All about Forex (Foreign exchange) trading

Forex is an abbreviation for foreign exchange. Forex trading is the buying and selling of currencies on the foreign exchange market with a profit-making motif. It is one of the most active markets in the world, with corporations and individuals carrying out numerous daily transactions. The number of currency conversions per day can increase the volatility of the price movement of some currencies while lowering that of others. The following is an overview of forex trading and what you need to know before embarking on the forex journey.

Basics

Currency pairs

In forex trading, currencies are traded in pairs, with one currency being the quote currency and the other being the base currency. The pair, therefore, provides a quotation of two different currencies. The pair price shows how much of the quote currency is required to buy a unit of the base currency.

Major, minor, and exotic pairs

A major currency pair consists of the two most widely traded currencies, such as the euro against the US dollar (EUR/USD). Such a pair is the most traded and, therefore, the most liquid in the world.

Minor pairs are the ones that do not contain the US dollar but contain other major currencies. Such pairs are more widely spread and less liquid compared to the major pairs.

Exotic pairs contain a currency of smaller emerging markets and a major currency such as the US dollar/Singapore dollar.

Market participants

The market participants in forex trading include retail traders, institutional traders, and government and central banks. Retail traders are individuals and other small speculators, and institutional traders include hedge funds, banks, and other large financial institutions. Governments and central banks intervene in the market to influence or stabilize their economies.

How forex trading works

The forex market is operational 24 hours a day, five days a week, due to the different international time zones.

Leveraging

Before traders determine their currency pairs, they must leverage to ensure they control larger positions using the least possible capital. Leveraging means using the borrowed funds, known as capital, to invest in a currency. While leveraging increases profit-making, it also enhances the risk of significant losses.

Bid and ask price

Bid price is the price at which a trader is willing to sell a currency, while ask price is the price they are willing to buy a currency. The difference between the bid and ask price is the spread, which, essentially, is the cost of trading.

Short and long positions

Going short denotes selling a currency pair with the expectation that its value will go down, while going long denotes buying a currency pair, expecting its value to rise.

Analysis

Before getting to forex trading, it is essential to conduct a fundamental analysis to evaluate basic factors such as interest rates, economic indicators, political stability, and other economic factors.

It is also important to conduct a technical analysis to evaluate the historical price movement and use technical indicators to predict the anticipated future price movement.

Risk analysis and management is also crucial to minimize losses and protect capital. The essential strategies in this analysis include using the right position sizing, setting stop-loss orders, and diversifying trades.

Challenges and risks

Leverage risk

While leverage increases profits, it also increases the traders’ exposure to losses. Leverage calls for some initial investment called margin, to access larger trades in foreign currencies. Fluctuation in prices leads to margin calls where the traders are expected to make an additional margin. During market volatility, traders use more leverage, leading to considerable losses in their initial investments.

Interest rate risks

Interest rate has a significant effect on a country’s exchange rate. A rise in interest rates increases the investment rate, thus strengthening the country’s currency, and vice versa happens when the interest rates fall. Such effects can dramatically affect the forex prices, leading to investment losses for the traders.

Transaction risks

These are exchange rate risks that arise from the time difference between when a contract starts and when it concludes. Forex trading takes place on a 24-hour basis, which can bring changes in exchange rates before the conclusion of trade. Consequently, it is possible to trade the same currencies at different prices at different times within the trading hours.

Market volatility

The Forex trading market has high volatility, leading to rapid price changes. This can lead to considerable losses for the investors.

Get a step-by-step guideline on how forex trading works in the next article.