Forex trading explained


Forex trading looks simple, but involves serious risks. Understand the basics and find out if this is the right way for you.

Understanding the forex market

Forex, FX, foreign exchange or currency market. You have probably already heard one of these expressions. They all mean the same: a market where you can exchange currencies or bet on the price movement of currency pairs.

The forex market has several outlets, from the currency exchange store on the street till the currency trading desk of big banks.

For a non-professional individual, as you probably are, the easiest and safest way to trade forex is by opening an account at a reliable online broker.

The vast majority of the currency transactions are conducted on OTC (over-the-counter) markets. An OTC market is a non-regulated market. On a non-regulated market, you have to assess for yourself how safe your counterparty is. For example, when you travel abroad to an exotic country and you need to exchange some money, you usually go to a bank office instead of changing money on the street. This is how you minimize your counterparty risk. You have to do the same risk minimization when you select your online broker for trading forex. You better go with a reliable one.

Forex trading is very tempting for the following reasons:

  • everybody has an opinion on where the currencies are going,

  • forex market for the first sight it is relatively easy to understand compared to other markets, like the stock market,

  • by using leverage, a trader can easily trade with 100 times more than he/she has on the trading account,

  • the market is open 24 hours a day, 5 days a week,

  • it is the most liquid market in the world, meaning it has tons of transactions every second and you do not need to worry about not finding a partner to trade with.

Although it looks easy, trading with forex can be risky if you don't know what you are doing. By using high leverage inappropriately, you can easily lose all of your money within a couple of seconds. So you better start off slow,  learn and open a demo account first. If you want to study more, check out our blog post about the best trading apps for learning.

Forex market trading hours

The forex market is open from 11:00 PM Sunday until 11:00 PM Friday, London time.

The highest trading activity within each day is when London and New York are open.

forex-trading-explained-forex-market-trading-hours

It is good to know that there is a difference between currency conversion and forex trading.

The end result of a conversion is basically changing one currency to another. Imagine you receive your salary in euro, but you spend it in GBP. In this case, you exchange the euros to pounds. At the beginning of the transaction you had euro and at the end, you will have pounds.

When you trade with currency pairs there is no physical conversion happening. Imagine you have an online broker account in US dollars and you want to bet on the price movements of the EURUSD. In this case, you effectively never convert your dollars to euro. If your bet was correct, the profit of your trade will be booked into your account in US dollars. If you were wrong, the loss will be deducted from your account in dollars as well.

Breaking down the forex trading jargon

When you trade forex, you bet on the price change of a currency pair, for example, the EURUSD.

EURUSD bid price EURUSD ask price
1.1700 1.1705

First of all, you need to understand the bid and the ask price. Let's take the EURUSD again as an example. The bid is the price at which you can sell the EURUSD, or in other words to go short in it. If the price goes lower, you will generate profit. The 'ask' price is the opposite. If you want to bet on the price increase, you can open a trade on the 'ask' price. The mid-price is usually half way between the two, but it is just a theoretical price, it is not used for trading.

The actual bid and ask prices together are called the quote.

A long position is when you bet on the price increase, while a short position is when you profit from the price decrease.

The spread is the difference between ask and bid price. In the example above the spread is 0.0005 that is calculated as 1.1705-1.1700.

The pip is the smallest amount of a currency pair. One pip is equal to 0.0001 for most of the currency pairs. In case of our example, the spread is 5 pips, or 5 times 0.0001, equalling 0.0005. For some currency pairs like the USDJPY, one pip is 0.01.

The leverage enables you to take bigger positions than the amount of money on your account. Imagine this as a multiplier of your profit or your loss. This can be as high as 300. Imagine you have one thousand dollars on your account and your applied leverage is 100. If you open a long position by using all your $1,000, this means you open a trade for $100,000, $1,000*100. If the price decreases 1%, you will lose $1.000 (1%*$100,000), all of your money on your account. And the price of a currency pair can very easily decrease by 1%. In case of EURUSD this would mean a price decrease from 1.1705 to 1.1588.

A lot is the standard number of units of a forex contract. It is usually 100,000 of the base currency. The base currency is the first currency in a currency pair. For EURUSD, the base currency is the EUR and one lot is €100,000. A mini lot is 10.000, a micro 1,000 and a nano 100 unit of the base currency.

You can meet three types of contract in forex trading, spot, forward and futures. The spot forex contract is traded by most of the people and you are also trading a spot contract when you use an online broker. A spot contract by definition is settled after two days of the trade. The settlement means the counterparties who traded are converting their currencies between each other at the price of the trade made two days earlier. Imagine the settlement as a currency conversion made at an exchange office on the street. The only difference is that this happens two days after the price was agreed on.

However, the settlement doesn't happen on most of the cases, because spot contracts are rolled over before the settlement. This is always the case when you trade forex with your online brokers. The rollover happens because when you are betting on the direction of a currency pair, you do not want to effectively exchange money. You just want to bet on the price movement. The rollover ensures that the conversion will not happen.

When your position is rolled over, your online broker in the background is basically closing your current spot position and opens a new one. This is not visible for you, but has a fee, the rollover fee or financing fee. The rollover fee is calculated from the interest rate difference between the two currencies you are trading. It can also happen that you receive a fee from the broker if the interest rates you trade are in your favor. 

A forward forex contract is a contract made on the OTC market. The specifics of the contract, like the term, the price and the settlement are defined by the counterparties case by case. For example, imagine a company which needs $100,000 in 30 days for paying its employees, but it will receive its revenue in euro. Since it wants to specify the exact exchange rate it can get in 30 days, it will seal a forward contract with a big bank at a fixed price, let's say 1.1710. After 30 days they will exchange the currencies and the company will receive €85,397 ($100,000/1,1710). Here the settlement actually happens.

A futures forex contract is traded on a regulated market, for example, a commodity exchange, like the Chicago Mercantile Exchange (CME). When you trade futures, your counterparty is the exchange and the specifics of the contract are predefined by the exchange. When your counterparty is a regulated exchange, you don't need to check your counterparty risk, this is one of the safest modes of trading. However, the exchange requires high initial money for trading, so this is not suitable for you with little money to invest. For example, if you want to trade one EURUSD futures contract on the CME, you need to have more than $2.000 on your account.

 

What drives the forex market price?

As told before, on the forex market, everybody has an opinion, because it seems simple to have one. However, currency markets are among the most unpredictable ones in the world.

Everything from monetary policies, government spendings, politics to wars can influence the price change of the currency pairs. The prices have so many influential factors it is hard to make an estimate on them.

Although, economic calendars can be on your help, so at least to know those scheduled events that can influence the forex market.

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