Forex trading, it's crucial to start with small investments. This approach allows you to learn from your experiences while minimizing potential losses. As your confidence and understanding of the market grow, you can gradually increase your investments. Keep in mind that the market won't always move in your favor, so it's vital to be patient and learn from any mistakes.

Select the most suitable currency pair:

When choosing a currency pair to trade, consider your trading strategy and comfort level with market volatility. Opt for active markets with high daily trading ranges for short-term gains and ensure there's sufficient liquidity. Explore various options and pick a currency pair that aligns with your trading objectives.

Define clear goals and manage risks:

Establish your trading goals and adhere to a risk management plan. Trade in the direction of the trend and set stop-loss and take-profit points in advance. Refrain from impulsive trading, and remember that sometimes staying neutral can be a strategic decision.

Recognize your limitations:

Risk management is a critical element of successful Forex trading. It involves understanding the amount of risk you're comfortable with, setting your leverage ratio according to your needs, and not risking more than you can afford to lose.

Utilize stop and limit orders:

Stop and limit orders are indispensable tools for managing risk in Forex trading. A stop order automatically closes your position if the market moves against you, helping to limit losses. A limit order, conversely, automatically closes your position if the market moves in your favor, allowing you to secure profits. Trailing stops are another valuable tool that can help protect your gains, as they automatically adjust your stop loss order when the market moves in your favor, enabling you to ride the trend while minimizing risk.

Keep emotions under control:

Emotions can be detrimental to traders, as fear and greed often lead to irrational decisions and deviations from trading plans. To keep your emotions in check, maintain discipline and adhere to your plan. Don't let losing trades tempt you into making impulsive decisions in an attempt to recover losses. Instead, focus on achieving small, consistent gains over time.

Reassess your trading plan:

Your trading needs may change as your experience grows. Your financial situation, risk tolerance, or trading goals may evolve, making it essential to periodically review and adjust your trading plan accordingly. For example, you might want to revise your profit targets, modify risk management strategies, or change the instruments you trade.

How to start trading in Forex?

To begin trading in the Forex market, follow these steps:

Ensure reliable internet access

To effectively trade Forex online, you need a stable internet connection and a device such as a smartphone, tablet, or computer on which you can run a trading platform. A reliable connection is crucial because any interruption could lead to losses if the market moves unfavorably while you're disconnected.

Select an appropriate online Forex broker

Look for an online Forex broker that accommodates your needs as a trader and accepts you as a client. The broker should keep your funds separate from its own and operate under the jurisdiction of a reputable regulator, like the UK's Financial Conduct Authority (FCA) or the US Commodity Futures Trading Commission (CFTC). Compare brokers based on factors such as margin rates, currency pairs, and trading conditions.

Open and fund a trading account

Once you've chosen a broker, deposit funds into a trading account. Most online Forex brokers offer various methods for funding an account, including bank transfers, debit card payments, or transfers from electronic payment providers like Skrill or PayPal.

Acquire a Forex trading platform

Download or access an online Forex trading platform compatible with your broker. Many brokers provide a proprietary trading platform or support widely used third-party platforms such as MetaTrader 4 and 5 (MT4/5) or NinjaTrader.

Begin trading

With all the previous steps completed, you're ready to start trading. You can also open a demo account, which allows you to test the broker's platform and services using virtual money before going live. Demo accounts are helpful for testing trading strategies and practicing trading without risking actual funds.