Did you know that there are over 9.6 million active forex traders worldwide and that more than $6 trillion is traded daily?
Forex trading is another way of describing the foreign exchange market where currencies are traded online.
When trading forex, you can choose between majors, minors and exotic currency pairs, ensuring diversity across your entire portfolio and allowing you to potentially make profits under various economic conditions.
In comparison to other financial instruments, forex trading is often commission-free with low trading costs and low spreads, and most brokers offer currency pairs.
Another reason forex trading is so popular is because you have the potential to make a profit on both falling and rising markets, as one currency often rises when the other falls.
There has been a substantial increase in the number of trading platforms and apps available, making forex trading more accessible than ever before to anyone with an internet connection and a smartphone.
In addition, the forex market operates 24 hours a day, five days a week and can be accessed at any time of the day.
If you are new to trading, this post will give you a better understanding of the basics of foreign exchange and how to trade on it. So, what is forex trading?
What is Forex?
Forex trading involves the buying and selling of currency pairs on the foreign exchange market to make a profit.
The Foreign exchange market is the largest and most liquid financial market in the world. It has high liquidity with minimal price fluctuation, making it a low-risk investment with high earning potential.
It is a decentralized online exchange where trades are conducted OTC (Over-the-Counter) through a network of brokers, banks and financial institutions.
Currencies are traded online 24 hours a day, 5 days a week through a large network of banks, brokers and institutions.
How does the Forex Market Work?
When trading on foreign exchange, currencies are always traded in pairs (e.g. EUR/USD). The pair consists of a base currency (EUR) and a quote currency (USD).
The way you read a currency pair is by asking yourself how much of the quote currency is needed to purchase one unit of the base currency and that amount will be represented by the price of the currency pair.
What are Currency Pairs?
There are three main types of currency pairs and each type of currency pair has its own liquidity, trading volume and volatility.
The types of currency pairs that you can trade are Majors, Minors and Exotics.
Majors
Major currency pairs are the most stable, the most liquid and therefore, the most traded. They also offer the lowest spreads and lower trading costs than other types of currency pairs.
Major currency pairs will always include the USD as one half of the pair.
Some of the most popular major pairs include:
- AUD/USD (Australian Dollar/US Dollar)
- USD/JPY (US Dollar/Japanese Yen)
- NZD/USD (New Zealand Dollar/US Dollar)
- GBP/USD (British Pound/US Dollar)
- USD/CHF (US Dollar/Swiss Franc)
- EUR/USD (Euro/US Dollar)
- USD/CAD (US Dollar/Canadian Dollar)
Minors
Minor currency pairs (or Cross currency pairs) consist of major currencies that are paired with each other, but which exclude the USD.
Minors are also popular but do not have the same liquidity as Major currency pairs.
The Minor currency pairs are:
- EUR/GBP (Euro/British Pound)
- AUD/JPY (Australian Dollar/Japanese Yen)
- EUR/AUD (Euro/Australian Dollar)
- CHF/JPY (Swiss Franc/Japanese Yen)
- GBP/JPY (British Pound/Japanese Yen)
Exotics
Exotic currency pairs are generally more volatile because they consist of one major currency paired with a currency from an emerging economy.
Exotic currency pairs tend to have higher spreads, higher volatility and lower liquidity. However, these pairs are still traded by investors with a higher appetite for risk seeking a more diversified portfolio.
The most-traded Exotic currency pairs are:
- JPY/NOK (Japanese Yen/Norwegian Krone)
- USD/TRY (US Dollar/Turkish Lira)
- USD/HKD (US Dollar/Hong Kong Dollar)
- EUR/TRY (Euro/Turkish Lira)
- USD/ZAR (US Dollar/South African Rand)
- USD/SEK (US Dollar/Swedish Krona)
What are the Key Concepts in Forex Trading?
When you first start trading, it is important to familiarise yourself with the terminology that is used. Some of the most important concepts you should understand as a new trader are:
Leverage and Margin:
Leverage allows you to enter the markets with a bigger capital investment. For example, with leverage of 1:10, you can control a position of $10,000 by depositing only $1,000.
Trading with leverage not only amplifies your potential profits, but also your potential losses, so please be careful when you trade using this feature!
Margin is the security deposit that is required to open and maintain a leveraged position, which ensures that you can cover potential losses.
Pip and Pipette:
In forex trading, a pip (Percentage in Point or Price Interest Point) is the smallest unit of measurement for price movements and it expresses the change in value between two currencies that are paired (e.g from 1.1051 to 1.1052)
Pipettes (fractional pip or micro pip) provide a higher level of precision when quoting exchange rates and it is represented as the fifth decimal place for most currency pairs. (e.g from 1.10500 to 1.10501)
Bid Price and Ask Price:
The Bid price is the price at which the market is willing to buy the base currency in exchange for the quote currency and it is the price at which you can sell a currency pair
The Ask price is the price at which the market is willing to sell the base currency in exchange for the quote currency and it is the price at which you can buy a currency pair.
Spread:
The spread is determined by the difference in price between the Bid price and the Ask price of a currency pair, and lower spreads are always desirable when trading forex.
Spreads determine the cost of trading, as well as the liquidity of currency pairs. The higher the liquidity of a currency pair, the tighter (or lower) the spread.
There are two types of spreads:
- Fixed: market conditions do not affect the spread and it remains constant.
- Variable: spread is determined by market volatility and liquidity.
Lot:
A “Lot” is a standardized unit of measurement for the size of a trade and it helps with managing risks and determining the potential profits/losses of a trade.
There are three types of lots:
- Standard: 100,000 units of the base currency (e.g 1 standard lot of EUR/USD means that you are trading 100,000 euros and the value of 1 Pip is usually $10)
- Mini: 10,000 units of the base currency (e.g 1 mini lot of EUR/USD means that you are trading 10,000 euros and the value of 1 Pip is usually $1)
- Micro: 1,000 units of the base currency (1 micro lot of EUR/USD means that you are trading 1,000 euros and the value of 1 Pip is usually $0.10)
Order Types
Order Types refer to the way traders enter/exit positions and may affect how they manage their risks and execute strategies.
There are multiple types of orders in forex trading. The most common order types are:
- Market Order: Buy/sell a currency pair at the current market price.
- Limit Order: Buy/sell a currency pair at a specific price.
- Stop-Loss Order: Close a position at a predetermined price to limit losses.
- Take-Profit Order: Close a position at a predetermined price to lock in profits.
- Stop-Limit Order: A combination of a stop order and a limit order.
- Trailing Stop Order: A stop-loss order that moves with the market price by a specific percentage or dollar amount, to lock in profits.
- Good ‘Til Canceled (GTC) Order: Order remains active until it is either executed or cancelled.
- Good for the Day (GFD) Order: Order remains active until the end of the trading day and automatically expires if it is not executed.
- One-Cancels-the-Other (OCO) Order: A pair of orders where one is automatically cancelled if the other is executed.
What is a Forex Trading Session?
Finding the best time to trade can be challenging if you don’t have a basic understanding of the forex trading sessions.
The forex market is operational 24 hours a day, but trading happens at different times across global financial centres.
The trading day always begins in Asia, then moves to Europe and finally, ends in North America before starting again the next day.
Forex markets can be accessed all day, but market volatility and activity levels vary from one session to the next.
The most favourable times to trade are during the London and New York Overlap (8 AM to 12 PM EST/1 PM to 5 PM GMT), during the London session (3 AM to 12 PM EST/8 AM to 5 PM GMT) and during the New York Session (8 AM to 5 PM EST/1 PM to 10 PM GMT).
The Asian session is generally the least favourable trading session because of lower volatility and lower trading volumes, which results in higher spreads.
The major trading sessions are the Asian Session, the European (London) Session and the North American (New York) Session.
The Asian Session
The Asian session has the following characteristics:
- Hours: 11 PM to 8 AM GMT
- Markets: Tokyo, Hong Kong, Singapore, Sydney
- Lower volatility, lower activity, higher spreads
- Potentially the best time for trading currency pairs involving the JPY, AUD and NZD
The European Session:
The European Session has the following characteristics:
- Hours: 7 AM to 4 PM GMT
- Markets: London, Frankfurt, Zurich, Paris
- Higher volatility, most activity, lower spreads
- Period with the highest trading volumes and usually the best time of the day for trading
The North American Session:
The North American Session has the following characteristics:
- Hours: 12 PM to 9 PM GMT
- Markets: New York, Toronto, Chicago
- Higher volatility, lower spreads
- Market is influenced by US economic data releases and announcements
The highest market volatility typically occurs when the European session overlaps with the Asian session in the early hours of the morning and with the North American session late afternoon.
The best time to trade depends on your trading strategy, your portfolio and your trading skills, but typically, most traders prefer to trade during the European (Or London) session when the spreads are lowest.
What are the Types of Forex Analysis?
Analysis is important in forex trading because it enables traders to potentially predict price movements based on charts, news and overall market sentiment.
Forex analysis methods can be used independently, but we recommend using them in combination with one another to make more informed trading decisions.
Most brokers offer access to analysis tools, such as Autochartist, TradingView, and Trading Central.
Depending on the platform you use, many platforms have built-in analysis tools that can be used to analyse and visualise your charts in different ways to get the most out of them.
The three types of analysis in forex trading are Technical analysis, Fundamental analysis and Sentiment analysis.
Technical Analysis
Technical analysis uses market statistics, historical price data, charts and technical indicators to identify patterns and predict market behaviour.
The technical indicators that are typically used are Moving averages, RSI (Relative Strength Index), MACD (Moving Average Convergence Divergence), and Bollinger Bands.
When doing technical analysis, traders generally look at a variety of chart patterns, including head and shoulders, double tops and bottoms, and trend lines. They also look at support and resistance levels.
Traders also analyze the trading volume of currency pairs to confirm price movements.
Fundamental Analysis
Fundamental analysis inspects the underlying reasons why currencies behave the way they do and takes into consideration how economic, social, and political factors influence the prices of currencies.
Traders generally look at economic indicators, such as GDP growth, employment rates, inflation, and trade balances.
Interest rates and the political stability of a country also play a role in the behaviour and price of currencies, and following major news and announcements is crucial when doing fundamental analysis.
Sentiment Analysis
Sentiment analysis focuses on the psychological factors that influence trading decisions and market movements.
This method of analysis considers the overall mood (or sentiment) that traders have toward a particular currency and the overall market.
When doing Sentiment analysis, traders use tools that measure the sentiment of traders, such as the Commitment of Traders (COT) report, surveys, polls, news and social media.
It is also important to analyse Information showing how traders are positioned in the market, by looking at net long or net short positions.
How to Get Started with Forex Trading
Before you can start trading, you need to choose a broker.
There are so many brokers to choose from, so make sure to choose a broker that meets your needs and offers the account type, instruments, tools and educational resources that you require.
Tips for choosing a broker:
Before you choose a broker, make sure to check the following:
- Is the broker regulated? (by popular regulators, such as CYSEC, ASIC, FSCA, FCA etc.)
- What is the minimum deposit required to open an account?
- What account types are offered?
- Does the broker offer a demo account to practice on?
- What instruments are offered?
- What platforms can you use?
- What are the commissions and trading fees?
- What spreads are offered?
- What do other customers say about the broker?
- Does the broker provide educational resources?
- Does the broker provide access to news, live price updates and analysis tools?
Once you find a broker that ticks all your boxes, it’s usually easy to open an account by following a few simple steps:
Step 1: Go to the broker’s website
Step 2: Locate the account creation button and click on it
Step 3: Fill in your details
Step 4: Complete the verification process
Step 5: Create an account
Step 6: Fund your account
Step 7: Download the platform you will be using
If you are new to trading or you would like to test your strategies before executing them using real money, we recommend opening a demo account.
Demo accounts allow you to trade risk-free using virtual funds and this is the safest way to learn how to trade in a lifelike market environment.
To open a demo account, follow the same steps listed above and choose a demo account instead of a real account.
What are the Risks and Rewards of Forex Trading?
With the pursuit of profit comes both risk and reward. Becoming a successful forex trader takes time and discipline, but even the pros know that not every trade will be profitable.
Forex trading can be fun and extremely challenging at the same time and various factors influence profitability, including risk management, market knowledge, broker choice, market conditions, trading strategy and your overall mental state and approach to trading.
The most common risks in forex trading are market risks, leverage risks, interest rate risks, liquidity risks, transactional risks, counterparty risks, political and economic risks, psychological risks, technical risks and regulatory risks.
All of these risks influence the profitability of your trading and you should always be mindful of these risks when trading online.
That is why it is so important to choose a broker that will minimise your risks and give you the most peace of mind and security.
There are ways that you can mitigate these risks:
- Make use of different order types to help manage your trades more effectively
- Educate yourself on market conditions, economic indicators and trading strategies
- Diversify your portfolio by trading different currency pairs
- Choose a broker that is regulated and has a good reputation
- Follow global news and economic data
Conclusion
Forex trading is exciting, challenging and has high earning potential with the right approach, but remember to always be mindful of the risks.
There is a lot to consider before you can start trading, so make sure to read some of our other posts to gain a deeper understanding of trading strategies and other instruments you can trade.
Now that you have an understanding of what forex trading is, how it works and how to manage your risks, why not open an account with AvaTrade and try out a demo account today?