Forex trading 101: What you need to know and how to begin.
Forex refers to the foreign exchange market, which is where international currencies are traded against each other with profits and losses made on shifting exchange rates.
The forex market is known for being:
- Fast paced: Currencies are traded 24 hours a day, five days a week. When the market closes in one country, it opens in another – so prices are changing constantly.
- Extremely big: The forex market dwarfs the stock market in terms of the sheer value of trades being made. Figures change constantly, but the forex market typically sees trillions of dollars of trades being made every day.
- Decentralized: There is no actual forex marketplace that trades run through like there is with share trading. Instead, buyers and sellers make direct over-the-counter deals with each other.
- High liquidity: Liquidity refers to how easily an investment, in this case currency, can be bought and sold without its value being affected and how easily it may be exchanged for other assets. Currency is the asset with the highest liquidity.
How does forex trading work?
All forex trades involve simultaneously buying one type of currency and selling another. These are known as currency pairs. Think of each currency pair as a different individual product which is bought and sold. The first currency listed is known as the base currency, while the second is the quote currency.
Example: USD/AUD = 1.25
- The US dollar (USD) is the base currency and the Australian dollar (AUD) is the quote currency.
When you buy a currency pair, you are buying the base currency and implicitly selling the quote currency. The opposite applies when selling a currency pair, where you are selling the base currency and implicitly buying the quote currency.
Example: USD/AUD = 1.25
- If you buy this currency pair, you are buying USD at a rate of $1.25 AUD per USD.
- If the American dollar goes up in value relative to the Australian dollar between when you buy this currency pair and when you sell this currency pair, you will have made a net profit.
The bid is the buying price. It refers to how much of the quote currency you need to buy one of the base currency. The ask is the selling price and it refers to how much of the base currency you will need to sell to get one of the quote currency.
Example: USD/AUD = 1.25
- The bid would be 1.25 because you need $1.25 in AUD to buy one full US dollar.
- The ask would be .80 because you need to sell $0.80 in USD to get one Australian dollar.
Just because you’re in America doesn’t mean you have to trade American currencies – you might buy a currency pair of euros and Japanese yen (EUR/JPY = 114.41). The key to actually making money with forex trading is to have an understanding of how currency values are likely to change. If you aren’t following shifts in both the euro and the Japanese yen, then that particular trade may not be a good idea.
How do I make money off forex trading?
Remember, the actual asset you are buying and selling is currency pairs. Your profits depend entirely on how the value of those two currencies change relative to each other.
The margins on forex transactions can be quite small, for example, a smart trade might net you a profit of one cent on every dollar. This means that traditionally, you could only make real money on the forex market if you could afford to invest huge sums. However, now everyone can stand to make reasonable returns thanks to the widespread use of leverage, also known as buying on margin.
Buying on margin is a relatively safe way of financing your trading with the effect of magnifying your profits and losses. Buying on margin involves having a broker put up some of the money for an investment and you putting up the rest. This money combined lets you make bigger investments for potentially bigger profits, but poor investments mean the losses are bigger too.
Example: You have $2,500 to invest in a currency pair
You’re feeling good about the odds so you decide you want to use leverage to magnify your potential earnings and get another $2,500 from your broker. Now you can invest $5,000 in total.
- If your forex investment goes up in value and is now worth 10% more, a $2,500 investment (without leverage) would net you $250 profit. A $5,000 investment (with leverage) would get you a $500 profit.
- If the forex investment goes down in value then your losses are also magnified. If your margin account drops below a certain value then your broker may require you to put more funds into it or close it and extract the remaining funds to cover their losses.
Predicting currency movements
The key to making smart trades is to understand the market. With forex, that means understanding the international currency market and foreign exchange rates. It’s important to keep up with the news and keep an eye out for factors that may affect currency values, like strong economic growth, natural disasters or political strife.
Want to learn more about how to make smart trades? Read up on some strategies that may help.
How to get started?
To start forex trading, you’ll need a forex trading account. Through this you can access features like margin accounts, leverage and a wealth of research and market analysis tools. For practical purposes the only viable forex trading accounts for individuals are based online. This is because only electronic mediums can keep up with the pace of forex trading.
- Signing up for a forex account online usually takes about 5-10 minutes
- You will need to provide your name, date of birth, address, contact details, residence information and proof of identification
- Some providers may require you to provide different levels of personal financial information
How to choose a forex trading account?
There are a variety of trading account options available, each with different benefits. Compare them by asking the following questions:
- What are their brokerage fees?
- What types of trades can I do with them? Only forex or shares too?
- Do they offer helpful information and advice?
- How easily can I link my trading account with my bank account?
Glossary and FAQ
Do you keep running into terms you don’t know? Try keeping our glossary handy.
Do you have a specific question you still need answered? Look for it in the forex FAQ.