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How Does Fоrеx Trаdіng Work?

FX Scouts By Jeffrey Cammack Updated: February 27, 2020
What is Forex trading?

People find their ways to Forex trading through several different paths. Unlike buying equities or bonds, Forex trading requires considerably smaller investment amounts, which makes it more accessible to any individual.

What is a Forex Trader?

An individual Forex trader speculates on the value of currencies in a practice that is reminiscent of buying and selling. Most of the time, a Forex trader is a private individual, called a retail trader, trading with their capital. Still, corporations and investment firms or banks also trade Forex alongside retail traders on the Forex market.

What is the Forex Market?

The Forex market is basically a currency exchange, and the largest decentralised financial market in the world, with 6,595 Billion USD turnover daily. That is a 30.2% turnover increase from 2016 and a 532% increase since 2001, confirming the Forex market as a major investing mechanism for Australians and other retail traders around the world.

With the advent of retail trading in the early 1990s and the introduction of leveraged trading, the Forex market is now accessible to anyone with a few hundred dollars and a computer.  Forex brokers who act as a conduit to this market are regulated by the Australian Securities and Investments Commission (ASIC) in Australia and other major regulators in other financial centres.

Unlike the stock market, the Forex market is open 24 hours a day 5 days a week, opening on Monday at 9 am Australian Eastern Time, and closing on Saturday at 8 am Australian Eastern Time.  Each 24-hour period is a cycle made up into three main sessions which coincide with opening and closing of the major stock exchanges in the region.

While currency value is not directly connected to the value of company stock, it is during these hours that economic news is made and market participants are most active, generating the liquidity needed to make effective trades. 

The market sessions are:

  • The Asia Session: The quietest of the sessions by trading volume, the Asia session is first to open. 
  • The European Session: Opening with the London exchange, this is the largest session by trading volume, where market participants trading the surrounding sessions will try and catch the open or the close.
  • The US Session: Starting with the opening of the NYSE, the US session is home to the United States Dollar (USD) and the most traded currency in the world, the currency markets can make big moves during this session and especially significant movements during major economic reports.

It closes for a weekend period when trading will be paused and then resumed the moment the market opens again.

Currency as an Asset Class

There are many different CFD asset classes, of which currencies or Forex is one. Currency CFDs are unique in that currencies are traded in pairs, meaning that as you buy one side of the pair, you are selling the other.

When trading AUD/USD, the trader is buying Australian Dollars and selling US Dollars simultaneously.

What currencies can you trade?

All currencies in the world can be traded, but there is a more standard set of currencies that most brokers offer and an even smaller set that most traders focus on because they are liquid enough to turn a profit.

Currency pairs are split into three groups based on how much market liquidity exists, called majors, the minors and the crosses.

The Major Pairs

The major currency pairs are most commonly traded because they are the most volatile and they are highly liquid.  The major pairs all include the USD as part of the pair.

Major Currency Pairs

The Minor Pairs

The minor currency pairs are not a fixed list like the majors.  They are generally currency pairs that do not include the USD.  Some examples might be:

  • EUR/JPY – Euro / Japanese Yen
  • GBP/AUD – British Pound / Australian Dollar
  • AUD/NZD – Australian Dollar / New Zealand Dollar

The Exotic Pairs

The final group are called exotics and are generally pairs containing currencies from a well-developed economy and a developing economy.  Examples could be:

  • EUR/BRL – Euro / Brazilian Real
  • GBP/ZAR – British Pound / South African Rand
  • AUD/MYR – Australian Dollar / Malaysian Ringgit

Understanding Price Change & Pips

Currency value change is measured in pips. A pip, or Percentage in Point, represents the smallest unit of price change in any given currency pair. A pip is measured at the 4th decimal place, meaning a pip as a value of a 1000th of a %.

Some brokers will quote you prices in five decimal places, where the 5th decimal is called a pipet or fractional pip.

Leverage in Forex Trading

Forex and other CFDs are leveraged products.  To generate larger profits from trading Forex, traders will borrow money to invest using a mechanism called leverage, as the movements in the Forex market are too small to make a significant profit from with a small account balance.

Leverage

Leverage is either offered by your broker or more commonly through a third-party liquidity provider. Depending on the broker, the country of residence and the experience of the trader, some brokers can make more leverage available.  

While leverage can amplify profits, it will also amplify losses.  In a leveraged trade, the capital borrowed must be returned after the trade is closed.  If the trade is closed at a loss, the remainder of the lost funds will be collected from the trader’s account balance.

High levels of leverage are the primary reason for large losses by retail traders.  A June 2018 study by ASIC showed that “63% of clients who trade CFD over currency pairs lose money” and promoted further investigations into leverage by the regulator.  It also noted that “Complex product features, such as the high leverage offered in CFDs—as high as 500-to-1 for foreign exchange CFDs—or the high likelihood of cumulative losses inherent in binary options, have contributed to retail clients’ financial losses and can often be misaligned with their needs, expectations and understanding“.

Following these findings, ASIC released a Product intervention: OTC binary options and CFDs in August 2019, which has will “impose conditions on the issue and distribution of OTC CFDs to retail clients including imposing leverage limits“.  Further information is expected in October 2019, but the likely outcome will be a restriction in leverage offered to retail traders who have not applied for professional status.

The mechanics of trading Forex

Currency Pairs

The currency pair is the asset in the trade, and thus the first consideration before opening up a trade. The major pairs will be more liquid with more favourable trading conditions, while the crosses will be less liquid and more difficult to generate a profit.

Simultaneous Buying & Selling

Forex is short for Foreign Exchange, and it is the word exchange is well suited for an asset class where there are two sides. In a Forex transaction, the trader is buying one side of the pair and selling the other in two simultaneous transactions.

It is these simultaneous translations that make Forex trading unique. When we open a long trade of AUD/USD we are buying Australian Dollars and simultaneously selling US Dollars, or if we short the currency pair, we are buying US Dollars and selling Australian Dollars simultaneously.

Whatever the direction of the trade, Forex is always traded in pairs of two currencies with two separate transactions.

Going Long or Going Short

In Forex trading, a trader can profit from either the rising or falling value of a currency pair.

When we open a long position on AUD/USD, where we are buying Australian Dollars and would profit should the value of the AUD increase, and we sell the AUD to close the trade.

However, a short position on the same AUD/USD pair would mean that we are buying USD and should the USD gain value, making the AUD less valuable by comparison, we would close the position by selling the USD and making a profit.

The trader needs to choose a long or short direction for the trade at the time the position is opened.

Volume and Size of Trade

The size of a trade is the amount of capital invested in a single trade.  Risk management tells us that trade size should always be connected to relative certainty of winning the trade, and basic trading guidelines.  

As a rule of thumb, traders should never risk more than 2% of their account balance in a single trade.  If a trader has an account balance of 500 AUD, then never risk more than 500 AUD x 0.02 = 10 AUD in a single trade.

2% Per Trade

While it is tempting for novice traders to think of trade size in Dollar amounts, experienced traders will advise considering trade size as a percentage of your account balance.  Always keep it below 2%.

Quotes & spreads

In Forex trading, the first currency in the pair is called the base currency, while the second currency in the pair is called quote currency.

base-quote-currency

Currency pairs are split into three groups based on how much market liquidity exists.  The more investors who are actively participating in trading a currency pair, the more liquidity will be exhibited.

Trade Profit and Loss

Here are two trading examples, both with the AUDUSD pair, where one is a long trade, and the other is a short trade.

A trade profit is calculated as the change in price, multiplied by the closing price, multiplied by the size of the trade (in units).  For more of an in depth look at how to calculate profit and loss.

Long Trade Example

Going long on AUDUSD means that for the trade to be profitable, the value of the AUD would need to increase. In this example, the AUD does increase slightly over the minutes the trade is open. The facts of our trade:

  • Account Currency: USD
  • Opening price: 0.6596 ‘
  • Closing price: 0.6604
  • Change in price: 0.0008 (8 pips)
  • Volume: 10,000 USD (0.1 Lots)
  • Profit = 8 USD

Since the trader predicted the market correctly and sold AUD at a higher price, the trade is closed with a profit of 8 USD.

Short Trade Example

Going short on the same AUDUSD trade, would require that the USD would increase in value for the trade to be profitable. When we sell the USD at a higher value a profit is made.

  • Account Currency: USD
  • Opening price: 0.6596
  • Closing price: 0.6573
  • Change in price: 0.0023 (23 pips)
  • Volume: 10,000 USD (0.1 Lots)
  • Profit = 23 USD

In this trade, the AUDUSD moved 0.0023 (23 pips) in a negative direction meaning that our short made a 23 USD profit.

Unrealised Profit/Loss

While a position is open, the trader will monitor the progress, looking for the best possible time to close the position for the best profit. Forex trading platforms like MT4, MT5 and cTrader continually display Unrealised Profit.

Unrealised profit is the realtime profit should the position be closed at any particular point, and as the currency value changes, so does the unrealised profit. The final profit is only calculated once the position is closed and all commissions paid.

Quotes and Spreads

The majority of Forex brokers largely make their money through the differences between the buy and sell prices in a currency pair. The difference between these two prices is called the spread and is measured in pips.

AUD/USD One Pip

While market maker brokers or instant execution account types may have fixed spreads, ECN brokers will have variable spreads dependent on the liquidity available at the time of opening the trade.

Rollover and interest

Although the Forex markets are open 24 hours a day, forex positions held open at 5 pm EST (9 am Eastern Australia Time) will be charged interest. Rollover also happens on weekends even though the market is closed, so trades kept over the weekend will either be charged or accrue interest daily.

Interest is calculated at a daily rate based on each of the currencies in the pair. For long positions, it is the bid interest rate subtract the quote interest rate. If the quote interest rate is higher than the bid interest rate, the rollover interest will be a gain instead of a loss.

The Pros and Cons of Forex Trading

Forex trading is an attractive investment to many entry-level traders. Forex trading may fit the knowledge and skill of some traders; however, generally, newcomers need to understand both the advantages and disadvantages of Forex trading as an investment mechanism.

Pros

The Forex market is open 24 hours a day, five days a week. Traders who monitor the stock market for trading opportunities will have a smaller time window to do so, which can clash with other commitments. As the currency market is open 24 hours a day, this allows Forex traders to set aside time either in the morning or evening to trade.

By comparison, the Forex market is easier to access than the other financial markets. One significant benefit is that the trading platform, the software where you place your trades, and the markets data feeds are free. Upon signing up with a broker and installing the software, much of the setup is complete.

The world of Forex trading is also significantly smaller than the world of stocks and bonds. If a trader opens a stock trading account, there are thousands of shares of companies available to analyse from numerous exchanges around the world. These countless options can be distracting for anyone trying to open an account, find and make an investment.

Regardless of the Forex broker, there will be the same limited set of currencies to trade. There will be the eight major pairs, some crosses and a few exotics, and the total number rarely passes 60. This limitation, and the fact that most traders will mainly trade the eight majors, means there is less distraction for newcomers by providing a more singular focus.

The initial minimum deposits Forex trading and the commission fees in making trades are considerably less than those of the other asset classes. Stock trading commissions can result in between 50 to 100 USD to open or close a trade, or a flat fee of 1-2% of the account balance annually.

By comparison, CFD brokers will charge the spread, or a narrower spread plus a commission based on the volume traded. Unless a client is trading institutional volumes, commissions can not reach 50 USD to open and another 50 USD to close a trade. Besides, the minimum deposit required with some brokers is 5 USD, but 200 USD is recommended to prevent margin calls.

Cons

Most retail traders lose money. If you have read a little about Forex trading online, you should have seen big banners that read something like this:

Trading Forex and CFDs is not suitable for all investors and comes with a high risk of losing money rapidly due to leverage. 75-90% of retail investors lose money trading these products. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Some newcomer Forex traders start with an unrealistic set of expectations and hope that Forex trading will be a part of their rags to riches story. I believe that this expectation is founded in that trading is so easily accessible, and seems so simple that they should be able to make a profit.

Nothing is farther from the truth. Forex trading is highly complex, made so because of the number and size of some of the market players. The market is not only being affected by other retail traders but the big banks, government policymakers and unannounced news events where each can cause significant fluctuations in the market.

Trading generates a lot of emotion that can quickly overtake a trader and alter their trading style and exhaust their account balance. Much has been written about the psychology of trading, but a couple of the main points are worth highlighting as downside risks for any Forex traders. Trading psychology mainly affects equity management skills. Overtrading and over-leveraging are two commons downsides of Forex trading.

A trader should go into a trading session with a profit target. When that profit target is reached, the responsible trader closes down for the day and moves the profit into their trading wallet. A common mistake is to continue trading, believing that this streak of luck will continue and additional gains could be made in an extended session. This practice is called overtrading and can lead to losses and frustration. Always stick to the plan and stay disciplined.

Over-leveraging is a lack of risk management discipline. A disciplined trader would recognise that a 20:1 leverage is appropriate for a trade. In contrast, the less disciplined trader may convince themselves that luck or additional knowledge is going to benefit them and will take a 100:1 leverage. While the trader may be correct this one time, this break from disciplined risk management through over-leveraging will have adverse effects on the account balance in the future.

The new Forex trader should have the correct expectations and trader psychology for this asset class. Forex trading is highly complex, most retail traders lose, and those who are disciplined and take time to learn the craft have a better chance to profit.

Forex Trading Risks

Trading CFDs comes with significant risk, and if you are concerned about losing any the money that you are depositing, then don’t trade Forex.  Forex trading is not a get rich quick scheme and requires dedication and study.

As a trader, you will need to develop a trading plan, understand risk management, and have a goal with what you want to achieve.  Don’t start depositing money until you are sure you want to give this a good shot. Every trader loses trades that they were sure they would win, so expect the unexpected and have a plan for when your trades fail.

How to become a successful trader

To be successful, you will need to learn the basics of trading, invest time into doing analysis and stay up-to-date with international news events.  You will also need to cultivate your self-discipline.  Trading successfully is difficult, and it requires focus and a strategy.

There are three main strategies for analysis in trading:

  1. Trading the fundamentals – trade based on analysis of news events that affect markets. An excellent example of this would be trading the Non-Farm Payroll Report from the USA or trading the COT Report.
  2. Trading the technical charts – trading by following charts and trading the patterns.  If you are going to be a technical trader, you should understand trends and momentum in the market, as well as pivot points where the market makes a sudden turn.
  3. Trading the market sentiment – Trading by watching what the traders and banks are doing, and following them or going against them.

Education is Important

Forex trading takes years to perfect, and most beginner retail traders are going to lose money on the live markets.

Getting Started

Beginners should always start with a demo account.  A demo account is a play-money account with real market data where novice traders can practice in a hands-on environment.  Beginner traders should also start by learning some of the basic strategies of Forex trading, and studying examples of trades.  Regardless of if the trader is opening a demo or a live account, the trader will need to identify a Forex broker with which to open an account.

  1. To start trading, you need to sign up with the Forex broker of your choice.  When picking a broker you will need to look at the minimum deposit expected, the leverage available to traders, the minimum spread, and the regulation.  Together, these will help you determine the right broker for you. After completing your details, the broker may call to introduce themselves and see if they can answer any questions for you.  They will also use this opportunity to explain a process called KYC or “Know Your Customer” that is a regulatory requirement to prevent money laundering.
  2. To complete your KYC requirements, you will need to provide a copy of a national identity document and a proof of residence.  As soon as these documents are completed, you will be able to finalize your account.

If you are ready for a live trading account, it will be time to make a deposit.  Some Forex brokers will let you start trading with as little as 5 AUD in your account.  A deposit of at least 200 AUD is recommended because your balance needs to be able to cover any unrealised losses on your account, which may not be possible with a smaller balance. In addition, if you are planning on using leverage in your trades, the account balance will be used as collateral.  If you don’t have ample funds in your account protect against the full amount of any potential loss, the broker will close your trade early in what is called a margin call.

Resources

Resources used for inspiration, research, data and quotes for this piece are listed below.

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Trading Forex and CFDs is not suitable for all investors and comes with a high risk of losing money rapidly due to leverage. 75-90% of retail investors lose money trading these products. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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