Introduction To Forex Trading
The online financial markets, as we know it today, was revolutionised by the introduction of Forex trading in the late 1990s and the early 2000s. It is no secret that investing in stocks and other financial components were reserved for a select few individuals and institutions, who had the opulence of a massive trading capital and an unhindered market access with privileges. Smaller retail traders never stood a chance to invest in the markets, and even if they did, they were at the mercy of the brokers and other individuals that dealt with stocks on the floor of an exchange.
Trading the markets was considered to be a tedious and complex affair, especially for traders from remote areas, who never had access to dedicated trading floors or brokerages. However, at the turn of the century, the internet and the proliferation of personal computing paved the way for a massive surge in retail trading, which saw the financial markets gaining an unbelievable amount of popularity among all sections of the society. Today, Forex trading is responsible for close to $5.5 trillion worth of transactions on a daily basis and is a 24 hours market that is available for trading from Sunday to Friday.
What Is Forex Trading? – A Brief History
Forex is an abbreviation for Foreign Exchange and is primarily a decentralised exchange that is responsible for exchanging currencies at a global marketplace through Over The Counter (OTC) transactions. Forex transactions can occur at any time and any place and is not generally mired by any geographical or time boundaries. Almost all businesses in the world with cross-border transactions involve the buying and selling of currencies, which determines the rate of each currency according to the underlying market conditions. Forex transactions primarily occur through global liquidity pools and exchange houses, which can include global banks, financial brokerages, and other liquidity providers.
Forex transactions and currency exchange is basically a platform that enables individuals, companies, countries, and corporations to pay for goods and services. However, the changes in market dynamics and the global demand/supply mechanisms keep the price of currencies fluctuating against one another. The currency markets have been a prominent fixture of the global markets for many centuries, but the speculative nature of Forex trading only gained prominence during 1973.
Until the 1970s, Forex transactions were controlled by the states, and the price fluctuations were strictly under governmental control. However, developed economies of the world decided to relinquish their control over the prices of the currency pairs, and the market was floated freely to create free market conditions.
Since the 1980s, several large economies and banking institutions, along with some high-net-worth individuals started speculating on the markets, which led to the rise of the modern concept of Forex trading that is proving to be popular in the modern financial markets today. The rise of online FX brokerages during the 2000s also witnessed an inclusion of household traders and individual investors in the Forex market, which increased the number of traders to unprecedented levels. As more and more retail traders and institutional investors started entering the market, the liquidity of the Forex markets increased exponentially, and the net result is that FX trading is now worth close to $5.5 trillion transactions every day.
Forex Trading Explained
Forex trading, in its most modern sense, involves buying or selling a currency against another. From this article’s perspective, we will take a look at Forex trading in its speculative form, rather than the traditional forms of currency exchange. Forex transactions typically happen in pairs, such as the EUR/USD pair, which is the most popular and widely traded currency pair in the FX market. The EUR (Euro) in this case is the base currency, while the USD (US Dollar) is the quote currency or the counter currency. The EUR/USD, like almost all currency pairs, is freely floated in the market and has two prices, the bid price and the ask price. The bid price is the existing market price that is available for buying the Euro against the US Dollar (or for selling the US Dollar against the Euro), and the ask price is the market price for selling the Euro against the US Dollar (or for buying the US Dollar against the Euro). The difference between the bid and ask prices is known as the market spread.
Traders can speculate on the currency markets by either going long on a currency pair (buying the base currency and selling the quote currency) or going short on a currency pair (selling the base currency and buying the quote currency). Transactions are usually performed through lots, with a single standard lot being 100,000 units of a base currency. Tradable lots can be different for different trading accounts, where traders have the opportunity to trade in mini lots (10,000 units) or micro lots (1000 units). Once a trader enters the market, the movement of the market determines the profit and loss, which is represented in pips or points of movement. Therefore, FX trading has an unlimited profit and loss potential, but several factors such as minimum margin requirements, leverage, invested lots, and pip movements contribute to the outcome of a trade. A more detailed insight into Forex trading is provided in our ‘The Basic Components Of FX Trading’ and ‘How To Trade Forex’ sections outlined later on in this article.
How Is Forex Trading Different From Binary Options Trading?
Forex trading and binary options trading are two entirely different trading concepts. Forex trading involves investing in the currencies market, where the profits and losses are determined by the movement of the markets according to the price changes. The returns in FX trading are variable, and the risk of trading cannot be known beforehand. On the other hand, binary options trading is a fixed win/loss financial product, where the direction of the asset plays an integral role in deciding the outcome of a trade. The payouts and losses are fixed per trade, and traders can be aware of the potential gains and losses beforehand.
Forex trading, regardless of its fast-paced nature and the probability of ruin due to high leveraged trading, is still considered to be a genuine investment opportunity, while binary options trading has been likened to gambling. Binary options trading may not be preferred by traditional investors, who like to have more control over their investments. Binary options trading, irrespective of the massive profit potential within a short span of time is still riskier than Forex trading. Forex trading allows investors to modify and manage their trades, while binary options brokers only allow limited trade management.
The choice between Forex and binary options trading is ultimately up to the trader. It undoubtedly depends on the risk appetite of the trader, and his/her ability to match their skills to the market conditions. Forex trading is also considered to be more sophisticated and advanced than binary options trading, which requires Forex traders to invest a considerable sum of money on education and trading resources.
Similarities & Differences Between Forex and Stock Trading
Forex and conventional stock trading have a lot in common, especially when one considers the market dynamics and the concept of trading for both markets. The profits and losses are determined by the market fluctuations, where both instruments offer an earning opportunity that is relative to the size of investments and the extent of movement of the underlying assets. Some traders may argue that stock trading may offer an added advantage of earning passive income through stock holding, but Forex traders also have the opportunity to earn passive income through SWAP or interest rates. While stock holding requires a trader to hold an underlying stock for a given period, in order to earn a dividend, Forex trading allows a trader to earn overnight interest by buying a currency pair that has a higher interest rate against a currency pair that has a lower interest rate.
Of course, there are some noteworthy differences between Forex and stock trading. For instance, stock trading only allows a maximum leverage of 1:20 (in extreme cases), while Forex trading offers an opportunity to trade with up to 1:3000 leverage. Under normal circumstances, Stock trading allows a maximum margin of 1:10, and the normal leverage for FX trading may be around 1:50 to 1:500. There are also differences in the price of an underlying financial instrument.
Perhaps one of the major differences between Forex and Stock trading is the trading schedule. Forex is a 24 hours market that is open throughout the day, apart from the weekend, while stock trading is only open during the opening and closing hours of the stock market of a particular country. Therefore, Forex trading may be able to offer better trading opportunities for global traders, and traders don’t have to modify their trading schedule according to match the market timings.
How To Trade Forex
Trading the Forex markets involves having an in-depth knowledge of the market dynamics, and a thorough awareness of the different strategies that can contribute to a lucrative trading experience. Traders should realise that there isn’t any holy grail system that promises unlimited profits. It is also important to note that the same strategy can have two different outcomes for two traders with different mindsets. Regardless, here are a few pointers for traders before investing their money in the FX market.
– Opening A Forex Trading Account
There are countless Forex trading companies that offer different types of account packages and FX trading products for retail traders. You have the choice of investing in a large and accomplished liquidity provider, or you can choose a broker that caters to smaller traders. Brokers can be broadly classified into two groups, according to their market access protocols. More often than not, brokers that cater to smaller retail traders often operate on the market maker protocol, which matches all clients’ orders internally. Therefore, the broker acts as an exchange for buying and selling of currency pairs. In some cases, brokers may be unable to offer the liquidity due to market conditions, in which case, market makers may choose to take the other end of a trader’s position. Therefore, market maker brokers may include a considerable conflict of interest.
The other category of brokers is known as the Direct Market Access (DMA) broker, which acts as an intermediary between a trader and the liquidity provider. In DMA trading, brokers use an Electronic Communications Network (ECN) or Straight Through Processing (STP) protocols to connect traders directly to a liquidity pool or exchange house. DMA brokers have no conflict of interest, as all orders are transmitted to an exchange where buyers meet sellers without any intervention from the intermediary broker concerned.
Another important consideration while opening an FX account is the regulatory status of the broker. Forex trading has been the subject of numerous scams, and it is indeed recommended that traders only deposit their funds in a regulated Forex trading company. Although regulation is not a prerequisite for genuine and credible services, it may help in enhancing the safety aspect of clients’ investments.
– The Forex Trading Platform
Choosing the right trading platform can be a difficult task, as numerous high-quality Forex trading platforms in the market offer varying levels of trading tools and features. The industry has come up with some established third-party Forex interfaces such as the MetaTrader and cTrader platforms, which offer different trading tools and market access to suit changing trader requirements. The MetaTrader4 (MT4), MetaTrader5 (MT5), cTrader, NinjaTrader, and Trading Station are some of the more common FX trading software in the market, although some brokers may also choose to offer a personalised and proprietary trading interface.
Traders should be cautious of their choice of trading platform, as it provides the ability to access trading charts and other analytical features for comprehensive analysis of the markets.
Trading platforms also have numerous features that facilitate convenient trading access, as professional traders often use platforms such as the MetaTrader and the cTrader for their trading needs.
It is vital to demo trade the FX market using a dedicated Forex demo platform, in order to find a software that suits your needs. Almost all FX brokers offer a dedicated demo trading platform, and you can sign up for virtual practice accounts using just an email address. Trading on a demo account can also help you to develop your trading strategies through a risk-free environment.
– Depositing Money
Brokers have different initial deposit requirements for different categories of traders. Generally, Forex brokers tend to cater to larger investors, primarily due to the minimum margin requirements of the FX market. Regardless, brokers also offer smaller accounts for smaller traders, but the average initial deposit may fluctuate between $100 and $1000. You can also open an account at a few brokerages by depositing a small initial deposit of $1, while some brokers, especially those from the EU, may ask its traders to deposit a minimum of $5000 or $10000. As a trader, you should realise that Forex trading and leveraged investment products are risky, and you may lose more than your invested amount. Therefore, your priority should be to invest money that you can afford to lose.
– Choosing The Account Leverage
Brokers may provide an amazing leverage for FX trading accounts, and it is not uncommon for brokers to offer as high as 1:3000. You must be careful with your leverage option, as an account that uses a 1:3000 leverage for the entire trading capital will theoretically result in a margin call for a 2 pip movement. In some cases, currency pairs may charge a 2 pips spread under normal market conditions, which is enough to trigger a margin call. Regardless, brokers may offer leverages in the range of 1:100 to 1:1000, while some countries such as the US have banned the use of any high leverage. The CFTC of the USA has clearly outlined a maximum leverage of 1:50 for all US traders and some countries in EU and Asia also have similar leverage requirements.
– Opening A Trade & Order Types
There are multiple order types for Forex traders, with the market execution being the most straightforward investment opportunity to enter a trade at market price. Trades are executed according to the available liquidity, and sometimes, it is possible for traders to experience requotes and order cancellations while trading with market maker brokers. In the case of DMA brokers, trades may be accompanied by slippages, and partial order fills since all orders are executed at market conditions.
Forex traders can also make use of pending orders to enter the markets at a future price. There are different types of pending orders such as OCO, FIFO, and other orders, but traders from the US will have to follow CFTC rules while trading the FX market. US traders are not allowed to hedge trades (the process of buying and selling on the same currency pair or asset), while there are several restrictions on the way a trader can open and close positions at market price. It is the responsibility of a trader to determine the different trading options that are applicable in their country.
– Trade Management
Forex trades can be managed by a trader according to his/her trading strategies and money management principles. Of course, the broker has an automatic mechanism in place, known as margin call policy, which automatically closes all trades according to the margin call induced by the account. Margin calls are only applicable when a trader uses higher leverage to control larger positions with a smaller capital. Aside from margin calls, traders have complete control over managing their trades, including setting take-profit/stop-loss levels, closing partial positions, and closing the trades at profit or a loss.
The Pros & Cons Of Forex Trading
- Trading is flexible.
- Investors can access the markets with a smaller trading capital.
- Access to margin trading that provides higher leverage and lower capital outflow.
- Cost of trading is comparatively less, when compared to stock trading.
- Highest liquidity that facilitates 24X5 trading.
- Profits are limitless.
- Traditional investors can quickly learn the different aspects of FX trading.
- Allows social trading and automated trading robots without any restrictions.
- Leveraged FX trading is exceptionally risky.
- Higher probability for scam practices from FX brokers.
- High volatility may not be suitable for traders with lower risk-appetite.
- The risk/reward cannot be known earlier.
- Traders would require access to expensive education.
Popularity Of Forex Trading In The Financial Markets
Forex trading is perhaps one of the most popular and widely adopted investment products in the online financial markets. Traders from all over the globe invest in the FX markets, and there are tons of resources and success stories that point to the efficiency of Forex trading as a viable alternative investment. Of course, there are known risks to trading, but with proper education, guidance, and sound technical know-how, even a novice trader can turn their career around to achieve the best profits from the Forex industry.