A Beginner’s Guide To Forex Trading
Forex (foreign exchange) is a financial market where you can trade currencies. It is simply exchanging currency from one country for currency from another country, for any reason, which could include commercial reasons, or because of tourism. In light of international business, it is easier to conduct business with international clients by using their local currency.
After the accord at Bretton Woods in 1971, countries were able to float their currencies against each other for free. As a result, each country’s currency value varied against the others, hence the importance of foreign exchange services. Investment and commercial banks conduct foreign exchange services for their clients. However, individuals can also take advantage of opportunities available online, where they can trade in different currencies.
Larger financial institutions generally carry out most of the forex trading. However, this is also a good avenue for an individual investor. There are low fees and commissions involved in forex trading, and as a result, this opens opportunities for all types of investors, whether trading short term or long term.
Forex as a Hedge
Fluctuations in currency value pose a risk to people conducting business in foreign countries, especially when trading across borders. For this reason, the foreign exchange markets tend to hedge against the risk of currency fluctuation. This is done by assigning a fixed rate, within which forex transactions are carried out shortly.
You can buy and sell currencies in swap markets or forwards markets. In these markets, banks usually provide a fixed rate for a specific time. With this information, you can mitigate against any risk to your investment in good time.
To hedge against currency risk, you can also invest in the futures market. This, however, will depend on the amount of money you plan to trade, and the currency involved. Unlike the forwards market, futures are less liquid and are exchanged only in centralized trades. Forwards, on the other hand, are relatively decentralized, and you can trade them in an interbank system anywhere in the world.
Forex as Speculation
There are supply and demand factors that determine the value of the currency at a given point in time, including the strength of the economy, tourism, trade flows, prevailing interest rate, and politics. Because of these factors, the value of currencies from different countries will always fluctuate.
As an investor, you simply buy or sell one currency against the other, to bet against some of these factors. In doing so, your hope is for the currency you purchase to gain in value against the counterpart, or for the one you are selling to lose value.
Currency as an Asset Class
Currency must meet these two conditions to be considered an asset class:
It earns value in the exchange rate
When exchanged for another currency, you earn an interest rate difference
Why We Can Trade Currencies
Before the internet, trading in currencies was restricted to banking facilities only, instead of their clients. However, the banks soon came up with departments where they could trade in currency in their accounts. Soon after, hedge funds, large multinational corporations, and individuals of high net worth followed suit.
Thanks to the internet, individual traders have come to benefit from an easily accessible retail market. In this market, you can trade in foreign currency either through a broker or the banks.
Forex Trading Risks
There are complexities in forex trading, which naturally increase the risks for people who do not understand them. The interbank market, for example, is largely unregulated, making it a very risky venture for someone who is not knowledgeable. This, however, is but a perception.
To understand the nature of risk, you would first need to understand the difference between a centralized foreign exchange market and a decentralized one. From that analysis, you can then decide whether the regulation and costs thereof, are necessary.
The interbank market brings together a lot of banks all over the world, exchanging currency with one another. They determine the credit and sovereign risk acceptable to them, based on their internal audit processes, so they keep their trade as safe as possible. To protect the participating banks, the regulations that apply are determined by the industry they operate in locally.
The market pricing mechanism here depends on the forces of demand and supply. This is because the banks involved presenting their bids and offers for a specific currency. It is virtually impossible for a rogue trader to influence the value of a single currency in the market, because of the high volume of currency that is exchanged in the market.
The amount of money that is traded daily is estimated at $2 – $3 trillion. Bearing this in mind, not even a single country’s central bank can control the market without the coordination or cooperation of other countries’ central banks.
To increase transparency in the market, there are plans to create an Electronic Communication Network (ECN) where buyers and sellers will be able to trade in the centralized exchange too. It is a welcome step for retail traders because they will be able to enjoy centralized liquidity and competitive prices. Banks, on the other hand, can choose to remain in the decentralized market, because they do not have a problem with liquidity or competitive pricing.
Any person who trades directly with forex banks might be less exposed compared to a person who trades with smaller and unregulated forex brokers. This is because the unregulated brokers often re-quote their rates and they are also known to trade currencies against their customers.
Thus, the need for regulation is imminent, especially to protect the interests of the simple, retail trader with little or no knowledge of the forex market, who might have been misinformed about the sure profits in trading forex.
For the sophisticated and knowledgeable trader, however, this is a good opportunity for them to open trading accounts with larger brokers or any of the major banks. However, the most important rule of financial trading (caveat emptor) still applies – buyer beware!
Forex Trading Pros and Potential Cons
Having looked at the previous statements on possible broker risks, if you are still interested in forex trading, the following are the potential risks and benefits you should know about:
Pro: This market features the largest currency volume in the world, hence the highest liquidity. It is very easy to enter or exit your desired position in the major currencies, and transactions are effected in a fraction of a second.
Potential Con: Considering the ease with which you can enter or exit a trade, brokers, and banks exploit this by leveraging. This means that they can control large positions in the market with very little of their own money.
Leverages as high as 100:1 are possible and happen from time to time. Before you do this, however, you have to understand how this works, and the risks that leveraging will impose on your account.
To enjoy any benefits from leveraging, you must apply it cautiously. Lack of information, understanding or caution in leveraged trading can easily see you lose all your money on a single trade.
Pro: The forex market, unlike other financial markets, is open 24 hours, beginning in Australia and closing in New York. The major trading centers are Hong Kong, Sydney, London, Paris, Frankfurt, New York, Tokyo, and Singapore.
Potential Con: Currency trading is a macroeconomic venture. Before you start trading, you need to understand how the economies in different countries work. You need to understand how they are connected with each other, and the factors that determine the currency values against one another. This is, therefore, for someone with in-depth knowledge of international finance.
It might be easier for some traders to understand the economics of making trade decisions than understanding the nature of the closed environments in futures and stock trades, where knowledge of microeconomic factors is needed.
In forex trading, however, you do not necessarily need to be learned about the management skills of a company, their financial strength, opportunities and any other information regarding the industry.
Note: Historical price analysis plays a major role in analyzing and predicting the future price action – this is one of the basic factors in the technical analysis. The forex market operates 24 hours, so there is a lot of information at your disposal that can help you preempt future price values. For traders who use technical tools, this presents numerous opportunities.
How to Approach Forex Trading
For people who are experienced in the stock market trade, transitioning into forex trading will require a change in attitude, especially if you are diversifying your portfolio.
1. Forex trading is considered an opportunity for active traders. This is a good opportunity for brokers because they can earn a lot from minor movements within the market.
2. Forex trading is largely a leveraged trading platform. For this reason, therefore, traders can open accounts with much less money than they would need to hold in their account if they were to trade in the stock markets.
Currency trading is not just for yield or profit but is also a good way to build your stock portfolio. A good example is if you build your portfolio in a country where your stock has a high likelihood of appreciating in value, but there is a risk in currency value like in the US most recently, you can simply keep your portfolio, but short your dollar against any other currency like the Euro.
In this case, the value of your portfolio will increase, but at the same time, the negative effect of a weakening dollar will offset. This is, in fact, a good idea for an investor who lives in another country, who can easily transfer their profits to their country by converting it to their currency.
Another way of going about this is to study and understand the market, especially when trading with a long-term view. It is better for you when the currency trend offers a positive interest differential, which eventually guarantees you a good return on your investment and an appreciation in the currency value.
This is referred to as a carry trade. In essence, you can buy the US dollar against the Japanese Yen. Assuming the Japanese interest rate is 0.05% while the US interest rate is 4.75%, you can earn 4%.
If, on the other hand, the US dollar strengthens against the Yen, your best bet would be to buy the USD/JPY and hold, so that you can enjoy the interest yield and currency appreciation.
Be Careful in Volatile Markets
Trading activity in the forex markets is determined by volatility. However, you must exercise caution or risk losing everything. A volatile market moves sideways, growing spreads and making your orders slip.
When planning your trade strategy, make sure you factor in volatility.
As a beginner, you must accept the fact that anything is possible as soon as you enter the market. This also has the potential to affect your strategy.
A good example is the Swiss Franc crisis of January 2015, which in a matter of hours, killed the businesses of so many brokers and traders.
Stay Calm And Level Headed
Forex trading can be exciting. It can also be stressful. There are several setbacks that you might experience before you make it. Keep your emotions in check, lest you open a trade earlier than you should, or close one too late.
Beginners usually struggle because they do not understand the market well. Bearing this in mind, there are some trades that will always end in a loss. However, do not give up just yet. Wars are not won in one battle. Your overall performance will eventually determine how you perform in forex trading. This is why you should have a trading journal.
Is Forex The Right Choice For Me
If your source of funds is limited, swing trading or day trading in small amounts can help you make some good returns in the forex markets. If you have more money, or if you are doing this for the long-term, a carry trade would be a better investment idea.
Whichever the case, you have to learn to time your trade through the charts. Profitable trading is heavily leveraged against good timing. Just like any other trading activity, you must also understand your personality as a trader. This will help you avoid unnecessary impulse trading, which only yields losses in the long run.