The Ultimate Guide To Forex Trading
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Forex trading has become one of the biggest and strongest markets in the globe. According to a 2019 triennial report from the Bank for International Settlements, “Trading in FX markets reached $6.6 trillion per day in April 2019, up from $5.1 trillion 3 years earlier.”
The Forex market, specifically, is enticing for many reasons including; traders can enter into it simply and easily, it is one of the most technologically advanced markets, and you can trade in your own time.
In this Forex guide, we’re going to delve into; what exactly the Forex Market is, and how it can both help you make money and protect you from potentially huge losses at the same time.
We’re also going to discuss the risks involved, so you can make the best decisions on your path to becoming an expert trader, from the get-go.
Overview and Summary
- The foreign exchange market is where currencies are traded. Currencies are used and recognised by almost everyone who partakes in society because we need them for so many things.
- The Forex market is the most popular market, making it the biggest and most active, trading over 5.09 trillion USD every day.
- Exchange rates define how much your currency is worth in another currency. You can think of it as the price you’ll need to pay in order to purchase a particular currency.
- A currency pair is the quotation of a currency from two countries coupled for trading.
- Foreign exchange trading will have both a bid and ask price. The bid is the price you want to buy the currency at and the ask is the price you want to sell at.
- Currency speculation is when traders buy and hold currency in the hope that it changes in value.
- A hedge is an investment that protects your finances from the risk of changing currency values.
- Forex trading is a complex, risky and extremely unpredictable industry, with varying regulations.
What is Forex?
Let’s begin by defining the term Forex. It stands for foreign exchange, and has many abbreviations including, FX. Foreign exchange is simply the process of exchanging currencies from one to another.
The foreign exchange market therefore, is where currencies are traded. Currencies are used and recognised by almost everyone who partakes in society because we need it for so many things.
The World’s Largest Financial Market
Today, the Forex market is the most popular market, making it the biggest and most active, with over 5.09 trillion USD in trades every day. This also makes the market very volatile and unpredictable, enabling traders to profit off both positive and negative fluctuations
Trade in Your Own Time
Forex is the market that never sleeps. It’s active 24 hours a day, 5 and a half days a week, which means that you can trade at a time that suits you.
The Forex market is an over-the-counter market (OTC) which means that traders don’t need to be in any physical location to trade currencies.
As a result, Forex traders are never restricted to any particular hours of the day. It also means that currencies are always moving somewhere around the world, because someone is always actively doing business.
For example, during daylight hours in the U.S, the U.S dollar will fluctuate the most. While in Europe, the euro will fluctuate the most during their daylight hours, or between 8:00 to 16:00 GMT.
This is a fantastic set-up for anyone that’s busy during the day because it means you can trade currencies in the evening and visa versa. If you’re busy at night, or you just like to sleep at night, then you can trade currencies in the morning.
Are you based in the US? See our best US Forex brokers.
An Accessible Market
One of the best advantages of Forex trading is its accessibility. The Forex market is one of the most technologically developed markets, and is accessible to people around the globe, once they have an internet connection.
While other markets use out-dated trading platforms, the Forex market is constantly upgrading the software used.
This means that we are constantly updated about how country’s situations affect the market.
For instance, traders can stay up-to-date on fluctuations on the British pound in the midst of BREXIT in real-time, which is important for individuals and companies alike due to its potentially turbulent exit from the European Union.
Similarly, after President Trump’s impeachment in mid December 2019, traders could immediately see if it had an effect on the value of the U.S dollar. However, true to the unpredictability of the market, the announcement barely affected it.
The Evolution of Forex
The Forex market is well and truly the market that never sleeps. It may be a new concept to many, and of course it has evolved and grown into what it is today, but the concept of changing currencies has been around a hella’ long time.
So, where did it all begin? The first known sign of currency exchange has been traced as far back as 259 BC in Egypt.
Fast forward to 1944 when the Bretton Woods Accord was signed which allowed currencies to fluctuate within a tight range.
Not long after, in 1971, a free-floating currency system was introduced and thereby, creating the market as we know it today.
This same year, computer monitors were introduced, replacing old-era telephone and telex methods. Then, in the 1980’s, electronic Forex trading was born. Traders could now trade on real-time.
Why We Need to Trade
Most people around the world will need to trade currencies at some stage in their lives. Whether they’re buying something online or going on holidays. In the age of technology, it’s unlikely you’ll manage to avoid the trade.
If you are in England and you want to buy a phone online from the U.S, then someones currency needs to be exchanged for the purchase to take place.
For example, the person in Britain would need to change their pounds (GBP) into U.S dollars (USD).
Travel and holidays also require the exchange of currencies. When you go on holidays to a region that has a different currency, you will need to exchange your money into whichever currency the country you’re going to has so that you can pay for your ice-cream, fake pair of Raybans, or 10 shots of tequilas, say.
If you’re a Spaniard going on holidays to Mexico, then you can bet your bottom dollar you’re not going to be able to buy that oversized sombrero off the local in Cancún with Euro. You’ll need to trade in your euro, at the current exchange rate.
Exchange Rates and What Affects Them
Exchange rates define how much your currency is worth in another currency. You can think of it as the price you’ll need to pay in order to purchase a particular currency.
The price of most currencies is decided by Foregin Exchange Traders who trade the currencies twenty-four hours, five and a half days a week. In 2019, $5.1 trillion market trades were made a day
A strong currency is good because it allows you to buy more of other currencies, which is great for many reasons, but especially for commerce.
What Affects Exchange Rates
The price of currencies is constantly changing and there are a lot of complex factors that influence this.
Currencies are not directly regulated by Governments or banks, and usually the most a Government will try to do is influence the rate.
However, it is intrinsically linked with how well a country is performing economically, and the interest rates of the country’s central bank, in addition to how much of that currency there is available.
The Role of Interest Rates
The first way an exchange rate can be influenced is through the interest rate paid by a country’s central bank.
Higher interest rates increase the value of a currency because more investors swap their currency for the better paying one and then invest it in that country to yield the higher interest rate.
In the U.S the nation’s central bank is the Federal Reserve, an independent arm of the government that influence exchange rates by raising or lowering the fed funds rate.
For example, if the Federal Reserve lowers the fed funds rate, interest rates will go down across the U.S. This in turn makes loans cheaper to encourage investing and spending in the economy.
When interest rates are significantly lowered, investors are less likely to exchange their currency to the U.S dollar. This is because they won’t get good returns on their money.
The Money Supply Effect
The central bank can also affect exchange rates by printing too much money to induce price inflation.
When a country spends, they get the money from taxing, borrowing, or printing more money. Countries that choose to print more money usually have inadequate tax revenue, high spending, and may have run out of any borrowing options.
When there’s too much money, demand outstrips supply causing the prices of their goods and services to increase.
In certain cases, when far too much money is printed, hyperinflation will occur. This is rare but it can happen when countries have extreme debts to pay, such as war debts.
The Role of the Economy
The country’s economic situation and financial stability also impact the value of its currency.
Investors are more likely to buy goods and services from a strong, growing economy. In order to do this, they’ll need to pay in the currency of the country they’re investing in.
Countries with less financial stability won’t be invested in as much because they need to know that they will get their money back if they hold government bonds in that currency.
Currency War: An Intentional Devaluation of Currency
Until now, it might have seemed straightforward enough that a stronger currency equates to good news for a country. But formulas are a rarity in this industry, and things are never that simple.
In some cases, a strong currency isn’t what’s best for a nation. Let’s look at China as an example of this.
In the past couple of decades, the Chinese Government have been accused of consistently devaluing the Chinese currency (Renminbi) in order to advance its own economy, especially by Donald Trump.
Why Devalue Currency?
China has a strong export sector which allows them to run a current account surplus.
A weak currency keeps chinese exports very competitive in a global market, and at the same time, it makes imports more expensive.
Chinese exports has been a key factor in the economic growth of the country, creating better paid jobs for traditionally low-paid agricultural workers.
The U.S have criticised this strategy as currency manipulation. A devalued Chinese currency results in an overvalued U.S dollar, which causes a loss of U.S jobs, they argue.
The negative effects of a devalued currency aren’t usually worth it however. It can create uncertainty in global markets and potentially spur a recession.
In the case of China and the U.S, it could result in a currency war where by both countries consistently devalue their own currency into the ground. This behavior can have negative and dangerous consequences.
Spot Markets and Futures Markets
Let’s broaden the scope a bit. Until now we’ve only been referring to the cash market in our Forex guide.
This is also known as a spot market, because transactions are settled right away, or on the ‘spot’. This the most popular market.
Stocks and currencies are the most well-known spot market instruments. Therefore, Forex, the exchange of currencies, is a global spot market.
The opposite of the spot market is the futures market. This is a contract based market where transactions are settled in the future, at a later date. This market was started to create currency futures to provide a place where banks and corporations could hedge against potential risks or huge losses when trading.
How Do Forex Quotes Work?
A Forex quote is the price of one currency when valued against another. This involves currency pairs, because there are two currencies involved; you are buying one currency with another.
A currency pair is the quotation of a currency from two countries that are coupled for trading.
The currencies involved are known as the base currency, which appears first, and the quote currency, which appears second.
Currency pairs are valued against each other. The base currency is always valued against the quote currency. This tells traders how much the base currency will cost in the quote currency.
Each currency is identified by The International Organization for Standardization codes, or ISO codes. These codes are 3 letter abbreviations of each country’s currency.
For example, the US dollar’s ISO code is USD and the Euro is EUR. ISO codes are the same around the world and are one of the few rules in the trading industry.
How to Buy and Sell to Make a Profit
Asking & Bidding
Foreign exchange trading will comprise of both a Bid and Ask price. The bid is the price you would like to buy the currency at and the ask is the price you want to sell it at.
What is a Long or Short Position?
A long-trade is when the first currency is bought while the second is sold. To go long on a currency means that traders buy a currency in the hope that their currency pair increases in value, so they can sell it and make a profit. In other words, they’re buying low and selling high.
This is particularly the case for long-term investments, including investments in bonds or stocks, where traders rely solely on the value of their assets increasing in value.
Traders can also sell currency or ‘go short’, with the hope that their currency pair decreases in value, so they can re-buy it at a cheaper rate. ‘Shorting’ is selling high and buying low, and it allows you to make profits on market trends moving both upward and downward. When ‘going short’, it’s important to utilize one of the top brokers for short selling, as not all brokers are geared toward this type of investing.
Speculate on Rising or Falling Prices
Currency speculation is when traders buy and hold currency in the hope that it changes in value. If they believe that a currency is undervalued, then they will buy that currency and hope to sell it later to make a profit. If they believe that it’s overvalued then they will start short selling it.
The most famous example of currency speculation happened, on what we know today as ‘Black Wednesday’, in 1992 when hedge fund manager George Soros shorted the pound, and forced the British Government to pull from the European Exchange Rate Mechanism (ERM).
During a time of economic instability, with low interest rates and high inflation, Britain made the unsound decision to increase its interest rates to attract attention to the pound.
After noticing this, Speculator George Soros shorted the pound, resulting in The British Government withdrawing its currency from the ERM because they were losing billions trying to artificially increase its value.
Soros went down in history as a world renowned currency speculator, earning himself a whopping $1 billion.
Keep in mind, extraordinary deals like this are done by extraordinary traders, and we don’t hear about all the unsuccessful speculations.
Fees and Commissions
Trading forex beats other trading when it comes to fees and commissions. One reason is that most brokers charge a variable commission on the spread as opposed to a fixed fee, or a percentage fee on the value of the trade. Charging a fixed commission can happen but it’s not as common, especially with recent market moves towards eliminating fees, which we’ll discuss a bit further down.
Understanding the Forex Spread
The Forex Spread is the difference between the bid and ask price of a currency pair.
For example, if the asking price of currency is 1.15558-1.15557, the spread is 0.0001, or 1 pip. This means that in order to make a profit, the value of a currency pair will need to increase more than the spread.
Currency pairs with too large a spread will take more time to become profitable. Low-spread trading earns a quicker profit and is therefore preferred by many Forex traders. They make a lot of smaller trades, instead of depending on larger trades to make a profit.
Looking for a more in-depth explanation on forex spreads and commisions? See our forex commissions and spreads guide.
Currency Liquidity and Its Role
Forex Traders rely on currencies to change prices in order to make a profit. But how much do currencies actually move?
This all depends on the liquidity of the currency; how much trading activity, or demand there is for that pair.
Liquidity refers to a currency pair’s ability to be bought and sold without causing any drastic change in its exchange rate. If a significant amount of the currency pair can be easily bought or sold then it has high liquidity.
For example, cash of a major currency is said to be completely liquid. Major currency pairs include:
Low liquidity then refers to a currency pair that cannot be bought or sold without causing significant change to its exchange rate. This is the case with more exotic currency pairs such as PLN/JPY.
What is Leverage?
Leverage is the amount a broker offers you to trade with, which can really help you out if you’re starting with a small fee. For example, if you have $1,000, your broker may provide a leverage of 1:10 which means that you can make an initial trade of a currency pair up to $10,000.
Using money that you don’t have is always a gamble, it could increase your winnings by ten-fold or multiply your losses. For this reason, the potential risk is always great with a leverage.
What is Hedging?
A hedge is an investment that protects your finances from the risk of changing currency values. It limits your loss to a pre-arranged amount if the currency loses value.
It’s kind of like taking out an insurance plan. You pay an agreed amount and if your house is robbed, you only lose the known amount of the deductible.
Hedging Strategies: Protect Yourself From Risky Situations
Usually, investors use derivatives to secure the right to buy or sell stock at a specified price.
Here’s how you could hedge a risk.
If you buy stock in the hopes that it would increase, but also want to protect yourself from it plummeting in value, you could hedge the risk with a put option. This would require paying a small fee for an agreement that allows you to sell the stock at the same price you bought it.
You could also hedge yourself from a risk through diversification. With a diverse portfolio your assets are unlikely to decrease at the same time, making it easier to manage if/when one does. It’s the idea of not putting all your eggs into one basket.
For example, traders buy bonds to offset the risk of stock ownership, because when stock prices fall, a bond’s value increases.
However, this is mostly only applicable to high-grade corporate bonds. Riskier investments like junk bonds fall when stock prices do because they are both risky investments.
Potential Risks of Forex Trading
Risk is an inevitable part of any high stakes industry, but without risk there also wouldn’t be much to gain.
Forex Trading is a complex, risky and extremely unpredictable industry, with varying degrees of regulation.
That said, the regulation protects the banks participating in Forex Trading first and foremost. As the banks trading around the world take on sovereign risk and credit risk there are processes to protect them as much as possible.
The market pricing structure, as we mentioned earlier, is based on a supply and demand theory. With such large trade-flows within the system, rogue traders will have a tough job of influencing any currency values. This structure helps ensure that the market is transparent for investors with access to interbank dealing.
If you’re an individual looking to trade then you’ll more than likely trade with a smaller or possibly semi-unregulated Forex broker. These brokers have the ability to and sometimes do re-quote prices, and even trade against their own customers.
This is something to be aware of, and depending on where the broker is located it may be held responsible to stricter regulations that have been enforced by the country’s government.
If you’re interested in entering the Forex market then make sure to find out where the Forex broker is regulated. Brokers regulated in the U.S or U.K will be liable to stricter regulations than most other countries.
What should you look out for in a Forex broker? Learn how to identify a Forex scam.
The Importance of Trading Emotion & Psychology
Traders undoubtedly have a mental battle when trading. Overcoming biases and ancient wiring in the human brain can be a difficult – if not impossible – thing to do, and can affect performance.
Leaders in the area of bias, and decision making, Daniel Kahneman and Amos Tversky (and later influential Richard Thaler) theorized that heuristics and biases led people to make errors, and that essentially humans take mental shortcuts. This goes against rational theory and demonstrates that humans display behaviors of irrationality.
Some biases that we can fall victim to include:
In a lot of cases people make decisions that are unwittingly anchored by the information that preceded it. This is called the anchoring bias.
For example, in trading you might purchase a stock at $90, and when it drops to $80 you may re-evaluate your decision. While the fundamentals may stack up in favor of the company, some may fall victim to the anchoring of the $90 purchase price and ultimately sell when no material change has come about. Therefore the decision to hold or sell will be influenced by the price, or anchor, rather than the fundamentals.
Sometimes, we assess the probability of something by how easily we can think of such instances, or occurrences. When trying to judge how likely it is that a middle aged person will have a heart-attack, we will usually try and think about how many people we know of that age who have had heart-attacks.
In the world of trading, people may weight stock picks based on the information that is available to them. For example, they might make their decision based on news they heard recently (perhaps even unknowingly). This is known as availability bias.
A form of availability bias can be seen in the latest research which shows that among other things, our ability to make decisions and reevaluate new information is bound in home bias. This is our tendency to invest in stocks in our home countries or states more often than not, which concentrates risk as opposed to diversifying it.
Even worse, it suggests that this can result in people investing in their own company stock, which exposes them to the loss of both labor income, and stock market wealth were the company to go into financial distress.
Myopia & Loss Aversion
Myopic loss aversion is the idea that people are affected more by losses than gains. For example, we get more upset by losing $50, then the amount of happiness we feel by winning $50. In trading, this can make us evaluate our outcomes more regularly which can have two implications.
This first is that we notice our losses. The second is that investors who get feedback more frequently, take less risk, and therefore earn less money.
Status Quo Bias
Status Quo Bias is a symptom of loss aversion bias. It’s an observation that people are likely to regret bad outcomes that result from new actions taken more than they regret any bad consequences that arise from any inaction.
Awareness is the First Step Towards Greatness
Being aware of our biases can give us a greater chance of making profitable trading decisions. Having the ability to recognize when our biases are affecting our decisions can help us remain objective and lessen the possibility of our emotions taking over.
For an interactive look at how cognitive biases affect trading psychology, have a look at this wonderful interactive from IG. This unique interactive guide unpacks the Psychology in Trading, with a specific focus on the factors influencing financial decisions, namely personality, emotions, moods, biases and social pressures.
Several surveys are referenced to support the research, which was further supplemented by feedback from the LR Thomas, author of the book “Trading Made Easy.” If anything, it’s fun site to play around with the inner workings of the human mind.
The Bottom Line
Forex trading is the most active and accessible market today. Its benefits outweigh the risks once you are aware of them and intentional in your decisions.
The Forex market is particularly desirable to beginners because it allows you to trade with small amounts, which can be more difficult in other markets.
Staying on top of current affairs, such as BREXIT and Trump’s impeachment, which may influence currency rates is a necessary, but don’t expect predictable results.
Be aware of regulations in various countries first and foremost and be sure to always research your brokers before making any decisions.