Forex Trading: A Guide For Beginners

What is forex trading? Glad you asked. If we were to define forex trading (aka foreign exchange or FX trading) at a high level, it essentially describes the trading of foreign currencies among one another.

By way of example, United States dollars can be actively swapped for Canadian dollars, Euros or British pounds. It’s often a common and necessary process that individuals must engage in (allowing an overseas tourist who’s visiting Spain, for example, to purchase local goods and services). However, clever investors – who actively engage in forex trading as a means to earn income – can also capitalize on changes in interest rate differentials between two currencies or changes in these currencies’ exchange rates to turn a tidy profit.

Here, we take a closer look at the practice of FX trading and how it works, as well as what you need to know if you’d like to explore the possibility of investing. Think of the following market overview as your guide to forex trading for beginners.

What Is Forex?

Foreign exchange transactions occur via the foreign exchange market (forex market), the largest and most liquid market in the world, via which over $6.6 trillion is traded every day. By way of comparison, roughly $5.1 trillion is traded on the New York Stock Exchange (NYSE).

Unlike exchanges such as Tokyo Stock Exchange or London Stock Exchange, there is no centralized location around which foreign exchange trading operates. Instead, the forex trading market revolves around an electronically linked network of banks, financial institutions, brokers and everyday traders.

In other words, forex trading involves tapping into a decentralized global market that facilities the buying, selling and trading of foreign currencies. Traders profit by making bets that the exchange rate of one currency will rise or fall relative to another currency (or that interest rate differential opportunities will present themselves), either in immediate or near future via futures contracts. It’s a classic example of “buy low, sell high” mechanics in action.

Of course, as much as you can research and study the space, you never can quite predict with 100% certainty just what the forex market will do, which also introduces elements of risk and volatility into the equation.

Basic Terms To Know

As you go about thinking about how to get started with forex trading, it’s important to keep several basic terms in mind.

• Ask: The rate at which a dealer is willing to sell a foreign currency.
• Bid: What a forex dealer is willing to pay for a foreign currency.
• Margin: A portion of your trading account balance that is put aside in order to trade (not a cost or fee).
• Leverage: Borrowing a sum of money as you go about investing in forex assets.
• Pip: Short for percentage in point or price interest point and represents a tiny measure of the change in a currency pair.
• Spread: Difference between a forex broker’s buy and sell rate for currency exchanges and trades.

Who Trades On Forex And Why?

Different types of traders (everyday or armchair investors) and businesses (banks, brokers, etc.) trade on the forex market. Sometimes these forex traders do so because they like the odds associated with potential risks and rewards. Others might do so because they see potentially larger upsides to be gained from forex trading than trading in stocks, bonds and other assets. Still more may also elect to turn to forex trading as a hedge against even greater volatility in other markets or investment asset classes.

In all cases, forex traders engage in foreign exchange and international currency trading as a means through which to turn a profit while also staying relatively liquid. For example, unlike selling a piece of real estate or equipment, which can take significant time to offload, currencies can be sold and swapped relatively quickly.

Likewise, while values and interest rates on foreign currencies may regularly rise and fall, there’s always a general appetite for them, as these currencies can be spent or traded without a large degree of difficulty. It’s also comparatively easier to turn a unit of foreign currency into a unit of domestic currency with which to pay for goods and services.

A mix of individual investors and financial institutions use the forex market as a way to generate profits, safeguard against economic uncertainty, and adapt to volatility in other investment areas. Prior to the advent of armchair forex trading technology, only banks and similar financial organizations had access to the market.

Institutional Investors And Banks

Forex trading and FX markets were historically the domain of commercial and investment banks that traded currency among each other and collectively set prices via supply and demand. 

Large Corporations

Large multinational corporations have also often used forex historically to convert currencies to more favorable mediums and pay their bills internationally.

For example: Currency conversion may enable a business that’s based in the United States to more readily import goods from European Union member states, and under more favorable terms and conditions. Likewise, it’s not uncommon for companies to convert U.S. dollars to euros and vice versa if it increases their purchasing power. 

Individual Investors

The advent of widespread forex trading technology has additionally made the foreign currency exchange markets available to individual investors. If you wish to engage in forex trading, you can open a forex account through a variety of online brokerages.

What Is The Forex Market?

Different international currencies with different valuations which are routinely changing float against each other all the time. These pricing differentials give investors who are able to buy low and sell high ample opportunity to profit.

Spot Market

A spot market transaction is an all-cash transaction. It may help to think of it this way: In a spot market transaction, an investor who deposits $1,000 will receive $1,000 worth of the foreign currency of their choosing. Although the U.S. dollar is part of 88% of forex pairs, and the most popular global currency overall, investors can use whatever pairings they like. By way of illustration, investors can make money from buying and selling for currency price differences or buying and selling for interest rate differentials when converting between euros and yen.

Futures And Forward Trading

Currency rates can also be used as the basis of futures contracts. Futures contracts allow you to bet for or against potential rises and drops in currency rates that may occur at a later date – presenting opportunities to pocket the difference.

For instance, an American investor who believes that the euro will rise in purchasing strength down the road may elect to buy a large sum of euros at present while the European currency’s relative purchasing power is lower. Alternately, if they believe that the euro might fall in purchasing power, they might elect to short this currency instead.

Who Sets The Price Of Foreign Currencies?

The market itself determines the exchange rates for various foreign currencies. These exchange rates depend on multiple factors ranging from the form of individual nations’ governments to the state of various economies and a host of macroeconomic forces such as the COVID-19 pandemic.

Government involvement here can run the gamut from what we see in China (which sets a currency price through its centralized government) to practices that are common throughout Western Europe and the U.S., which allow their currency prices to be set by the market with government intervention.

How Does Forex Trading Work?

With forex trading, there is no centralized market and very little regulation – investors are largely left to shape their own destiny. Transactions will also be spread out across four major forex trading centers in different time zones. As there is no centralized location around which foreign exchange trading circulates, an investor can additionally trade forex currencies 24 hours a day.

Set Up A Forex Account

There are three types of forex accounts available to aspiring foreign exchange traders:

• Micro forex accounts: Accounts that allow you to trade up to $1,000 worth of currencies in one lot.
• Mini forex accounts: Accounts that allow you to trade up to $10,000 worth of currencies in a single lot.
• Standard forex accounts: Accounts that allow you to trade up to $100,000 worth of currencies in one lot, potentially increasing your losses or gains by several orders of magnitude. 

Trading In Pairs

It’s worth noting that global currencies trade against each other as specific exchange rate pairs. Case in point: Euros and US dollars represent a common exchange rate pairing. The U.S. dollar is the most common currency pairing that is traded.

That said, forex traders are continually trading currency pairs that are represented in the form of three-letter codes, with two letters representing the region and one representing the currency itself. For instance, in the case of the above example, the currency pairing would be displayed as EUR/USD.

Leverage

Leverage describes the practice of borrowing a certain amount of the money that you need to invest in foreign currencies.

Important to remember: A certain amount of the trading limit for each type of forex account that you sign up for will include margin money that is applied toward leverage. While leverage can magnify your potential profits, it can do the same for your losses.

By way of example, your broker may be willing to leverage $50 for every $1 that you use for personal trading – allowing you to trade $1,000 in currency by putting up just $20 of your own monies.

Who Regulates Forex?

The forex market is subject to limited oversight. Select nations may also be subject to government involvement.

Internationally

Curiously, no one regulates the forex market internationally. That’s because it is not a centralized market with investor protections in place. In effect, only individual countries can regulate their specific currencies. Investors are largely on their own when investing in the foreign exchange market. 

In The United States

To the extent that forex is the basis of derivative futures and forwards contracts, the Commodities Futures Trading Commission and the National Futures Association (NFA) have some limited jurisdiction over forex trades in America.

How Do I Get Started With Forex Trading?

Foreign exchange trading is a complex and often highly volatile proposition. Taking the time to learn more about what it entails is an essential part of any beginner’s guide to forex trading. 

Learn About Forex

Readers who are interested in foreign currency and FX trading are advised to take their time learning about forex and how international currency markets work prior to getting started. It’s important to remember that foreign currency trading has long been the province of bankers and institutional investors, not general interest investors, and there is often a steep learning curve associated with it.

Find A Forex Broker

To engage in forex trading, you’ll need to set up an account with a brokerage. Be advised that forex brokers won’t charge you a commission for their services. However, they will make money through spreads in difference between buying and sales prices. Note that it’s wise to do your homework when researching and considering options here, as disreputable players may be drawn to the unregulated nature of the forex trading market. As ever, an ounce of prevention outweighs a pound of cure here.

Open A Trading Account Online

As transactions are processed electronically, and time is often of the essence, it’s important to open an online trading account into which you can deposit sums that you wish to invest. Most brokers accept several means of funding an account, such as via bank wire transfers, debit card payments, and so forth.

Gain Access To A Forex Trading Platform

To trade foreign currencies, you’ll need to gain access to a forex trading platform. Luckily, most forex brokers you’ll deal with will offer a proprietary trading platform or support a popular third-party platform that you can use to complete foreign exchange trades.

Create A Trading Plan

Developing a sound trading strategy is also important – a task which you’ll be aided in by tracking interest rates, exchange rates and currency conversions on a spreadsheet. Research and planning are also important: Although you won’t always be able to perfectly time or anticipate changes in the market, you can always strategize around your individual investments, preferred tactics, and desired investment positions. Knowing how much money you’re comfortable spending, how much risk you can handle, and when it’s time to invest or bail is also important. So is a willingness to stay the course if you ultimately believe in your investment strategy, even if unexpected events present setbacks in the immediate.

What Are The Advantages Of Forex Trading?

Like every other form of financial investment, forex trading comes with its ups and downs. However, among the many reasons that veteran forex traders swear by the marketplace are as follows.

Liquidity

One major advantage of forex trading is that it takes place within the most liquid market in the world. Because there are a large number of buyers and sellers making trades, it’s easier to acquire foreign currency or divest yourself of it than other investments such as inventory and real estate.

Automation

Another major upside of forex trading is automation. Because of its presence, automation helps reduce costs for brokers. 

Few Fees And Commissions

Low fees and commissions are another benefit of forex trading. Decide that you’d like to learn how to engage in forex trading, and it will come with fewer upfront costs.

What Are The Disadvantages Of Forex Trading?

Of course, forex trading isn’t guaranteed to produce profits, let alone huge returns. A few of the disadvantages associated with it that you’ll want to be aware of also include:

Volatility

Currency valuations and interest rates can fluctuate and shift with surprising frequency in the FX market. A host of national and international factors (both of governments’ making and due to external events) can impact pricing and disrupt trading strategies, often with little to no warning. This can raise forex traders’ potential exposure and risk. 

Little To No Regulatory Protection

With little to no regulatory protection attached, you’ve got to look out for your own financial interests and be warier of associated investment risk. Forex traders have minimal recourse if they find themselves in a tight spot.

Fewer Residual Returns

Forex traders also won’t enjoy the benefit of residual returns on their investments over an extended period. Unlike rental income, for example, any profits made on a forex trading investment may be short-lived.

The Bottom Line: Forex Trading Is Yet Another Investment Opportunity, But It Doesn’t Provide A Safety Net

Foreign exchange trading presents another vehicle and opportunity through which investors can hope to potentially turn a tidy profit. But any such profits are neither predictable nor guaranteed, and – as with any other financial market – fortunes can often change in the forex space on a dime. (In this case, quite literally.)

Understanding currency values in the FX market, and how they ebb and flow over time, can help you make smarter decisions as you go about investing in the space.