Forex Learning Site

Introduction to forex trading

What is forex?

The foreign exchange market, usually referred to as forex or FX, is the international market for buying and selling currencies. Forex is also the largest financial market in the world. With a daily turnover of 4 trillion dollars, it is 160 times bigger than the New York Stock Exchange (NYSE). Currencies are traded in currency pairs. For example, you can exchange the Euro for the US dollar or the US dollar for the Euro (EUR/USD). Currencies need to be exchanged in order to enable international trade, investment, and tourism. But besides that, much of forex trading is done for purely speculative purposes. If you think that the Euro will appreciate against the American dollar, you can buy the Euro now and sell it with a profit after its price increases. However, if you are wrong and Euro in fact depreciates, you will lose money.

Who can trade forex?

The traditional participants in the foreign exchange market are central banks, commercial banks, and hedge funds. However, the development of the Internet has opened the forex market also to a great variety of small retail traders, from Russian finance students to Japanese housewives to American retirees. Basically, anyone with a computer, an Internet connection, and a starting capital of $1 can start trading forex. Currencies are traded through a broker. You can learn more about differences between forex brokers in another free tutorial.

When and where are currencies traded?

Forex is open 24 hours a day, 5.5 days a week. It is up to you when you want to trade – full-time from 9 to 5, part-time after work, or once a day, before going to bed.

Unlike a stock market, the foreign exchange market has no physical location. It is rather a decentralized electronic network of banks and forex brokers.

Which currencies can be traded?

Forex currency symbols consist of three letters. For example, USD stands for the US dollar, EUR for the Euro, and JPY for the Japanese Yen. Some currencies are also known under nicknames:

  • American dollar (USD) = Greenback
  • British pound (GBP) = Cable or Sterling
  • Swiss franc (CHF) = Swissy
  • Canadian dollar (CAD) = Loonie
  • Australian dollar (AUD) = Aussie
  • New Zealand dollar (NZD) = Kiwi

The most popular currency pairs include the so-called majors (EUR/USD, USD/JPY, GBP/USD, USD/CHF) and commodity pairs (USD/CAD, AUD/USD, NZD/USD). Any other combination of these currencies (for example EUR/GBP or AUD/JPY) is called a currency cross. Many forex brokers also offer exotic currencies, such as HKD, TRY, and ZAR.

What is a quote?

The quote records the value of one currency in terms of another currency. The currency on the left side of a currency pair is called the base currency and the currency on the right is called the counter currency. A quote indicates how much worth one unit of the base currency is in terms of the counter currency. For example, EUR/USD quoted at 1.5102 means that 1 Euro can be purchased for 1.5102 American dollars.

What is a pip?

Pip stands for “percentage in point” and it represents the smallest change in price that a currency pair can make. In other words, it is the last decimal point of the quote. If the EUR/USD moves from 1.5230 to 1.5432, it rises by 2 pips. Most currency exchange quotes have four digits after the decimal place; only the Japanese yen is quoted out to two decimal places. So, USD/JPY would move by two pips for example from 108.11 to 108.13.

What is a long trade? What is a short trade?

If you expect the base currency to appreciate, you want to buy it and then sell it back at a higher price. In the forex jargon, buying a currency is called “taking a long position” or simply “going long”.

If the base currency is expected to depreciate, you can sell it now and buy it back later, at a lower price. Selling a currency is called “taking a short position”, “going short” or “shorting”.

What is the spread?

Currency quotes are expressed in two prices, a bid price (buy) and an ask price (sell). For example, an online forex broker will show the quote of the Euro as something like 1.5102/1.5105. You can buy the base currency (enter a long trade) at the bid price (1.5102 in our example). You can sell the base currency (enter a short trade) at the ask price (1.5105). The difference between the bid and the ask price is called the spread. The spread is in fact a hidden commission paid to a broker. So, if the bid price of EUR/USD is 1.5102 and the ask price 1.5105, you automatically pay the spread of 3 pips from every trade to your broker.

What is leverage?

Leverage is a ratio between the total capital available for trading and the actual capital that you have on your trading account. For example, a ratio of 100:1 means that a broker would lend you $100 for every $1 of your actual capital. Therefore, you can control $100,000 with an account of only $1,000.

High leverage maximizes both potential profits and potential losses. For example, if you use your $1,000 to buy USD/CHF and the exchange rate goes up by 100 pips from 1.1000 to 1.1100, your profit would be equal to $10. Had you used the 1:100 leverage instead, the return from the same trade, with the same starting capital, would have been $1,000. Of course, higher leverage also increases potential losses. Had the USD/CHF fallen by 100 pips, you would have lost all of your starting capital with the 100:1 leverage.

Although you technically borrow huge amounts of money from a forex broker, you can never lose more than the actual capital that you have in your trading account. If the account falls to below the minimum amount required to maintain an open position, you will receive a margin call and your positions will be automatically closed to prevent further losses.

Why to trade currencies?

  • Forex is a 24-hour market. This creates a great number of trading opportunities every day. It also allows to trade currencies part-time.
  • No big player controls the forex market. Because of the liquidity, no single bank or fund can influence the price at the expense of small retail traders, at least not for long.
  • The forex market cannot crash. Unlike stocks, currencies are valued relatively to each other. If one currency depreciates, another goes up.
  • You can profit from both rising and falling currencies. Even if you do not physically hold a particular currency, you can still sell it. You can go long or short, capturing all the price movements. But, of course, if the currency moves in the opposite direction to that you have predicted, you will lose money.
  • Low starting capital. Some online forex brokers let their clients trade with as little as $1. Thanks to high leverage, you can make substantial profits even with a small trading account.
  • Low transaction costs. Most forex brokers do not charge any commission. They are compensated by the spread that can be sometimes as low as 10 cents for every $10,000 traded.
  • Free tools. Most online forex brokers give away tons of free stuff. You can practice forex trading on a free demo account. You get access to free forex charts, free technical indicators, free economic news feeds... even to free professional market analyses.
  • Instant execution of trades. Under normal market conditions, trading orders are executed instantaneously. Many forex brokers also allow you to automate your trading strategy, using algorithmic trading.

Where is the catch?

Forex trading takes time to learn. If it was so easy, everyone would trade currencies instead of working. But, in reality, most new forex traders fail and quit. Successful forex trading requires a lot of knowledge. You can start with one of the forex books recommended for beginners to get the basic understanding of the foreign exchange market. Then you can move on to more advanced books on technical analysis, fundamental analysis, and money management. Do not expect to succeed in the largest financial market on Earth just because you have read some pdf file downloaded from your broker's website. In addition to reading, forex trading also involves a lot of experimenting. Traders constantly refine and retest their trading strategies. If you are a creative person, you will enjoy this aspect of forex trading a lot. If you just look for quick money without any work, forget about forex.

Forex trading requires great discipline. It is difficult to stick even with a time-tested strategy if the market suddenly goes in the opposite direction, cutting into your trading account. You can avoid the most common errors by learning from trading psychology books, but the serious test of your nerve comes only when you risk real money.

Forex trading will not give you a free lunch. If you start trading forex with an account of $100, you cannot expect to become a millionaire. Like in any economic activity, only a reasonably high investment can bring substantial profits - and even then losses are still possible. In general, professional forex traders rarely gain a higher return than 30-40% a year. Many new traders want to offset their small starting capital by using too much leverage. Although this may work for months or even for years, they risk to eventually blow up their overleveraged accounts. There is no free lunch. On the other hand, 30-40% is still much more than you would get from a saving account.

Beware of suspicious get-rich-quick schemes. You can google thousands of websites offering forex signals that will make you a millionaire in few weeks and without any education. Of course, they are all scams. Forex trading requires understanding of the market. Warren Buffett, the richest person in the world, never invests in what he does not understand. Why would you?

The next crucial step in learning to trade forex is to develop, adapt, and test a profitable forex strategy. If you want to learn how to do it, you can read our tutorial about forex systems and strategies.