Beginner’s Guide to Trading the Forex Markets
What is the foreign exchange market?
The foreign exchange market – or forex – is all about buying and selling currencies.
And what is an exchange rate?
It’s the rate at which one country’s currency can be exchanged for another country’s currency. (Simply, its how much one currency is worth compared to another one). If the UK exchange rate for US dollars was $2 it means you could exchange £1 for $2. So £1 is worth $2 – and $1 is worth 50p.
What happens in the forex?
Billions of pounds worth of trading is done on the forex every day – it’s the largest financial market in the world. Traders buy a currency and aim to sell it when the currency is worth more.
How can a currency change in value?
Many things can affect an exchange rate including the state of a country’s economy, interest rates and inflation.
But regardless of the state of the economy, a pound is still worth a pound when I’m in the shops. So how can a pound be worth less than it was worth yesterday?
Your pound coin might get you the same amount of carrots at the greengrocer’s but we’re talking about how much that pound is worth compared to another country’s currency. Let’s say that interest rates had fallen in the UK and, as a result, the pound had weakened against the dollar. Your pound coin could buy the same amount of carrots as it did yesterday but it would now buy you less dollars.
What’s the first thing I need to know about a forex trade?
Currencies in the forex are always in pairs. When you make a trade you are buying one of the currencies and at the same time you are automatically selling the currency that it’s paired with.
Why are they in pairs?
In the UK, your pound is always worth 100 pennies but the forex is about how much that pound is worth compared to another currency. For example, you might want to know how strong the pound is compared to the euro. If you don’t trade in pairs you wouldn’t be measuring your pound against anything. It would be like saying that West Brom were going to beat Aston Villa – but then only allowing West Brom players on the pitch. You can’t measure which team is the strongest if you’ve only got one team playing.
So does each currency just have one pair?
No. If you wanted to speculate on the euro you could, for example, trade it against the US dollar, the pound or the yen. See our Forex Comparison Table to see what markets are available.
How do I know how much a currency is worth?
By looking at the forex quote. Here’s an example of a quote using sterling and US dollars…. GBP/USD = 2. The first thing to learn is that the first currency is called the ‘base currency’. It’s called that because it’s what the transaction is based on. The second currency is known as the ‘counter currency’ or the ‘quote currency’. GBP/USD = 2….tells us how much of the quote currency (dollars) we could get for one unit of the base currency (pounds). So £1 is worth the same as $2.
What do I do if I think the base currency will strengthen against the quote currency?
Then you buy the base currency. Using the above example, you would buy pounds (which means you would automatically be selling dollars at the same time). This kind of trade is also known as ‘going long’ on pounds. You would complete the trade after you’d sold back the pounds. The aim is to sell after the pound had strengthened against the dollar.
What do I do if I think the base currency will weaken against the quote currency?
Then you’d sell the base currency (which means you would automatically be buying its pair at the same time). This type of trade is called ‘going short’ on the base currency. You would complete this trade by buying back your short. The intention here is to, for example, buy back the pounds after they had weakened against the dollar. If you think it sounds a bit odd to sell pounds before you buy them you can think about it the other way – ie that you had bought dollars and then sold them.
Using our example of GBP/USD = 2, when you sell the base currency you are ‘going short’ on pounds and ‘going long’ on dollars. And vice-versa.
The currency quotes I’ve seen have two figures. Why is that?
Our example above was just to keep things simple to start with. There will always be two prices quoted, like so….GBP/USD = 2-2.05. The first price is the ‘bid price’ and the second price is the ‘ask price’.
And what exactly is the bid price and the ask price?
The ask price is what you buy the base currency at and the bid price is how much you sell the base currency at. So in the above example you would buy pounds at $2.05 and sell them at $2. The difference between the two prices is what is called ‘the spread’ or the ‘bid-ask spread’.
What is the spread for?
It’s there so the dealer can make a commission on the trade. You always buy at the higher price (the ask price) and sell at the lower price (the bid price). So when you close the trade you have paid the spread. The wider the spread, the more commission for the broker. The Forex Comparison Table will allow you to see which broker has the smallest and biggest spread.
So how does the spread work in practice?
Well let’s say you bought the pounds and sold them back straight away. You bought at the ask price of $2.05 and sold at the bid price of $2 – so you’re down by five cents. Even though it was a quick trade the dealer has made the commission. You will always end up paying the spread – even when you win money.
What are pips?
A pip is the smallest unit in a forex quote. Currencies are usually measured against each other to four decimal places so a typical quote might look like this…GBP/USD = 2.0005/2.0010. If the pound weakened and the quote changed to GBP/USD = 2.0000/2.0005 it would have moved by five pips. How much money you win or lose will depend on how many pips the quote has changed by. The yen is usually calculated to two decimal places but a pip still refers to the last decimal place.
So how would I make money on a forex trade?
Here’s an example of a winning trade. Let’s say the forex quote was GBP/USD = 2.0000/2.0005. You are expecting the pound to strengthen against the dollar so you ‘go long’ by buying 500 pounds. You must pay the ask price of $2.0005 per pound so your 500 pounds costs you $1,000.25. Let’s say the pound has increased by 100 pips and you decide to complete the trade. The new currency quote looks like this… GBP/USD = 2.0100/2.0105. You sell your 500 pounds at the new bid price of $2.0100 per pound, so you sell them for $1,005 – a profit of $4.75.
Okay but that didn’t seem like a big return.
Currencies don’t normally move by huge amounts during a day’s trading so people usually deal in big sums of money.
And how would I lose money on a trade?
Let’s take the above example again but say that you thought the pound would weaken against the dollar. You ‘went short’ by selling 500 pounds – and simultaneously buying dollars. You sold your pounds at the bid price of $2 per pound – that’s a total of $1,000 – and bought the pounds at the new ask price of $2.0105. Five hundred pounds at $2.0105 per pound means you bought the pounds for $1007.50 after you sold them for $1,000 – a loss of $7.50.
What if I’m still a bit confused?
You can practice trading on the forex market with on-line simulations.
How long can I hold a trade open?
That’s up to you. Many trades are made in a single day but if you don’t close the trade it will be rolled over to the following day. If it is rolled over then you need to be aware of interest rates. Let’s take a currency pair of the yen and the US dollar. Let’s say the interest rate in the US is 5% and it’s 2% in Japan. If you had bought US dollars your account would be credited overnight because the interest rates are higher in the US. If you had bought yen then your account would be debited overnight.
The amount of money you get (or lose) depends on the differential between the two sets of interest rates and how much money you are trading with. You will pay or earn a rollover interest rate every time the trade is rolled over to the next day.
If I want to buy 100,000 euros, do I have to pay for them up front?
No. But you will need to have a deposit. That deposit is called a ‘margin’ and the trade is called ‘trading on a margin’. Basically, it’s like a store or a bank giving you credit. You could, for example, be on a 1% (or a 100-1) margin which means that for every pound of your deposit you could make a trade worth £100. So a deposit of £1,000 means you could make a trade worth £100,000. The way that you can use relatively small amounts of money to make big trades (and win – or lose – big money) is called leverage.
Which currencies can I deal in?
The majority of trades are done with ‘major’ currencies – the US dollar, the pound, the euro, the yen, the Swiss franc, the Canadian dollar and the Australian dollar – but you can also trade with many other currencies.
When can I make trades?
The forex is open 24 hours a day through the week. In the UK it opens on Sunday night and closes on Friday night. The market is said to “follow the sun”; trading starts when the Australian market opens and ceases when the New York market closes. The time difference means that Monday morning in Australia is still Sunday night in the UK which is why the market opens in the UK on Sunday night. Check out the comparison table to see which brokers offer 24 hour markets.
Does that mean you can trade for longer if you live in Australia rather than the UK?
No. You have exactly the same amount of time. The market opens and closes at precisely the same moments wherever you are in the world. It’s just that Monday morning in Australia just happens to be Sunday night in the UK. Similarly, Friday afternoon in the US happens to be Saturday morning in Australia – which is when trading Down Under stops for the week.
I’ve gone long on the euro against the US dollar. But the euro is losing ground on the yen. Am I in trouble?
Not necessarily. A currency can be gaining and losing at the same time. Put simply, the euro could be weakening against the yen but simultaneously strengthening against the dollar.
Let’s say I can’t keep a close eye on a trade all day, are there ways to ensure that I can still complete a trade when I’ve made enough profit – or bail out when things have gone against me?
Yes. A ‘stop loss order’ will close the trade when losses reach a certain level. And a ‘take profit order’ closes the deal when your profit hits your target.
Will all the brokers give the same forex quotes?
No. There will be different prices and different spreads.
What’s a trendline?
This is a line in a graph that shows how the currencies in a currency pair are faring against each other. It won’t show the day to day blips but it will show the general picture.
What is scalping?
This is very quick trading – opening and closing a trade in the space of a few seconds – to take advantage of small changes in the market. It is a controversial practice.
Do I have to make forex trading decisions for myself?
No. You can rely on brokers – or software.
How do I get started?
There are numerous brokers with whom you can start an online account.