How forex trading works and how to make money trading global currency pairs.
The global foreign exchange market is the largest financial market in the world. While it’s a highly liquid marketplace that basically enables traders to trade currency pairs round the clock, it can be confusing to new participants. Read on to find out more about global currency trading.
Disclaimer: Trading in financial instruments carries various risks, and you can lose more than your capital. This article may contain general advice. You should always seek professional advice when deciding if a product is right for you.
What is forex trading?
Foreign exchange trading (also known as forex, FX or currency trading) refers to exchanging currency with the goal of making a profit on the exchange rate between two currencies.
The forex market is large and complex and involves many different players, both institutional and individual. When talking about forex trading for individual traders, most people are referring to a set of instruments that are traded on the retail forex market, and which allow people to profit from currency movements without actually owning or holding foreign currency at any stage of the transaction.
Forex trades always involve two currencies. The two currencies involved in the transaction are known as currency pairs. Some examples of currency pairs are set out below:
The first currency in the currency pair is the base currency. The second currency is the quote currency, and indicates how much of that currency is required to buy one unit of the base currency. In a forex transaction, the investor is understood to be exchanging one currency for the other.
Rather than physically exchanging the two, however, traders lodge a ‘buy’ or ‘sell’ order with a broker. Forex brokers are basically intermediaries who facilitate trade by standing ready to accept either buy or sell orders on a range of currency pairs.
If the trader lodges a ‘buy’ order, they’re understood to be buying the base currency and simultaneously selling an equivalent amount of the quote currency. If they’re lodging a ‘sell’ order, they’re understood to be selling the base currency and buying an equivalent amount of the quote currency.
Once the exchange rate moves, the trader ends the trade (or ‘closes out their position’) by entering into an opposite transaction to the one they initially lodged. So if they initially lodged a ‘buy’ order for the currency pair, they’ll now lodge a ‘sell’ order, which reconciles the arrangement with the broker and ends the trade.
To learn more about currency pairs, visit our guide to the most widely traded currency pairs.
Is forex trading profitable?
The main way that you can realise a profit from forex trading is when the value of one currency changes relative to the other.
Say you lodge a ‘buy’ order (or in other words, purchase a quantity of the base currency while selling an equivalent amount of the quote currency). In that scenario, you stand to gain if the value of the base currency increases relative to the quote currency. Once you ‘close out your position’ (or in other words, sell the base currency while buying an equivalent amount of the quote currency), you get more of the quote currency back than you initially sold, because the exchange value of the base currency has gone up. You stand to profit off that difference.
Another of the attractions of forex trading for many is the fact it enables short-selling, which means you can profit when the exchange rate of a currency decreases. In this scenario, if you had an inkling that the value of the base currency was about to fall (relative to the quote currency), you would lodge a ‘sell’ order, which would simultaneously result in you ‘buying’ a quantity of the quote currency. Once the value of the base currency fell, you’d then place an order to ‘buy’ it back. Because the exchange rate has fallen, you can now buy it for less of the quote currency than you initially bought. Once again, you pocket the difference.
Movements in currency values tend to be quite small. Usually, a large initial investment is required to realise any gains from forex investments. Most consumer forex trading products are leveraged, meaning individual traders enter into a contract. They contribute a fraction of the total amount of the trade, and the broker contributes the rest. The trader stands to gain the value off any profit made from the full trade amount, meaning that significant profits can be realised from relatively low upfront investments. Equally, leveraged agreements between investor and broker mean any losses are magnified too.
How do I begin?
After deciding to trade in the forex market, you need to open a margin account with an initial deposit. The size of the initial deposit depends on the amount of leverage that’s been agreed with the broker, often expressed as a ratio. For example, the leverage ratio may be 50:1 or 100:1 or 200:1. The leverage ratio indicates the percentage you must have available as cash in the account. For an account with a 100:1 leverage ratio, you need to have a cash deposit of 1% of the total invested amount. Most trades are done on 100,000 units of currency, so if you want to trade $100,000, you would need to have a $1,000 deposit.
Case study: Michael decides to invest in forex
Michael has AUD$1500 to invest in the forex market. He decides to trade the currency pair EUR/AUD which is currently trading at 1.25*. This means that one Euro buys 1.25 Australian Dollars. Michael does some research and believes the Euro will rise even more, relative to the Australian dollar.
He opens a margin account with a forex broker offering a 1:100 leverage ratio. Leverage is the loan the broker provides you to trade forex. A leverage of 1:100 means Michael can borrow up to 100 times the amount of his initial deposit of AUD$1500. This also increases his profit potential up to 100 times. At the exchange rate of 1.25, Michael exchanges all of his AUD$150,000 and purchases EUR€120,000.
Michael is correct in his assumption. The Euro strengthens against the Australian dollar. It’s now trading at 1.26. He now exchanges his EUR€120,000 back into AUD, except now it’s worth AUD$151,200. As a result, Michael now has AUD$2200 in his trading account after returning the loan ($149,000) to the broker. Taking into account his initial deposit of $1500, this is a profit of $700.
Is forex trading safe?
The highly-leveraged nature of currency trading means that any profits realised from the trade can be magnified. Equally, so can the losses. If the currency you’ve invested in goes down in value instead of up, the potential losses you stand to make are amplified. Most investors put in place mitigation strategies to contain any losses. These measures include limiting the amount of capital that they invest in any one trade, plus issuing stop and limit orders.
Tips for getting started
- Start with one currency pair. You can trade in any currency pair. However, tracking the movements of multiple currencies can be difficult. It’s usually best to focus on one currency pair to start with.
- Choose your broker wisely. Consider which type of broker is appropriate for your situation. Many consumer banks and investment banks offer a forex brokerage service. Recently, more discount online brokers have started to appear, many of which are based overseas. Look closely at your options and the pros and cons of each.
- Have a strategy. Decide on your trading strategy. Make sure you have an appetite for conducting the analysis you need to confidently manage your trades.
- Try a demo account. Take advantage of a demo account. Many online forex traders offer demo or practice accounts, to provide you with the experience of making trades without needing to invest actual cash.
Choosing the right broker
Once you’ve decided to trade forex, the next step is to consider how you’ll go about executing the trades. One consideration is whether to use a broker to execute trades on your behalf, or an online discount forex broker.
In deciding to use a broker to execute trades, make sure you consider the following:
- Compliance. The forex market isn’t as regulated as other trading environments. Local forex brokers are issued licenses by the Australian Securities and Investment Commission (ASIC), but the same doesn’t apply to overseas brokers. However, there’s a requirement in most developed countries for forex brokers to be licensed. Your broker should list which regulators have issued the license, along with the registration number.
- Remuneration. Some brokers are paid via a commission structure, meaning they receive a percentage of any profit realised for a particular trade. Other brokers rely on the bid-ask spread for their earnings. The “spread” refers to the difference between the amount the market is prepared to pay for a particular currency (the bid) and the amount that currency is selling for on the market (the ask). The broker may make a profit from this difference or via a combination of the spread and a commission. It’s important to understand the remuneration scheme of your particular broker.
- Other considerations. Other factors include liquidity (how easy it is to move cash around and withdraw from your account), the size of the deposit required to set up your trading account, and any other fees and charges.
When comparing online forex trading platforms, there are a couple of key considerations to keep in mind:
- Platform features - to succeed in your investment strategy, you need to monitor your forex investments closely. Ensure that the trading platform is robust and reliable. It should come equipped with the latest tools to keep you informed about the status of your currency exchanges. Real-time data visualisations and live news feeds are key features to look out for.
- Customer service - make sure you read reviews of your preferred online forex trading platform. Get a feel for how queries and complaints are handled.
You can use our handy Forex Trading Finder to compare forex trading platforms side by side.
Benefits of forex trading, compared to other asset classes
Forex presents some distinct advantages over other asset classes, such as:
- 24-hour trade. Unlike most global exchanges, forex markets never close. This makes them an attractive option for part-time traders.
- Safety in numbers. The highly leveraged nature of forex trades arguably makes them a risky proposition. However, some argue that the market is a safer trading environment than others. The sheer size of the market makes it harder for single players to have undue influence, so it’s less prone to manipulation.
- Liquidity. The forex market is the most liquid of all financial markets. Because millions of transactions occur within the market each day, it’s generally easy to buy and sell currency as you wish.
See our guide to online trading and investing for a rundown of other products available for trade.
Deciding your forex trading strategy: Short-term versus long-term forex trading
As with other forms of trading, there are various strategies available to forex investors when they trade. Short-term strategies involve buying and selling currencies over shorter timeframes. A few different approaches are common within this strategy.
- Day trading. As in other types of securities, forex investors can opt for day trading. The aim is to repeatedly buy and sell currency pairs over the course of one day to realise many smaller gains. This has the advantage of minimising risk, as the potential losses from any one trade are less pronounced. Also, investors who employ this strategy don’t need to monitor their investments overnight, as all trades are typically closed out at day’s end.
- Scalping. This is a more extreme version of short-term trading. Scalping refers to the practice of holding currencies for very short intervals, with the intention of realising small incremental increases (known as “pips”) in the value of those currencies.
With a long-term forex trading strategy, investors are banking on a gradual upward trend in the value of one currency against another. They therefore hold their currency pair over a long period of time and ignore any intraday or intra-week volatility. This has the advantage of necessitating fewer transactions. A level of patience is required to enable the trader to weather daily fluctuations in the value of their currency holdings.
|Currency pair||The two currencies involved in a forex transaction. When you trade forex, you are understood to be exchanging one currency for another.|
|Base currency||The first currency quoted in a currency pair.|
|Quote currency||The second currency in a currency pair. The quote currency is always shown in the amount required to buy one unit of the base currency.|
|Pip||A “point in percentage”, or a fraction of a single unit of currency. It’s usually 0.0001 of a single unit, though this varies from currency to currency.|
|Bid||The amount the forex market is prepared to pay for your currency pair. If you purchased a particular currency pair, this would be the price to be mindful of.|
|Ask||The amount at which the forex market is ready to sell a particular currency pair.|
|Spread||The difference between the bid and the ask price of a particular currency.|
|Stop order||A price point you can set, which needs to be exceeded before any trades are executed. Essentially, it’s a directive you can issue, to start buying or selling a particular currency pair once it reaches a certain price.|
|Limit order||An order that sets the maximum or minimum price at which you are prepared to buy or sell a particular currency pair.|