Saxo Group
Summary: Learn the dynamics of trading the forex markets for the first time, understand how the forex market works, and how to develop a forex trading plan.
If you’ve heard the term forex trading and you’re intrigued by the prospect of making money from money, you’re in the right place. Forex – short for foreign exchange – trading is the trading of one currency price against another, with the goal of making a profitable transaction.
Some conversions or exchanges from one currency to another are for practical reasons in the real world, like changing up your travel funds for an overseas holiday. Forex traders exist to correctly speculate on specific price movements on one currency against another. Forex trading is also used for commercial purposes too. It’s required to pay for services and products in countries overseas. It’s also used for hedging existing open investments in the markets, with the idea of reducing potential losses by opening one or multiple forex trades that offset or even eradicate risk.
Foreign currencies are traded on an open marketplace that’s designed to facilitate 24/7 peer-to-peer transactions, allowing individuals, banks, corporations and even governments to exchange currencies. It’s long been the most liquid trading marketplace on the planet. Daily transactions are made to the value of more than $5 trillion.
The US dollar is one of the most influential currencies in the world. That’s because 60% of all forex reserves housed in central banks worldwide consist of the ‘greenback’. As a result, the US dollar is one of the most popular foreign currencies to trade against other currencies, such as the British pound (GBP), Euro (EUR) or Chinese yuan (CNH).
Although the Chinese fiat currency is known as the people’s renminbi (RMB), the yuan (CNH) is a subtle distinction as it’s used to denote a unit of China’s economic and financial system. If you were to trade US dollars for Chinese renminbi, you would receive Chinese yuan (CNH). The renminbi is the fiat currency that only acts as a medium of exchange within the borders of mainland China.
In fact, the US dollar appears in most ‘major’ forex currency pairs, which equate to approximately three-quarters of all trades placed in the forex markets.
A forex currency pair is the most direct way you can trade currencies. As the name implies, it consists of two currencies, which together make a pair. As a newcomer to forex trading, it’s often recommended to trade ‘major’ forex pairs when starting. The main reason is that these pairs offer the most market liquidity. Liquidity is important. It means that many investors are trading the pair. This is good for you as it will make it easier to buy and sell. It also means that in most cases you’ll encounter smaller gaps between the price you can buy and sell for.
More ‘minor’ forex currency pairs may have bigger gaps between the two prices, which immediately brings with it increased market volatility. The volatility occurs due to the reduction in the number of active buyers and sellers in the market. Minor forex pairs have wider ‘spreads’ in the buy and sell prices as sellers aren’t prepared to lower the selling price and buyers are equally reluctant to bid more. It’s also worth noting the bigger the gap between the buy and sell price, the more the price must move for your forex trade to be profitable.
When you choose a forex pair, you will see one currency listed before the other e.g. EUR /USD. The first currency is known as the ‘base currency’ and the second currency is known as the ‘quote currency’. The price of a currency pair equates to how much of the quote currency is needed to purchase one unit of the base currency.
Using the EUR/USD currency pair as an example, let's say that EUR/USD pair is displayed at a value of 1.13. This means that one Euro is the equivalent of USD 1.13. If the value of this currency pair goes up or down, it means that the value of the USD is strengthening or weakening against the Euro. It’s the role of a forex trader to correctly predict the price movement of a currency pair in either direction.
There are seven prominent forex currency pairs in the market. These include the EUR/USD, GBP/USD, USD/JPY and USD/CHF. The JPY is the Japanese yen, the official fiat currency of Japan. The CHF is the Swiss franc, the official fiat currency of Switzerland. In addition, there are three popular ‘commodity pairs’ that are also listed alongside the major forex pairs – AUD/USD, USD/CAD and NZD/USD. The AUD is the Australian dollar, the official fiat currency of Australia. Meanwhile, the CAD and NZD are the official fiat currencies of Canada and New Zealand respectively.
If you want to explore these popular forex currency pairs in more detail, you can read our deep dive article “Money Makes the World Go Round: Around the World in Seven Pairs”.
A commodity pair consists of foreign currencies from nations with extensive natural resources. As such, these resources underpin their respective currencies, with the price of commodity currencies heavily influenced by raw material prices.
Aside from the major currency pairs, you’ll also encounter ‘cross currency pairs’ in the forex market. Essentially, a cross currency pair does not feature the US dollar. These include EUR/CHF, EUR/GBP and EUR/JPY. The liquidity for these cross currency pairs is not quite at the same level as the four major forex pairs, but it’s still sufficient for direct exchange and minimal volatility.
The forex market also includes ‘exotic’ currency pairs. These pairs feature one major currency and one currency from a developing economy or region. The spread or gap between the ‘buy’ and ‘sell’ price of exotic pairs is typically wider than major and cross currency pairs, which means the market needs to move slightly further in your favour to get a profit. The biggest risk when trading forex pairs with wider spreads is incurring slippage. If you attempt to enter a trade at a certain buy or sell price, but the execution happens at a different price, this is slippage. With exotic pairs, it’s possible for there to be insufficient volume to take the buy or sell price you initially aimed for. Your order is then placed at the next available price, potentially more or less than you agreed. The most popular exotic currency pairs include GBP/ZAR, USD/HKD, NZD/SGD and EUR/TRY.
One of the most common ways forex traders monitor the forex markets and highlight trading opportunities is by using technical analysis. The goal of technical analysis is to use available price charts to view price action and pinpoint trends of support and resistance in the market. Support trends are visible where buyers view the price of a currency pair as undervalued, while resistance trends are visible where sellers view the price of a currency pair as overvalued. Both trends are powered by the market forces of supply and demand.
To become an effective forex trader using technical analysis, it’s a good idea to familiarise yourself with the following three charts used in forex trading:
Candlestick charts are the most common trading chart you’ll find on a forex trading platform. Candlesticks show the high-to-low range of a currency pair’s value using a red or green vertical line during a set timeframe, depending on the movement of the open and close prices. Think of these red lines as the ‘wick’ of the candlestick. The thicker bar, which is the candlestick itself, displays the opening and closing prices of the currency pair during the same timeframe.
A line chart is one of the simplest forex trading charts for beginners to use. Line charts are used to display the closing price of a currency pair from one timeframe to the next. If you want to quickly determine general patterns in the price movement of a currency pair, line charts can display periods of support and resistance in the blink of an eye.
Bar charts are another effective graph for plotting the opening and closing prices of a currency pair during a set timeframe. The bar itself demonstrates the highest and lowest traded price during each period. The marks to the left and right of each bar denote the opening and closing prices. That’s why bar charts are commonly used by forex traders to pinpoint the expansion or shrinking of price ranges on a specific currency pair.
Once you’ve selected the forex currency pair you wish to trade, you need to decide whether to ‘buy’ or ‘sell’ the pair.
You will choose to ‘buy’ the pair if:
If you were to buy EUR/USD at 1.13220, you would need that figure to rise to 1.13221 or higher than your entry position plus costs to be in profit.
This is known as ‘going long’ in trading terms. As long as the base currency’s value rises higher than your entry position plus costs, you will be in profit. For every pip that the base currency’s value falls beneath your entry position, you will be making a loss.
A pip stands for 'percentage in point' and is used almost exclusively in forex trading. Most forex pairs are quoted in terms of pips, which are calculated using the last decimal point. With most major currency pairs quoted to five decimal places, the smallest change is one-hundredth of a percent.
Let's say the EUR/USD rose from your entry at 1.13220 to 1.13245, you would have a profit of 25 pips, less your trading costs.
You will choose to ‘sell’ the pair if:
If you were to sell EUR/USD at 1.13220, you would need that figure to fall to 1.13219 or lower to be in profit.
This is known as ‘shorting’ in trading terms. Providing the base currency’s value falls lower than your entry position, you will be in profit. For every pip that the base currency’s value rises above your entry position, you will be making a loss.
When it comes to managing open positions on forex currency pairs, one way to limit your downside is to use one of two types of market orders – stop loss orders and limit orders.
You could also combine the two for the best possible risk management strategy when forex trading. For example, you could set your stop loss at a 1% loss of your overall risk and your take profit order at a 1% gain of your overall risk. This would equate to a risk-reward ratio of 1:1. In this instance, you would only need 50% of your trades to be profitable to break even.
When you trade the forex markets, you may be offered leverage. We also know this as trading ‘on margin’. Leverage means you only need to commit a small percentage of the overall trade value to open a position in the market.
Let’s say that you were offered 5:1 leverage on a currency pair. This means you would only need to deposit 20% of the overall value of the trade to execute a long or short position in the market.
It's important to remember that leverage carries a significant risk in all forms of financial trading, not just forex trading. After all, this is a concept that sees you ‘borrow’ capital from your broker to gain greater market exposure. As a beginner to the forex markets, it's a good idea to minimise your use of leverage wherever possible. Although your profits are magnified by your total exposure in the market, your losses are equally exaggerated.
Many brokers will offer a 3.3% margin on the major forex currency pairs. This means you only have to commit USD 3,300 to get exposure of USD 100,000 in the market. Although USD 3,300 may seem like a small amount to find, any losses will be incurred in line with the full value of your open position (USD 100,000).
If you do feel the need to use forex leverage, use the lowest multipliers available while you learn the ropes.
Most brokers will provide a host of risk management tools designed to help forex traders use leverage in the most sustainable way possible. Stop-loss orders can be entered into the market, closing out your position if the price moves against your entry position and hits the maximum loss you are willing to accept on an individual trade. A guaranteed stop-loss order is the most watertight of all stop-loss orders, as it commits to taking your loss at the specific price you want, regardless of any market volatility and subsequent slippage. Although you do pay a premium in charges to execute this order, it can offer genuine peace of mind.
With most forex currency pairs, you’ll see a holding cost applied to your trades. This will either be debited or credited to your trading account, based on the direction you are trading in.
Holding costs can be positive or negative, depending on the direction of your trade. Applicable holding rates for overnight forex positions are usually expressed as an annual percentage. In forex trading, the holding cost is classed as the ‘tom-next rate’ (tomorrow to next day). The rate is usually influenced by the difference in interest rate between the two currencies you’re trading.
Typically, those holding long (buy) positions in the forex market will have a holding cost credited to their account. Meanwhile, those holding short (sell) positions will have the holding cost debited from their account. This means if you plan to sell a position and leave it open at the end of a trading day, you’ll need to factor the holding costs into your trade. These holding costs are charged daily, so if you plan to hold an open position for several days or weeks, this should be factored into the overall cost of your trade.
As a forex trading novice, it can be hard to know where to begin with planning your trades in the market. Forex trading is considerably more speculative and riskier than investing. Forex traders enter the markets daily looking to extract short-term profits from the exchange, as opposed to building a long-term portfolio. As such, they rely on road-tested trading strategies that can be replicated daily when trends occur in the markets. Take a look at the four following approaches many seasoned forex traders use today:
Now that you are more familiar with the concept of forex trading and the dynamics that can influence the foreign exchange markets, be sure to keep the five following pointers in mind when starting on your forex journey:
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