How forex trading works (for total beginners)
Read our beginner's guide to forex trading, currency markets and the opportunities they offer to investors.
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At first hearing, forex trading seems pretty straightforward: you buy and sell foreign currencies to try to profit from movements in the exchange rate. But while forex trading may sound simple in theory, doing it successfully is much more complicated and difficult.
If you're new to the world of forex, you'll need to wrap your head around how currency markets work, how you can buy and sell currencies, and the risks involved. In this guide, we'll explain the basics of foreign exchange trading to help you decide whether it's the right investment for you.
What is forex trading?
When we say forex, we're not talking about the beer they drink in Queensland. Forex is short for "foreign exchange", and when you trade forex, you buy and sell foreign currency.
Forex traders speculate on movements in currency exchange rates. They do this by selling one currency to buy another.
Let's say you think the value of the Aussie dollar (AUD) is going to increase relative to the value of the US dollar (USD). If you sell some of your USD to buy AUD, and the market then moves in the direction you predicted, you make a profit. If the Aussie dollar falls in value against the US, you make a loss.
But it's a little more complicated than that.
How does forex trading work?
When you trade forex, you're not speculating on the value of one currency but two. As a result, forex is traded in currency pairs, for example AUD/USD or GBP/EUR.
The first currency listed in a pair is known as the base currency and the second is called the quote currency. So if you see AUD/USD listed as 0.7456, that means 1 AUD is worth 0.7456 USD.
Brokers list two prices for every currency pair. One is the buy (or ask) price, the other is the sell (or bid) price. If you think the AUD will increase in value against the USD, you buy the currency pair – this is known as going long. If you think the AUD will fall in value against the USD, you sell the pair – this is known as going short.
The most basic trades take place on the spot forex market and are settled based on the current exchange rate. But you can also trade forward and futures contracts, which allow you to exchange currency at an agreed-upon price and date in the future.
What factors affect forex markets?
If forex markets could be summed up in a Facebook relationship status, it'd definitely be "it's complicated". There are a number of factors that can affect the value of one currency compared to another, so predicting which way the exchange rate will head is far from easy.
Election results, interest rate and inflation changes, civil unrest, consumer sentiment, trade deals and so much more all have the potential to influence currency values. Some events can have a global impact, such as the Global Financial Crisis or the COVID-19 pandemic, while others can have much more localised effects. As an example, commodity prices, in particular the value of iron ore, have historically had a big impact on the value of the Australian dollar.
With this in mind, it's impossible to overstate the importance of doing your own research. Find out what specific factors commonly impact the value of different currencies, and keep up to date with the latest news to inform your trading decisions.
How much does forex trading cost?
Many online forex brokers proudly announce that they offer zero-commission trading, but this certainly doesn't mean that they offer their services for free.
The main cost you need to be aware of when trading forex is the spread. The spread is the difference between the buy and sell prices listed by a broker for a currency pair – in other words, the broker buys currency at one price and then sells it to you for a higher price. Think of the spread as a built-in transaction fee that applies every time you make a trade.
To further complicate matters, spreads are quoted in "pips", with pip standing for "percentage in point" or "price interest point". On most major currency pairs, 1 pip is equal to a 0.0001 price movement.
For example, multi-asset trading platform IC Markets offers competitive spreads across a host of major currency pairs. These include an average spread of 0.77 pips on the AUD/USD pair with a Standard Account or 0.17 pips with a Raw Spread Account. These spreads accurate at time of publishing: June 30, 2021.
So before choosing a broker, check out the minimum and average spreads it offers for a wide range of currency pairs.
There are other costs you'll need to be aware of, including account inactivity fees or interest charges when you leave a position open overnight. Check the fine print closely to find out what charges apply before you sign up for a trading account.
Why trade forex?
OK, now you know the basics of forex trading – but why should you consider it as an investment? Well, there are a few key reasons.
Many forex brokers allow you to trade with something called leverage, which allows you to place larger trades with a smaller initial investment. For example, if your broker offers 30:1 leverage, then when you deposit $1,000, you can effectively trade with $30,000. If the market moves in your favour, this allows you to magnify the profits you would earn.
Until recently, retail traders in Australia were able to access leverage of up to 500:1. However, ASIC imposed new laws that came into effect in March 2021 restricting the maximum leverage for retail traders of forex CFDs to 30:1. Meanwhile, regulations in the USA limit traders there to maximum leverage of 50:1.
Forex markets are also large and highly liquid, and because they're global, you don't need to worry about trading within specific market hours. While anyone wanting to buy shares on the ASX needs to trade within the exchange's trading hours, you can trade forex 24 hours a day, 5 days a week.
SPONSORED: How much does forex trading cost and what do terms like “spread” and “pips” mean? Find out here.Read more…
What are the risks?
Every type of investing comes with a certain level of risk. However, forex trading is considered highly risky, so it's not something you should try unless you're thoroughly aware of how the market works and the potential dangers involved.
The biggest risk you need to be aware of is the potential to lose more money than you deposit. While trading with leverage allows you to earn bigger profits, it also means any losses will be amplified. And even though you can open a trade with a small amount of money, you're still responsible for the full value of the trade.
Exchange rates are also constantly fluctuating, and the many factors that affect global markets can make it difficult to predict which direction prices will go. And with some dodgy brokers and online scams out there, it's vital that you search for a fully regulated broker.
If you're thinking of trading forex, it's a good idea to open a demo account with a reputable online broker. For example, you can open a free demo account with IC Markets to practise forex trading, experimenting with a virtual balance before trading with the real thing. Along with in-depth research and a careful approach to risk management, this will improve your chances of trading successfully.
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