How to Trade Forex
What is Forex and how does it work?
Forex trading is the process of buying one currency while selling another. The combination of these two currencies make up what’s known as a currency pair. Forex is always traded in currency pairs, e.g., USD/EUR, with the price of one currency being quoted against the other. The first named currency is called the ‘base currency’ (here USD), the second ‘quote currency’ (here EUR). The listed price indicates how much of the quoted currency (EUR) is needed to purchase one unit of the base currency (USD).
Currency pair price quotes are generally quoted to either 4 or 5 decimal places. For example, 1.1022, for the pair EUR/USD in the above example. The 4th decimal represents the smallest generally recognized value amount in the price quote and is known as the “pip”. The difference between the exchange rate of 1.1022 and 1.1023 is one pip.
There are two basic ways to trade forex. Forex can be traded either on the spot market or through futures, forwards, and swap contracts.
Read the guide: How to Trade Futures
When investors talk about the forex market, they usually refer to the spot market. Currencies are sold and purchased at their trading price. Supply and demand determine the price of a currency pair. Macroeconomic factors such as interest rates, economic growth, political stability, and perceived future performance of one currency area against another influence a currency’s price development.
Futures and Forwards Market
Futures contracts are standardized agreements between parties to deliver and purchase a currency pair at a predefined price at a future date. Forwards contracts on the opposite are private, customized agreements between two parties to buy and sell a currency pair at a predetermined price at a future date.
The futures and forward markets, unlike the spot market, do not deal with actual currencies. Instead, they work using contracts that establish claims to a specified currency at an agreed upon price at a future date for settlement. Forex futures contracts can be traded on public commodities exchanges, such as the Chicago Mercantile Exchange. Forwards contracts, on the other hand, are bought and sold OTC, which allows for customization of the contracts while at the same hampering standardized trading.
Both types of contracts are legally binding and are generally settled for cash upon expiration. As with most derivatives, forex contracts can be traded at the respective exchanges prior to expiry. Large international firms typically utilize these contracts to protect themselves against potential exchange rate volatility, although speculators participate in these markets as well.
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Hedging and Diversification with Forex
In today’s globalized world, many companies have earnings and liabilities in multiple currencies other than their base currency. Even more important, production costs can incur in a different monetary jurisdiction than sales revenue. To mitigate the resulting exchange rate risks, multinational companies can hedge their position on the forex markets. By purchasing futures or forwards contracts which guarantee a fixed exchange rate for a specified amount at a future date, companies can protect their future cash flows against exchange rate volatility and currency devaluation.
Another interesting aspect of forex trading is the fact that it knows no bull or bear markets as a whole. As forex only trades in currency pairs priced relative to each other, there is no direct link to global markets. Shifts in exchange rates therefore only reflect the relative economic change between economic regions, but not the country’s absolute economic performance. Even if the world economy slithers into a recession, a forex trader’s positions aren’t necessarily impacted. This leads to a low correlation between the forex market and the rest of the financial markets. A forex trader’s risks are therefore less in the overall performance of the world economy but more in sudden economic or political shifts of one country in comparison to another. This makes forex investments a welcomed diversification tool for many investment portfolios.
How to trade forex
If you decide to take up forex trading, access to the currency markets has never been easier as today. A wide range of online brokerage platforms offer everything from forex spot trading to derivatives contracts and CFDs. Just as in the stock or crypto markets, there are many forex brokers to choose from. Here are some qualities to look for in a broker:
Choosing a Forex Broker
Low spreads: Most brokers don’t charge commissions on forex trades, but they do make money on spreads. Spreads are the difference between the price a currency is purchased for and the price it can be sold. Depending on the frequency of your trading, the spread of any given currency pair can have a significant impact on your bottom line. The comparison of spreads among different brokers is therefore highly recommended.
Quality broker: Most forex brokers are, due to the large amounts of required capital, connected to a large financial institution. Therefore, a broker should be backed by a reliable institution and regulated by a governmental agency. Brokers can also be checked through the Financial Industry Regulatory Authority’s BrokerCheck website.
Research and analysis tools: Forex brokers often provide different trading platforms, which offer real-time charts, historical data, macroeconomics reports, an economic calendar, and tools for technical analysis. Before committing to a broker, make sure to test the different available platforms and tools.
Leverage options: As price movements in forex are merely fractions of a cent, leverage is a necessary tool in forex. Especially for investors with limited capital, high leverage options can be necessary to generate substantial earnings. A large variety of leverage options gives investors the needed flexibility to adjust their positions according to the currency pair and the current market volatility.
Defining a Trading Strategy
A second key to successful forex trading is finding the right strategy. Some traders focus only on one or two currency pairs, others on news and events and again others on exotic currencies and volatile pairs. In general, there are two basic, often-used strategies: technical analysis and fundamental analysis.
While equity analysts value companies, forex traders using fundamental analysis try to evaluate whole countries and their economic and political developments. This is no simple task, and the findings are often used to predict long-term trends. Traders who focus on fundamental analysis try to capitalize on the release of macroeconomic news which can lead to short term shifts in exchange rates. There are many different macroeconomic indicators, often released by governmental agencies or central banks which can influence a country’s currency value.
Examples of these are:
- Central Bank Interest Rates
- Employment Summary / Non-farm Payrolls
- Purchasing Managers Index (PMI)
- Consumer Price Index (CPI)
- Retail Sales and Durable Goods
Like technical analysts in equity markets, forex technical analysts analyze price trends using metrics, charts, and key indicators. As forex trading is a 24-hour market, certain metrics must be adjusted for this timeframe. Some of the most commonly used technical analysis tools are:
To get a holistic market overview, these tools can be combined and evaluated together, as each one provides a different angle on the current market situation.
How to enter the trade
Step 1: Choose your direction
Placing a Forex trade is simple. A trader has two options:
- Go long by buying a currency pair
- Go short by selling a currency pair
Depending on your market view and forecast, choose a currency pair and the respective instrument. For an expected value increase of the currency pair, go long. For an expected value decrease, go short.
Step 2: Choose the leverage
Most Forex brokers offer leverage trading up to 20:1, some even up to 50:1. Traders therefore only have to put up 5% (20:1) or 2% (50:1) of the position’s value. When trading with leverage, be aware of the larger upside, but also the larger downside such positions carry.
Also, make sure to have enough money in your account to cover the necessary margin, especially if the market (temporarily) moves against your position. Otherwise, your position will be closed.
Step 3: Choose the trade size
Forex trading mostly happens in so-called Lot sizes. There are three types of lot sizes.
- 1 Lot USD/EUR = $100,000 USD
- 1 Mini Lot GBP/EUR = $10,000 GBP
- 1 Micro Lot CHF/EUR = $1,000 CHF
Choose your lot size. Some brokers also let you purchase fractions of lots. Divide the lot size by the leverage to get the amount of cash needed for the trade. E.g., 1 Lot ($100,000 USD), Leverage 20:1. Cash required for trade: 100,000 / 20 = $5,000 USD.
Step 4: Purchase the contract
Step 5: Set Take Profit and Stop Loss orders
Once the position is purchased, define a target price and the maximum loss you are willing to take. Then, set Take Profit and Stop Loss orders accordingly to ensure profit taking and as well as smart risk management. The higher the leverage, the more important these orders become, as high-leveraged positions show larger price swings.
In summary we note: the Forex market has its own rules and dynamics. It combines macroeconomics, politics, and finance and has to deal with complex interrelations between states or economic regions. This leads to a low correlation to other financial markets and opens interesting investment opportunities. In a world that gets more globalized by the day, understanding the basics of forex is therefore more important than ever before.