In our first course, you will be introduced to the world of Forex trading. You will learn what Forex trading is all about, why someone chooses to trade Forex, and what actually happens when you make a Forex trade.
We will take you from a simple explanation of how Forex works to the selection of the various currency pairs that make up Forex trades. We will discuss how currencies are listed in the Forex markets. What is the base currency and what is the quote currency? How do global Forex markets interact?
We will also review the many reasons why someone might trade Forex rather than a different investment vehicle, and detail both the advantages and disadvantages of this type of trade.
This course will provide the background needed to understand our more advanced courses in Forex trading.
1.1 What is Forex Trading?
We begin with an introduction to Forex trading and the world of the global Forex market. It is important to try to understand the basics from the beginning so the aspiring trader can answer the question "What is Forex?" beyond simple currency exchange.
In this introductory lesson, we will bring you into the world of Forex trading, the foreign exchange markets, and what trading Forex is really all about.
Additional Reading about What is Forex Trading
An introduction to Forex trading must contain a bit of history.
The creation of the gold standard monetary system in 1875 was extremely significant in the history of the Forex currency market. Countries attached an amount of their currency to be equal to an ounce of gold; the changing price of gold between two currencies became the first standardized means of currency exchange in history.
The gold standard broke down in World War I because the major European powers did not have enough gold to exchange for all the currency that the governments were printing off at the time in order to complete large military projects. The gold standard began anew between the wars, but it was dropped again by the start of WWII. Gold never lost its spot as the ultimate form of monetary value.
1944 saw the implementation of the Bretton Woods System which led to the formation of fixed exchange rates resulting in the U.S. dollar replacing the gold standard as the reserve currency. Thus, the U.S. dollar became the only currency that would be backed by gold. 1971 marked the end of this system when the U.S. declared that it would no longer exchange gold for U.S. dollars that were held in foreign reserves. This led to the almost global acceptance of floating foreign exchange rates in 1976 effectively producing the current foreign currency exchange. It became electronically traded only in the mid-1990s.
What is Forex Trading - Text Version
Introduction to Forex Trading
This introduction to Forex trading is the first lesson in our FXAcademy tutorial. Throughout our online courses, we will be teaching all about Forex trading, which has become a very popular money-making vehicle.
Since Forex trading has become so popular and there are Forex brokers advertising their services all over the web, traders should understand as much as they can about Forex trading before choosing a Forex broker. The term “Forex” is short for the foreign exchange market, which is the “place” where different currencies are exchanged in a continuous fashion by millions of people all over the world.
It isn’t difficult to conceptualize about Forex trading. Tourists who travel from one country to another must exchange currencies in order to pay for a local product or service. A wad of Euros would be totally useless to an Italian tourist wishing to visit the Sphinx in Egypt because it is not the locally accepted currency. The tourist would have to exchange his Euros for the local currency, Egyptian pounds, at the existing exchange rate that day.
Even without knowing much about Forex trading, residents of one country exchange currencies with another country each time they purchase a foreign product. For example, someone living in the U.S. who wants to buy a nice bottle of French wine may pay for it in dollars but the wine has already been paid for in Euros. Somewhere along the line, either the wine producer or the American importer had to have exchanged the equivalent value of U.S. dollars (USD) into Euros. This is all about Forex trading.
Unlike the New York Stock Exchange or other stock markets, there is no central marketplace for foreign exchange. Rather, currency trading is conducted electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week.
Another thing about Forex trading: The need to exchange currencies is the primary reason why the Forex market is the largest, most liquid financial market in the world. It outperforms other markets including the stock market, with an average traded value of around the U.S. $2,000 billion per day. Being aware of the magnitude of Forex trading should be enough of an introduction to Forex trading to motivate the eager investor to plunk down his money and start to trade.
Traders can make a lot of money by trading on the Forex market. The more a trader knows about Forex trading, the more successful he will be. It’s really a very simple concept. In our next lesson at FX Academy, you will learn more about Forex trading and what exactly is traded on the Forex markets. Stay tuned.
1.2 Why Trade Forex?
So why trade Forex? There are many reasons to trade Forex and this lesson will discuss several of them, each of which might induce a novice trader to take the plunge into Forex trading.
When you have finished the lesson, you will understand the opportunities available in the Forex markets.
Additional Reading About Why Trade Forex
So why trade Forex? Ask three different people and you will get more than three different answers. Right off the bat, making money is the most frequently cited reason for why Forex. And this is a perfectly legitimate motivation: we all live in a world where money, even if it can’t buy everything, can certainly make life a lot more enjoyable.
There are some people who trade in the Forex market because they see it as a form of gambling and betting on the winning number. It really can be a lot of fun, especially if you win. And there are others who trade Forex just for the personal satisfaction of making a trading system work for them and coming out with the results they aimed for. We are always satisfied when we make the right choice and come home the winner.
So Why Forex?
Traders experience a lot of excitement when placing a trade of any kind. Forex trading, however, has many features other investment vehicles don’t have. Included in these are the very convenient trading hours. Since most Forex trades are placed online and many Forex brokers are located across the globe, trading hours are longer than those of NASDAQ or the New York Stock Exchange. This presents opportunities for investors to do their trading all through the nighttime hours.
Another major feature of Forex trading is its diversification. Just as every competent investor needs to diversify his investments by asset classes and sectors, so too he needs exposure to assets in multiple currencies that’s why Forex trading has become so popular.
The lesson’s video outlines some reasons to trade Forex:
Some currencies are positively correlated with certain commodities and stock markets, and so can be used to hedge positions, or as a proxy where the Forex instrument is cheaper to trade
High Risk-Adjusted Returns
Suitable for both short and long-term traders
Leverage is freely available
True short-selling does not exist in Forex, so no trading restrictions ever come into operation, unlike in stock markets
There are some equally good additional reasons worth considering:
It is easy to open a Forex trading account, even with deposits as small as a few hundred U.S. dollars
There are a large number of Forex brokers to choose from
Trading commissions are relatively small
Forex is widely believed to be relatively easy to analyze technically, making it popular with traders who wish to trade their beliefs about mathematical patterns and probabilities
Successful traders are able to make excellent returns for relatively little day-to-day effort, provided they are comfortable taking a risk and are well prepared. This is the major attraction of all types of trading
Why Trade Forex?
With the recent popularity of Forex trading, many investors wonder why Forex is the way to go. Here are a few reasons which answer this question.
Why Forex? One of the reasons why people trade Forex is diversification. Just as every competent investor needs to diversify by asset classes and sectors, so too they need exposure to assets in multiple currencies and an understanding of Forex trends and what drives them.
Why Forex? Certain currencies tend to move with certain commodity prices. Having commodities exposure is a means of hedging this currency risk and playing Forex trends, so both Forex brokers and traders typically also deal with commodities. Thus while they are different asset classes, in practice Forex tends to include commodity trading and investing.
Why Forex? Forex has higher risk-adjusted returns. Forex is among the most rewarding asset classes for traders and investors. Although Forex has a reputation of being for short-term, high-risk speculators, there are trading styles suitable for both short term and long term traders:
More conservative active traders use longer-term holding periods and specific methods and instruments to reduce risk.
Long-term investors know how to:
Ride stable, proven, long-term Forex trends for capital gains.
Earn steady income from different kinds of currency trades or from investing in bonds, dividend stocks, and other income vehicles.
For those willing and able to handle more risk, and understand why Forex has become so easily implemented, the availability of leverage, or borrowed funds to control large blocks of currencies allows greater gains and losses. Using leverage creates unmatched profit potential for those with limited trading capital only if they learn how to control the downside risk. For example, with 100:1 leverage, a 1 percent move means 100 percent profit. It also means a 100 percent loss. If not for this ability, why trade Forex?
If you know how to manage the risk of high leverage, you can grow your principal with leverage far faster than in other markets. And that is why Forex has taken center stage to all other investment vehicles.
Why Forex? A Forex trader can profit just as easily in a falling market as in a rising one.
During times when markets are in strong downtrends and the easiest profits and least risky trades come by betting that stocks or commodities will go down in price, regulators will impose restrictions that make betting on downtrends harder or impossible. Stock markets will see uptick rules or outright bans on short selling. Commodity markets will raise margin requirements so that such trades are more expensive and less profitable.
That can’t happen in Forex markets. In every single trade, we’re buying one currency and selling another, so it’s impossible to ban selling (or buying) of certain currencies without shutting down the entire Forex market. We’ll explain this in greater depth later. For now, just know that in Forex it doesn’t matter if markets are rising or falling. There are always ways to profit regardless of the trend.
If you’re heavily exposed to a certain kind of asset, you can hedge that position with a currency trade designed to move in the opposite direction.
1.3 More Reasons to Trade Forex
So, why trade Forex? Once the reasons become clear, many are eager to jump on the bandwagon. Why trade Forex? To make money, of course, would have to be one of the main reasons!
In this lesson, we will show the difference between trading Forex and other exchange-based markets, and why trading Forex through a broker can be very profitable.
Additional Reading about More Reasons to Trade Forex
There is one more reason why Forex is so popular of late: it has low start-up requirements and relatively inexpensive account costs.
Trading starts with as little as a few hundred dollars, sometimes less.
Forex brokers typically provide free full-featured trading platforms and data feeds, and the better brokers offer extensive archives of free training materials and market analysis. With online stock brokers, traders typically need to maintain significant minimum balances or minimum average monthly trading volumes to get similar service.
Brokers typically provide full-featured practice or demo accounts that allow smart beginners to simulate most of the trading experience and practice with play money until they feel ready to risk their capital.
Most Forex brokers charge no fees, commissions, or hidden charges. They earn their money on the difference, called the spread, between the buy and sell price, typically a few ten-thousandths, called pips, of the price. Depending on the lot sizes traded, a typical two-pip spread to open and close a position can cost anywhere from $0.20 to $20. In general transaction costs are very competitive compared to those of online stock brokers.
More Reasons to Trade Forex
Why Trade Forex?
We are continuing to outline why people choose to trade Forex.
Why trade Forex? Forex expertise makes you a better trader and investor.
Forex markets often reflect changes in sentiment before other markets, and so offer profitable clues of where other markets are going.
Another reason why we trade Forex is flexible hours.
Forex markets trade in a seamless 24-hour session, 5.5 days a week, from Sunday 5:15 P.M. EST until Friday 5:00 P.M. EST.
We trade Forex markets because they offer the best liquidity.
A liquid market is one that has many buyers and sellers. The more buyers and sellers at any given moment, the more likely you are to get a fair market price when you buy or sell. The more liquid a market is, the less likely it is that a few big players can manipulate prices to their advantage. Indeed, unlike in stock markets, even the biggest players will have trouble manipulating the price action in major currency pairs beyond a matter of hours.
We trade Forex because there is no centralized exchange with specialists holding monopoly power to regulate prices.
In most stock markets, the specialist is a single entity that serves as a buyer and seller of last resort and controls the spread, which is the difference between the buy and sells price for a given stock. Though in theory they are regulated and supervised to prevent their abusing that power to manipulate prices at the expense of the trading public, specialists are experts at knowing when they can get away with a degree of this and force you to buy higher or sell lower.
With Forex trading, no single specialist regulates the prices of individual currency pairs. Rather, multiple exchanges and brokers are competing for your business.
Another reason for trading Forex is that there is high liquidity and decentralized markets which means less slippage.
Slippage is the difference between the stated price on your screen and the actual price you pay or receive. The less liquid the market, the more often slippage happens because fewer traders are present to take the other side of your trade.
Forex markets are less prone to slippage because they are:
Usually Highly Liquid--typically running at full speed in at least one if not two continents 24 hours a day, over five days a week and trading at such larger volumes than equities,
They have no specialists influencing prices.
Indeed, many Forex market makers provide some kind of “no slippage” policy that lessens the degree of price uncertainty.
1.4 Trading Currency Pairs
What actually takes place when you trade Forex? What does it mean when we talk about "currency pairs"?
The concept of Forex trading can be a little tricky to grasp. Trading stock involves the buying and selling of a piece of a company while Forex trading involves buying a portion of a country’s currency. The price of one currency in a currency pair is measured against another currency. It’s like going to the bank and exchanging a dollar for a euro. You are selling your dollar and buying a euro or a part of a euro.
The Euro/US Dollar is a currency pair.
This lesson will go into more detail regarding the currency pairs list.
Additional Reading about Trading Currency Pairs
There are many official currency pairs used all over the world, but only a handful are traded actively in the Forex market. In Forex trading, only the most economically or politically stable and liquid currencies are demanded in sufficient quantities. The American dollar is the world's most actively traded currency because of its strength and size.
The eight most traded currency pairs today are the U.S. dollar (USD), the Canadian dollar (CAD), the Euro (EUR), the British pound (GBP), the Swiss franc (CHF), the New Zealand dollar (NZD), the Australian dollar (AUD) and the Japanese yen (JPY).
Mathematically, there are 27 different currency pairs that can be derived from those eight currencies alone. However, there are about 18 currency pairs that are conventionally quoted by Forex market makers as a result of their overall liquidity. The total amount of currency trading involving these 18 pairs represents the majority of the trading volume in the FX market.
More Reasons to Trade Forex
What actually takes place when you are trading currency pairs on the Forex market?
Just like trading stock involves the buying and selling of a piece of a company, Forex trading involves buying a portion of a country’s currency. The price of the currency is a direct reflection of what the market thinks about the current and future health of the economy of that particular country compared to other countries' economies.
By buying a British pound, for example, you are really buying a share in England’s economy. When the price of the pound changes in relation to another currency and you have correctly predicted the direction, you have made a profit. If you buy a soccer ball in London and pay 10 GBP (British Pounds), using a conversion of $1.00 to 2.5 GBP, you have now paid $4.00 for the soccer ball. If you take it home to Chicago and want to sell it to your neighborhood soccer club and the conversion rate has now changed to $1.00 = 3.00 BP, your ball has lost .50 GBP’s per dollar and the $4.00 you thought you spent on the ball is now really only $3.33. Your soccer ball has lost value and if you want to make a profit on your sale, you need to pump up the asking price.
The symbols used with currency pairs are always listed as three letters, where the first two letters identify the name of the country and the third letter identifies the name of that country's currency. USD stands for United States dollars. NZD stands for the New Zealand dollar.
Currency Pairs List
The major currencies in the currency pair lists are EUR/USD, USD/JPY, GBP/USD, USD/CHF which involve the euro, US dollar, Japanese yen, pound sterling, Australian dollar, Canadian dollar, and the Swiss franc. Those currency pairs that are not paired vs. the U.S. dollar are called “crosses.” Some examples of crosses are:
AUD/NZD – Aussie dollar vs. the New Zealand dollar
EUR/AUD – Euro vs. the Australian dollar
EUR/CAD – Euro vs. the Canadian dollar
GBP/JPY – British pound vs. the Japanese yen
In addition, there are the following two: XAU/USD – Gold
XAG/USD – Silver because gold and silver are actual commodities and can also be considered “commodity currencies.”
These currency pairs are considered by many to drive the global forex market and are the most heavily traded. Some traders also think that the USD/CAD and USD/AUD pairs should also be regarded as major currency pairs. These two pairs can be found in the group of pairs known as the "commodity pairs".
The first currency of a currency pair is referred to as the "base currency" and the second currency is called the "quote currency". The currency pair shows how much of the quote currency is needed to purchase one unit of the base currency.
All Forex trades involve the simultaneous buying of one currency and selling of another, but the currency pair itself can be thought of as a single unit, an instrument that is bought or sold. If you buy a currency pair, you buy the base currency and sell the quote currency. The bid (buy price) represents how much of the quote currency is needed for you to get one unit of the base currency. Conversely, when you sell the currency pair, you sell the base currency and receive the quote currency. The ask (sell price) for the currency pair represents how much you will get in the quote currency for selling one unit of the base currency.
Here’s an example: A USD/EUR currency pair is quoted as USD/EUR = 1.5 and you purchase the pair, this means that for every 1.5 Euros that you sell, you purchase (receive) US$1. If you sold the currency pair, you would receive 1.5 Euros for every US$1 you sell. The inverse of the currency quote is EUR/USD, and the corresponding price would be EUR/USD = 0.667, meaning that US$0.667 would buy 1 euro.
1.5 Market Price Basics
What actually causes the market price of anything to move?
The answer is the interaction of supply and demand.
How do supply and demand affect prices?
In this lesson, we will show how the supply and demand for the two currencies that make up a currency pair move its market price from moment to moment.
Market Price Basics
In earlier lessons, we have shown how Forex traders want to make money by buying before the price goes up and selling before the price goes down. Now we are going to talk about how and why the market prices of currencies move.
How do Supply and Demand Work?
Supply and Demand Theory
The market price of anything bought and sold in a free market like Forex moves for one reason only: changes in supply and demand. There is no other reason why the market price moves. For example, suppose the exchange rate of the Euro against the US Dollar is at 1.3375. This means it costs 1.3375 US Dollars to buy one Euro. Let's say a bank puts order into the market to buy 500 million Euros right away at the best market price it can get. That's a big order, and it significantly increases the supply of US Dollars and the demand for Euros in the market. If nothing else changes, the price of the EURUSD will now definitely rise above 1.3375. This is because the Bank's buy order will consume all the selling orders at 1.3375, then at 1.3376, and so on, until the order is fully filled and the Bank gets all of the 500 million Euros it asked for.
You see, no trade can be made unless there is someone to take the other side. There needs to be someone else willing to trade their Euros for US Dollars in order for the Bank to get its Euros. That's why it’s called “trading”, even though we use words like “buy” and “sell”.
Supply and Demand Analysis
As you can see, a Bank that needs to buy a large order like 500 million Euros would be foolish to try to get it all at once at the market price, because it would almost certainly get it at an average price higher than the current market price. The Bank would be putting the price upon itself. Instead, the Bank would probably decide on certain market price levels where it expects US Dollars will be in demand and lots of Euros will be available at what the Bank considers to be relative bargain prices. That way, the Bank can quietly buy some Euros every time the market price gets to these levels, eventually accumulating all its 500 million Euros at a lower average price.
Stop and Limit Orders
So far, we talked only about market orders. Market orders are orders that tell your broker or exchange to make a trade immediately, at whatever price they can get for it. There are two other kinds of pending orders, both conditional upon price reaching a certain level, which you should know about: stop orders and limit orders.
Stop orders are orders you tell your broker to execute at a certain price that is worse than the current price. These orders are often used to enter breakout trades, which we will talk about later.
Limit orders are orders you tell your broker to execute at a certain price that is better than the current price.
Stop orders should not be confused with stop losses. A stop-loss can be either a stop or limit order telling your broker to get you out at a certain price if your trade becomes a losing trade. This is an important way for traders to limit risk. You should know that large limit and stop orders, as well as market orders, can move the market price if they are visible to market participants. This is because they affect market participants’ perceptions of supply and demand.
In this lesson, we've talked about how and why the market prices of currencies move. The most important thing for you to remember is that only one thing moves the market: supply and demand from buyers and sellers. Traders profit by buying where there is demand and selling where there is supply.
1.6 Choosing an Online Broker
With hundreds or even thousands of online Forex brokers to choose from, the abundance of choice can be bewildering. How to know which one of these brokers is right for you when you are ready to choose an online broker?
In this lesson, we will explain a little about how online Forex brokerages work, and outline the important questions you should ask in determining which one to open an account with when you are finally ready to take that step.
Choosing an Online Broker
In the previous lesson, we showed how the supply of and demand for currencies changes price. Now we are going to talk about how Forex traders actually make trades.
The Mechanics of Online Trading
Unlike stocks and shares, there is no central Forex market. For example, if you buy or sell the stock of a company that is listed on the New York Stock Exchange, you have to do it through the exchange itself. Everyone gets the same prices. Forex is different. You can exchange currencies anywhere, and it is the biggest market in the world. Most of the currency traded comes from four large banks that do not deal with retail clients like us. Instead, retail traders with accounts from a few hundred to thousands of dollars trade Forex through Forex brokers. Forex brokers are companies which provide an opportunity for us to trade Forex over the internet in small sizes. There are some banks that also offer Forex brokerage services to larger retail clients. How to choose a broker, then? We’ll talk about the different types of brokers later on, but what’s most important are the things you should consider when you are deciding where to open your Forex trading account.
How to Choose a Broker
The security of your money is the most important concern. You should be able to withdraw your money whenever you want to. Find out if you are protected by some kind of deposit insurance, and check the reputation of any broker with your country’s financial regulators. Avoid any brokers that look financially unhealthy, or have bad reputations about paying their clients.
Next, you should think about any legal or tax issues that might affect you. For example, residents of the U.S.A. are subject to tough regulations governing foreign brokerage accounts. Tax residents of the U.K. can enjoy freedom from U.K. taxes on any winnings if they use spread betting companies instead of traditional brokerages. Obviously, you don’t want to get into any trouble, or pay any unnecessary taxes. Once you’ve found out which brokers you can safely trade with, you are ready to compare what is on offer. Areas that you should consider include:
Reliability and speed of trade execution. It’s important that you can enter and exit trades as soon as you want. You don’t want to see a broker’s server go down just when you want to make a market order!
Commissions / Spreads. Spreads – the difference between a currency’s buying and selling prices - should be competitive, and if you trade very often or in large quantities, it might make more sense to pay fixed commissions instead of spreads. Spreads effectively are a commission your broker charges you on every trade you make.
A range of currency pairs offered. Some brokers offer you the chance to trade more currency pairs. This might not be so important to a new trader, who could be sticking to the major pairs, which usually have cheaper spreads or commissions.
Quality of customer service. If you have a technical problem or there is something you don’t understand, you need to be sure you’ll get help fast.
Platform. Many brokers offer their own customized trading platform, either browser-based or downloadable software. Many brokers offer the Metatrader 4 or 5 platforms, which we will talk about in a later lesson. You need a platform that runs smoothly and is comfortable to use, because if you make a mistake trading, it might cost you money.
Type of trading. Some brokers will not work with clients who make lots of fast, short trades over very small fluctuations in price. This kind of trading is called “scalping”.
In this lesson, we’ve talked about how Forex traders actually make trades, and the questions you should be asking in choosing a forex broker, to find a secure Forex broker who meets your needs.
Additional Reading about Choosing an Online Broker
Be aware that most retail Forex brokers do not actually buy and sell any currency in the market.
They simply allow their clients to bet on the movement of the prices they are quoting.
You don’t have to worry about this too much, because if their prices aren’t almost the same as whatever the major banks are quoting interbank, they will be put out of business by smart traders exploiting the difference. This fact alone should usually ensure that prices are honest. The fact remains that the broker’s quoted prices are created by the broker.
You should be aware that these brokers lose money when their clients win trades, and make money when their brokers lose trades.
There follows another implication from this that is worth considering. If a broker does not cover their client’s trades to some extent in the real market, then they will go bankrupt if enough of their clients win consistently and ask for withdrawals of their funds. Some brokers mirror the trades of their clients with winning records in the real market to protect themselves against such a thing happening.
It can be said that most of today’s retail Forex brokers are similar to the “bucket shops” that were prevalent in the late 19th / early 20th-century U.S.A.
Having said that, this does not mean these brokers are necessarily dishonest, because they can make money from the spreads and/or commissions they charge, as well as from the sad fact that most retail traders lose money over time.
However, dishonest brokers might succumb to a strong temptation to create a very fast temporary price spike into levels where many of their clients will have placed stop losses on their open trades. Sometimes the true market acts in this way in any case, but if you see a spike like this on your broker’s price feed that is not reflected in the wider market, you should move your account somewhere else, but ask first for a refund on any losing trade that was caused by the spike.
You should also be suspicious of brokers who widen their spreads way beyond the rest of the market, or who won’t accept your trades through their platform when the market is running strongly in your favor. Once this happens two or three times in succession, you should consider moving your account elsewhere.
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