What is Forex Trading?

Updated on Mar 2, 2020 at 8:15 am UTC by Adedamola Bada · 7 min read
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Photo: Wikimedia Commons
Photo: Wikimedia Commons

Forex market is in effect the world’s biggest and most liquid asset market. This guide will educate you on the basics, pros, and cons about Forex trading as well as enlighten you on trading as a newbie.

The Forex market is often referred to as the most unpredictable, yet profitable one in the financial industry. The market requires adequate training, before delving into it. Without sufficient knowledge about how the market works, a trader might have a tough time achieving success. The problem usually encountered by many new traders is that they approach it with unrealistic expectations which usually end with setbacks and regrets.

What Is Forex Trading?

Before one can embark on a journey to another country, it is advisable to exchange your local currency with that of your intended destination. The process of carrying this task out is called Foreign Exchange (Forex).

Forex can also mean a marketplace where people speculate on currency changes and correlations with the goal of making significant profits. Paired currencies are the focus of every trade and each currency’s value is dependent on its pair.

For example, as a currency pair, the EUR/USD has been set against each other. This means that their market behavior will determine their profitability. When the price of the first currency (Euro in this case) surges, the price of the other (USD) will decrease and vice versa. So, the ability of traders to predict their price movements accurately will determine who profits or losses in the Forex market.

Essential Forex Terms

Leverage: leverage is simply help provided to a Forex trader in the form of capital by a broker in order for the trader to access high volume trades. For instance, the effect of leverage of 1:10 on a trader’s capital of $1,000 will translate to $10,000. With the bigger capital, the trader can trade a currency pair worth $10,000. The success of such trade will mean a profit multiplied by 10 and if it is unsuccessful, the loss is also multiplied by the leverage chosen. Therefore, proper care must be employed in the usage of leverage.

Pip: every currency pair has a base unit which is known as a pip. A pip is 0.0001 of the price quoted. So, using the EUR/USD pair as a case study, when its bid price goes from 1.16667 to 1.16677, it means a pip change of one.

Spread: this is what differentiates the bid price of a currency pair from its ask price. Most of the time, popular currency pairs have low spread and in some cases, it is even lower than a pip. On the other hand, pairs that don’t receive as much attention from traders tend to have a much higher spread. The profitability of a Forex trade is dependent on the ability of a currency pair’s value to cross the spread.

Margin: margin is used to refer to the money in the account of a trader. Often, the average Forex trader cannot trade a high volume due to insufficient margin, which is a requirement for such trades. Thereby, they lose the opportunity to make a good profit. But today, a lot of Forex brokers provide their clients with leverage to meet up with the right margin for high volume trades.

Which Pairs Can You Trade?

Forex currency pairs are classified under different names such as majors, minors, and exotics.

Those in the major category are mostly currencies that are frequently traded like: the US Dollar, British Pound, New Zealand Dollar, Swiss Franc, Canadian Dollar, Japanese Yen, Australian Dollar, Euro.

To be classified as a major currency pair, the criteria is for the currency to be paired against the US dollar. Minor pairs also have the above listed major currencies, the only difference from the major pairs is that the US dollar is not included. For example, EUR/CHF or EUR/GBP.

Exotic currencies include the following: the Thai Baht (THB), the Norwegian Krone (NOK), the Hong Kong Dollar (HKD) and the South African Rand (ZAR). Those classified as exotic pairs are made up of one exotic currency and one major currency.

The major currency pairs have become the only choice for most traders, especially beginners, because of their tight spreads and daily volatility. However, one should also give attention to exotic pairs because they promise numerous opportunities as well.

How to Select Trading Pairs?

The process of selecting trading pairs should not be started without adequate market analysis and information at the fingertips of the trader. The purpose of this precaution is to have an educated guess on the possible behavior of the currency pair within a specific period. A trader must know the conditions responsible for price changes, volatility and also the way a currency can be detrimental to another.

As a result of all this, some traders are avoiding major currency pairs and no longer consider them as the best option. In their replacement, they go for pairs that are familiar to them because they understand the factors that can influence them as well as have deeper knowledge about their value.

One important principle traders must adhere to is to never get involved with currency pairs with high spreads. Instead, they should go for those with 0 – 3 pips. This is because the more a trader goes high, the more risky and expensive it gets. The average trader may not afford the consequences of anything above six pips.

How Liquid Are Different Forex Pairs?

Some Forex pairs are more liquid than others. Those with a greater level of liquidity are more popular because everyone wants to trade with them. Their level of demand and supply is second to none on the Forex market.

This is because most stakeholders attach much more importance to such pairs when compared to others, thereby driving up their value. Pairs that make up this category are referred to as major currency pairs, like the EUR/USD currency pair.

Forex traders tend to gravitate more towards the major currency pairs than any other pair simply because they can be easily liquidated. Also, they abound in opportunities, especially in the aspect of short-term trading, a trait that is too irresistible for traders. Nonetheless, this doesn’t mean other currency pair categories are without use because they do. A lot of opportunities are inherent in exotic and minor currency pairs, which traders will find useful.

The only requirement with these other categories is a sound knowledge about various world currencies and economies if one must profit from them.

Pros of Forex Trading

In the aspect of liquidity, the Forex market is second to none as its daily trading volume is ranked largest in the globe. Consequentially, Forex traders can easily enter a position in any of the available major currencies and exit it all within seconds for a small spread without being fazed by most market constraints and conditions.

The Forex market is always busy and is operational 24 hours every day, five days a week. Every day, trading begins in Australia and closes in New York. Across the world, the major centers for Forex trading are in New York, Frankfurt, Sydney, London, Singapore, Hong Kong, Paris, and Tokyo.

Cons of Forex Trading

A lot of traders have become impoverished by ill-advised usage of leverage. Traders are provided with leverage by brokers, dealers, and banks to enter large positions with their little capital. The use of leverage comes with a lot of risks and it is important that a trader is aware of them before utilizing leverage.

Currency trading cannot be done without some basic tools like indicators and an understanding of basic economic principles. For a trader to be able to tell currency movements and what drives the values of currencies, he needs to have a good knowledge of the economies of different countries and how they affect each other.

Conclusion

Forex is a profitable business for those who are willing to let go of the wrong perception of the market and are ready to put in the required work. Both the traders with little funds and those with lots of it have good opportunities to make money in the Forex market but they must understand what works best for the resources they have.

Traders with little capital are advised to adopt day trading in little amounts, while those with more capital can go for long-term fundamentals-based trading. New Forex traders should invest in the knowledge of macroeconomic fundamentals which influences currency values as well as in technical analysis in order to make the most of the Forex market.

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