The foreign exchange market, also known as forex or FX, is the most liquid market in the world. Daily trading volume is estimated at $6 trillion, which makes it easy to enter and exit your trades whenever you want. This gives you ample opportunity to earn money — or lose it if you’re not careful.
But first, you have to know the terminology, how the market works and how to take advantage of it.
6 things to know about forex trading
- The foreign exchange markets are open 24 hours, five days a week.
- Each currency has a code: EUR (Euro), USD (US dollar), British pound (GBP), etc.
- Currencies are always traded in pairs, such as EUR/USD or GBP/USD.
- Forex trades are executed over the counter, via brokers, market makers, banks and financial institutions.
- Forex brokers offer high leverage that can let you trade $50,000 worth of currencies with a $1,000 account.
- Most retail traders use forex to speculate on the exchange rate, while large multinational companies use it to hedge against currency risk.
What we refer to as forex trading is speculation on currency moves — whether the US dollar or another currency goes up or down in value, often in a short time period — minutes, hours, days and rarely weeks. This speculation is done on the spot market, meaning two parties agree on the spot to exchange currencies. Similar to stock trading, you can earn money going long or short on a currency.
There are other ways to trade currencies, which includes the futures market and options contracts. Currency futures are mostly used by companies and large multinational conglomerates who do business with other countries. This is a way to hedge their business transactions and protect their revenue from currency fluctuations.
Forex trading is similar to stock trading: Open an account with a broker, fund it and start trading. You can have long and short positions and earn money whether the currency rises in value or falls. But there are a few ways in which forex and stock trading differ.
Currencies are traded in pairs
In forex, you’ll see currency pairs such as EUR/USD, GBP/USD and EUR/AUD. The first currency is called base currency and the second is called quote currency. The base currency always has a value of 1.
When you see that EUR/USD exchange rate is 1.1801 it means you have to pay 1.1801 of the quote currency (US dollars) to buy 1 of the base currency (Euro). The opposite is also true — you get 1.1801 USD when you sell 1 EUR.
Long and short positions
Being long or short is similar to trading stocks. The difference here is that to short one currency, you have to have a long position in another. For example, if you believe the Euro will appreciate in value against the US dollar, you buy the EUR/USD pair — meaning you are long EUR and short USD. If you think the US dollar will rise against the Euro, you sell the EUR/USD pair — or go short EUR and long USD.
- Example 1: EUR/USD exchange rate today is 1.1801. Tomorrow it drops to 1.1701. If you had a short EUR/USD position, you would earn money. If you had a long position, you would lose money.
- Example 2: EUR/USD exchange rate today is 1.1801. Tomorrow it rises to 1.1901. If you had a short EUR/USD position, you would lose money. If you had a long position you would earn money.
Pips are important
One pip is the measurement of change in the exchange rate between two currencies. For most pairs, a pip is the fourth decimal point in the exchange rate.
For example, if the EUR/USD exchange rate moves from 1.1801 to 1.1800 or to 1.1802 — we say it moved by 1 pip. This is what you have to watch when you trade forex because the difference in pips is what will earn you money or lose it.
Note: Most brokers today offer trading up to five decimal points. This means you’ll see an exchange rate in the form of 1.18011.
Forex is traded in lots
When you buy stocks, you enter the number of shares or sometimes the amount of money you are willing to spend. When you open a position in forex — whether it be long or short — you specify your lot size. One full lot equals 100,000 units of currency.
For example, if you go long on one full lot of USD, you buy $100,000. With full lot trades, one pip represents $10. So if the exchange rate of EUR/USD moves 1 cent, with a full lot that would be a move worth $1,000.
Here’s how that would look:
- You have a $2,000 account.
- EUR/USD trades at 1.1801.
- You buy 1 lot of EUR/USD, meaning you go long EUR and short USD.
- The exchange rate moves 100 pips higher or 1.1901.
- You close your position.
- Each pip is worth $10, meaning 100 pips are worth $1,000.
- Your balance is now $3,000.
Note: There are mini, micro and nano lots for smaller accounts or for those who are risk-averse. Mini lots are popular with retail traders, and they are traded in the form of 0.1 lots. In this case, each pip is worth $1.
Trade 50,000 currency units with a $1,000 account
The most common feature in forex is leverage, using more money than you have in your account. This is money borrowed from your broker.
In the US, the maximum leverage you can typically get is 50:1. This means you can buy 0.5 lots — or 50,000 currency units — with a $1,000 account.
You often don’t have to pay anything to the broker for using their money. Instead, the broker locks some of your funds — say $200 — and if the exchange rate goes against your position, the broker will initiate a margin call. This will close your position and you lose your locked funds, but the broker won’t lose any money in the process.
Fun fact: In unregulated markets, you can get up to 400:1 leverage, meaning you can trade 400,000 units of currency with $1,000.
Forex trading involves speculating on currency exchange rates. This gives you a variety of trading strategies. Here are the three that work best for beginners:
- Trend trading. This is the simplest of all strategies. All you need to do is identify a trend by connecting two or more lows in an uptrend or two or more highs in a downtrend. Every time the price touches the trendline, you enter your position. Every time it extends beyond the trendline, you close your position.
- Range trading. Aside from going up or down, currency pairs can move sideways. This is known as ranging. Connect the lowest lows and the highest highs and enter and close your positions every time the exchange rate moves closer to the lines.
- Scalping. Scalping is a strategy in which you open and close your positions within a short period of time, often within minutes. Combine this with trend trading and range trading, but you’ll need to find the right currency pairs and the right time of the day for this strategy to work.
Forex trading can be fun and profitable, but it comes with its downsides.
- Using high leverage can easily wipe out your account. If you use the maximum leverage and you lose two or three trades in a row, you can lose all of your money.
- You can lose more money than you deposit. Some brokers have a protection of up to $50,000, meaning if your account goes negative, you won’t be liable up to $50,000.
- Your broker often trades against you. This is known as a dealing desk broker where the broker doesn’t route your orders to the market. Instead, the broker takes the opposite side of your trade. To avoid this, look for no dealing desk (NDD) brokers or Electronic Communications Network (ECN) brokers that provide direct market access.
The forex market is mostly reserved for active and day traders who want to speculate on currency moves in a short period of time, while the stock market is often used by long-term investors and traders. There are pros and cons to consider before deciding which of the two suits you best.
- Can use 50:1 leverage
- No cost to borrow broker money
- Markets are open 24/5
- The most liquid market in the world
- Lower risk
- You invest in companies
- Can’t lose more money than you deposit
- Can lose more money than you deposit
- High risk due to high leverage
- Brokers may sometimes work against you
- Trade only during the stock exchange working hours
- Lower risk often means lower reward
- A company you invest in can go bankrupt
Even though currencies have existed for more than 2,000 years, the foreign exchange we now know was made possible after 1971 with the collapse of the Bretton Woods system. The Bretton Woods system was designed to keep the global currencies stable by pegging the US dollar to gold at $38 per ounce.
The collapse of the Bretton Woods system allowed currencies to become free-floating. During this time some traders realized they could make money speculating in currency moves.
Thanks to the Internet, forex trading grew in the 1990s as technology allowed individual traders to buy and sell currencies from their home. Today, with more than $6 trillion dollars exchanging hands daily, the forex market is the most liquid market in the world.
To be successful in trading forex, find the right broker. This means looking into brokers that offer ECN or no dealing desk (NDD) accounts, and they must have low spreads.