The foreign exchange market, commonly referred to just as the forex or FX market, is a global financial market where foreign currencies are bought, sold, and exchanged. Currencies are important as they are needed to make purchases of goods and services both locally and internationally.
International currencies must be exchanged to conduct foreign trade and business. Apart from conducting business, currencies are also exchanged by retail forex traders who speculate on the price movements of currencies to make a profit from exchange rates and fluctuations in the market.
Beginner forex traders are novices who do not have any prior knowledge, skill, or experience in the financial markets and who have never exchanged currencies in forex markets before.
Beginner traders who are just starting need a guide that will provide them with the necessary information that they will need on their trading journey, ensuring that they are equipped with the right tools to make the right investment decisions and to prevent them from incurring a loss.
The following sections in this article will serve as a comprehensive guide for novice traders in getting them started in the forex markets, helping them become experienced traders.
What is Forex Trading?
The foreign exchange market has been around for centuries, coming from simple barter systems and evolving into technology-driven electronic trades that are done through innovative trading platforms, exchanges, and forex brokers facilitating these trades.
Forex trading involves a currency pair and where one currency is exchanged for another. The forex market is subjected to demand, and supply and exchange rates fluctuate according to this principle.
If there is a high demand for US Dollars from European citizens that have Euro, they will exchange their Euro for US dollars. With higher demand for the US Dollar, its value will increase while the value of the Euro will subsequently fall.
To trade in the forex market, traders try to speculate on the direction of price movements. If traders think a currency will appreciate, they buy the currency or “go long.” If they feel that the currency is going to depreciate, they sell the currency or “go short.”
To determine the price movements that may occur, retail forex traders use either technical analysis to analyze the price charts of a currency or currency pair, or they conduct a fundamental analysis that analyses news and information.
Many retail investors also use a combination of the two to direct their investment decisions. To buy/sell currencies and make a profit, traders use trading strategies that are based on predefined rules and principles surrounding their entry/exit into trades.
There are millions of participants in the forex market, and it is the most liquid, largest, and most volatile financial market that experiences more than $6 trillion in trading volume daily.
Participants in the forex market include hedge funds, international banks, commercial banks, experienced and professional traders, institutional traders, corporations, retail traders, and several others.
There are two types of traders in the foreign exchange market, namely hedgers and speculators. Hedgers are always trying to avoid risky or extreme movements in the exchange rate.
Speculators, on the other hand, are those seeking risk and who are looking for volatile conditions in the market and exchange rates to take advantage of it.
All forex pairs contain two currencies, namely the base currency, or the first currency in the pair, and the quote currency, or the second one in the pair.
What are the Advantages of Forex Trading?
- Potential for Fast Returns
- Easy short-selling
- Technical strategy
- Less potential for inside price manipulation
- Fewer fees and commissions
- Simple Tax Rules
In terms of accessibility, the forex market is one of the most accessible financial markets for individual traders. Traders can easily set up a retail trading account with an online broker and start trading with low minimum deposits.
The trading of currencies is facilitated by online brokers, giving forex traders access to real-time market pricing as well as a range of tools, trading strategies, price charts, and innovative, powerful online trading platforms.
In addition, the forex market is open 24 hours a day, five days a week, meaning that forex trading can easily fit into the busy schedules of forex traders than other types of trading.
In terms of leverage, forex traders can make larger gains in trading as the broker offers them leveraged forex pairs. This is considered as a loan taken from the broker, allowing traders to open larger positions despite their initial deposit.
In terms of fast returns, the forex market moves fast and has prominent levels of liquidity. Combined with leverage, there is potential for significant gains for professional traders and other investors.
In terms of short-selling, the forex market makes the process of buying and selling currencies quite simple and does not require borrowing assets or risking exposure.
In terms of liquidity, the forex market is the largest financial market in the world, and this means that there is ample liquidity for trading, especially in major currencies.
Traders who deal with a trading desk model at their forex broker are offered more liquidity for trading as the broker takes up the opposite position of the trade when liquidity is scarce, such as the case with Market Maker brokers.
In terms of technical strategy, the forex market lends itself well to technical analysis, whereas other markets rely on fundamentals as well as financial health where shares and indices are concerned.
Unlike fundamental analysis, where a detailed background on the financial health of assets is concerned, technical analysis is based on price histories and certain trends that yield clues about the market perception of supply and demand along with the market sentiment.
In terms of price manipulation, other markets such as stocks, bonds, and commodity markets often experience influences of privileged information held by the insider as well as key shareholders.
The currency market, however, is not as centralized as other markets and less influenced by insider information.
Even if some market participants have inside information to sway the forex market, the trend will not hold, and the forex market will balance the playing field automatically.
In terms of fees and commissions, currency trading on the foreign exchange market saves traders from certain commissions and hidden fees that other markets such as equities, bonds, mutual funds, and others face.
Forex trading costs are determined by the bid price and the asking price, and the spread, which is the difference between these two prices, which is published by online brokers in real-time.
In terms of tax rules, forex trading has more simplified tax rules that make tax calculations easier than with other markets.
In terms of automation, the forex market is adapted to automated trading strategies which involve forex robots. These robots are programmed to enter and exit trades, set a stop-loss, and limit prices on behalf of the trader.
Auto trading makes it easier for traders to take advantage of the markets without having to spend all day and night in front of their trading terminals.
What are the Disadvantages of Forex Trading?
- Small traders can face disadvantages
- Lighter regulatory protection
- Fewer residual returns
In terms of volatility, the forex market is known for volatility as a result of quick changes in currency prices and exchange rates as supply and demand on currencies change.
Forex traders who depend on short-term profits may be exposed to unexpected and extreme volatility, which can render their trading strategies unprofitable.
In terms of disadvantages that small traders may face, there are large participants in the forex market such as active traders, hedge funds, large financial institutions, international banks, and more.
Larger participants in the forex market have a natural advantage at setting prices and influencing price movements in the forex market as a result of large trading volumes which are executed.
In terms of regulatory protection, the forex market is an over-the-counter (OTC) market where trades are not carried out on a centralized exchange.
This means that regulatory oversight is often limited, and because of this, forex traders need to ensure that they only deal with legitimate and regulated brokers.
In terms of residual returns, forex aims at obtaining capital gains from the appreciation of one of two currencies in each forex pair, as opposed to other markets such as stocks and bonds that can rely on regular scheduled interest and dividends, which enhance the long-term value of assets.
History of Forex Trading
Forex trading traced its beginning back to the barter system in 6000BC and was introduced by Mesopotamia tribes.
This involved system goods being exchanged for other goods, and over time, the system evolved to include popular mediums of exchange such as salt and spices.
Eventually, ships would sail across the ocean to barter for these goods, shaping the first-ever foreign exchange between countries.
As early as 6BC, the first gold coins were produced, and they started acting as currency because of their characteristics. Gold coins started becoming widely accepted as a medium of exchange until they were replaced by the gold standard in the 1800s.
The gold standard meant that the governments could redeem any amount of paper money for the value in gold.
During World War I, the European countries suspended the gold standard and started to print more paper money to fund the war. Until the 1900s, the foreign exchange market was backed by gold standards, which could not hold up during the two world wars.
From 1944 to 1971, the Bretton Woods System was in use, intending to create a stable environment by creating an adjustable pegged foreign exchange market.
The adjustable pegged exchange rate between currencies was pegged against the US Dollar, which was pegged to gold as the United States held the most gold reserves in the world at the time.
The Bretton Woods System was ended in 1971 by President Richard Nixon, and this led to the free-floating system or Smithsonian Agreement, which allowed for a greater fluctuation band for currencies.
During the early 1980s, the Plaza Accord occurred as a result of the US dollar's weight on third-world nations, leading to the appreciation of non-dollar currencies. From this, traders started realizing the profit potential in the new world of currency trading.
After WWII, the European Union was established following the Maastricht Treaty, and the Euro was created.
The 1990s market momentous change in foreign exchange with the advent and widespread adoption of the internet or online trading using computers.
The greatest change that came from this was that retail traders could emerge in the forex market with the necessary tools to trade in the international forex market, allowing them to profit from a plethora of trading opportunities.
What are the Ways For Forex Trading?
There are diverse ways in which retail traders can participate in the forex market, namely the spot market and futures market, while the forward market is reserved for institutional traders.
1. Spot Market
The spot forex market is considered an “off-exchange” market which is more commonly known as an over-the-counter or OTC market. The off-exchange market is large and growing rapidly.
The spot market is the largest as it trades in the biggest underlying real asset, and it has seen an increase in popularity as a result of the advent of electronic trading.
On the spot market, currencies are bought and sold according to their trading price. This price is determined by supply and demand and calculated according to several factors such as:
- Current interest rates
- Economic performance
- Sentiment toward the ongoing political situations, both locally and internationally
- The perception of the future performance of one foreign currency against another
Finalized deals in the spot market are often referred to as “spot deals.” This is a bilateral transaction that involves one party delivering on agreed-upon currency amounts to the counterparty.
They then receive a specified amount of the other currency at the agreed-upon exchange rate value.
Once the position is closed, the settlement is made in cash. The spot market is typically known as a market that deals with transactions in the present, but the trades that take place in this market can take up to two days to settle.
2. Forward Market
In this market, a forward transaction in forex is a contractual agreement between two parties to partake in a forex transaction on a date other than the spot value date and at a certain rate of exchange.
Forward contracts are transacted in the OTC or OTC forward market between counterparties who define the contract's terms between themselves, usually either electronically or telephonically.
The forward contract involves the buying of one currency and selling of another at the same time or for delivery at a certain rate on the same day.
The interbank forward market typically trades for standardized value dates, which are also considered “straight dates,” which can be one week, one month, two months, three months, six months, nine months, and even one year from the spot date.
There is also odd date forwards, which are those contracts that do not conform to specific straight dates. They are used by some bank customers who may ask for forwarding contracts to tailor to their own hedging needs.
The forward prices for these odd dates typically depend on the pricing that surrounds the straight dates that are derived from the market.
3. Futures Market
Forex futures can simply be defined as exchange-traded currency derivative contracts that tie both the buyer and the seller in a transaction that is executed at a predefined price and a predetermined date and time.
The price of all futures contracts depends on the underlying asset, which, in this case, will be a currency instrument. All forex futures are written on a certain date, at which point the delivery of the currency must happen unless there is an offsetting trade made on the initial position.
The key difference between spot forex and futures forex is that spot forex is OTC and, therefore, not subject to exchange rules and regulations.
Forex futures is transacted on established exchanges, especially the Chicago Mercantile Exchange (CME).
What should you know before getting started with Forex Trading?
Many prospective forex traders may not always have all the right information before they decide to commit to forex trading. Because forex trading is not for everyone, people must know what they are getting into before they invest capital.
- When trading forex, you do not own physical currencies
- Know the Bid-Ask spread
- You are capturing profits from volatility
- Be familiar with the currency pairs that you trade
- Leverage is a double-edged sword
When forex traders participate in the forex market, and they buy currencies, it is important to remember that you are entering an electronic system where your transactions are recorded.
Forex traders do not own physical currencies that are being traded. Traders make profits or losses based on the currency rates and how they fluctuate.
In terms of the bid-ask spread, the spread is the difference between the bid and ask prices which are expressed in pips. The forex market has competitive spreads, and the spread that traders face will affect the profitability of trades.
Traders will start each trade with a slight loss as a result of the spread that they incur. Thus, the lower the spread, the easier it is for traders to break even and to make profits on their trades.
In terms of profits captured from volatility, traders may often get confused between investing and trading. When investing, traders buy into an asset that they believe will appreciate over the long term.
When trading, the aim is to make profits according to the exchange rate fluctuations in the short term.
In terms of the currency pairs being traded, traders must consider and research the different currency pairs available to trade. Different currency pairs, such as major currency pairs, will exhibit different behavior than others, such as minor currency pairs, and a trading strategy that works well for one currency pair may not work for another.
Traders must ensure that they adopt and develop a trading style that works for their chosen currency pair. The forex trading strategy must also be tested by the forex trader, and it must be aligned to the trading plan.
In addition, traders must consider major macroeconomic policies that can affect currencies, such as interest rate announcements, fiscal spending, policy updates, and other factors that will influence currency price movements on both a small and large scale.
In terms of using leverage, traders must consider that using leverage can increase their chances of earning great profits, but it can also lead to losses in periods of high volatility when currency pairs take wild swings.
Traders must consider demo trading before they participate in the forex market. The demo trading account will also help traders test their trading plan, determine their trading style, trading activity, and indicate which trading platform works best.
Demo accounts can help traders work towards successful trading and help the transition from beginner traders to successful traders.
Another consideration before starting to trade, which must form a part of the trading plan, is the trader's risk tolerance and financial situation, willingness to be exposed to risk, and risk management protocols to limit certain loss levels.
How to Get Started with Forex Trading
To start trading forex, traders can follow these simple steps:
1. Find a regulated forex broker that has the right trading conditions, low fees and spreads, a range of financial products and currencies, educational resources, a range of trading tools such as economic calendar, a choice of retail investor accounts, trading accounts, and more.
2. Get the necessary forex trading education and guides to starting learning about forex trading and how it works.
3. Register a demo account with the broker and start practicing trading.
4. Start by opening small position sizes and using a little capital to avoid huge losses and practice risk management protocols.
5. Never stop learning and make use of trading tools, trading, and investment advice from professionals to direct trading decisions.
Important Terms of Forex Trading
Forex trading has a lot of terminologies that may be confusing to novice traders. Some of the most popular and important forex trading terms and their definitions are as follows:
Base Currency – which is the first currency in a forex pair and the currency being sold.
Quote Currency – which is the second currency in the forex pair and the currency being bought.
Major forex pairs – are currency pairs that include the US Dollar as either the base or quote currency along with one other major currency such as EUR, CAD, GBP, CHF, JPY, AUD, or NZD.
Cross-currency pairs and exotic currency pairs – cross pairs include two major currencies except for the US Dollar. Exotic currency pairs include exotic currencies that are not in the Top 10 of the most traded currencies, for example, the Mexican peso, South African rand, and several others.
Exchange rate – often called the price as it shows the price of the base currency expressed in terms of the quote currency, for example, the exchange rate between EUR/USD is 1.18, which means that one Euro costs 1.18 USD, or it takes 1.18 USD to purchase one EUR.
Bid Price – is the highest price that a buyer, or bidder, is willing to pay for a forex pair.
Ask Price – is the opposite of the bid price, and it represents the lowest price that the seller is willing to accept for a forex pair.
Spread – this is the difference between the bid and asks price, representing the actual spread in the underlying forex market as well as the additional spread charged by the broker for their service.
Pips/Points – this refers to the smallest increment that a currency pair can move, and it is the one-digit move in the 4th decimal place.
Going long/short – going long simply refers to buying, while going short refers to selling.
Leverage – is a useful tool that brokers offer traders, often seen as a loan, allowing them to open larger positions while paying a small fee as collateral.
Margin – is the amount of capital needed to open a leveraged position. It is the difference between the full value of the position and the funds being lent to the trader by the broker.
Margin Call – When the trader's total capital deposited, plus or minus the profits or losses, dips below the margin requirement.
Liquidity – refers to conditions where many participants are trading the same pair, making the specific pair extremely liquid.
Support – is an important concept in technical analysis and refers to a previous low on the price chart at which the price of a currency pair has a large chance to retrace and move in an upwards direction.
Resistance – is another valuable tool in technical traders' arsenal of tools. While the support levels show the previous lows of a currency pair, the resistance level tracks the currency pair’s previous high where the price had difficulties breaking above the line.