Figuring out what is forex trading and how does it work can be frustrating. Still, you’ve got to start somewhere. Welcome to somewhere.
Congratulations! You have just found something few forex trading beginners ever ﬁnd. Here is a practical, well-detailed, step-by-step guide to understanding WHAT is forex and HOW forex trading works.
There is quite a bit you should know before you dive in. If you want to trade forex right away, here is a quick guide.
How to Trade Forex - Quick Guide
- Open a Forex trading account. Provide personal information, including name, address, and tax ID number, and some financial background information. You will also have to answer some questions about your finances and investment as part of “know your client” compliance.
- Fund your Forex account. Funding is typically accomplished by bank transfer, wire transfer, debit card (after verification) and other available methods in your country. With CAPEX.com you can begin forex trading with as little as $100.
- Research currency pairs and trade setups. Utilize technical analysis to determine your timing points and price levels for trade entry and exit. Trade size and trade management are very important to achieve the preservation of capital on losing trades and growth of capital on profitable ones.
- Size up your first forex trade. Understand how much capital you have, as well as the specific leverage available for your chosen currency pair. Since leverage in forex trading can be up to 30:1, it is critical to understand how much capital you will have at risk on any trade.
- Monitor and manage your position. Once the position has been established, you should have a clear understanding of your position and, through research prior to trading, have clear exit points for either taking profits or taking a loss on your trade.
For more info about how to trade forex, you can discover everything you need to know in this forex trading for beginners comprehensive guide.
What is Forex?
FOREX, also known as the FX market, Foreign Exchange Market, or Currency Market, is a global decentralized market for the trading of currencies. This includes all aspects of buying, selling, and exchanging currencies at current or determined prices.
The foreign exchange market assists international trade and investments by enabling currency conversion. It also supports speculations on the floating exchange rate and interest rate between two currencies.
Foreign exchange (forex) prices are the product of the movement of one currency relative to another. For example, when people talk about the price of the Euro (EUR), they are referring to the EUR value relative to another currency, depending on which pair they are considering (e.g., EUR/USD).
The forex market is the largest financial market in the world, with $6.6 trillion traded every day.
In its most basic sense, the forex market has been around for centuries. People have always exchanged or bartered goods and currencies to purchase goods and services. However, the forex market, as we understand it today, is a modern invention.
After the accord at Bretton Woods in 1971, more currencies were allowed to float freely against one another. The values of individual currencies vary based on multiple factors, including demand and circulation and they are monitored by foreign exchange trading services.
The amount of currency converted every day can make the price movements of some currencies extremely volatile. It is this volatility that can make forex trading so attractive: bringing about a greater chance of high profits, while also increasing the risk of great losses.
Commercial and investment banks conduct most of the trading in the forex markets on behalf of their clients, but there are also speculative opportunities for trading one currency against another for professional and individual investors.
How Forex Trading Works
Forex trading, also known as foreign exchange trading, currency trading or FX trading is the simultaneous buying of one currency and selling another for the aim of earning a profit.
Forex Trading includes all speculative trades or capitalizing on floating exchange rate between two currencies (e.g., EUR/USD) by either:
- Buying low and selling high a currency pair anticipating that the base currency (the one on the left) will appreciate against the counter currency (the one on the right).
- Selling high and buying low a pair anticipating that the base currency (the one on the left) will depreciate against the counter currency (the one on the right).
In either case, the forex trader could earn an amount of money on the difference between the opening and closing price of the trade. However, if the currency pair will move in the opposite direction the trader could suffer a loss.
Most professional and individual investors will not plan to take delivery of the currency itself; instead, they make predictions to take advantage of the exchange rate changes and/or interest rate differential between two currencies.
Unlike stock trading, forex trading does not take place on exchanges but directly between two parties, in an over-the-counter (OTC) market. The forex market is run by a global network of banks, spread across four major forex trading centres in different time zones: London, New York, Sydney, and Tokyo. Because there is no central location, you can trade forex 24 hours a day.
Traditionally, a lot of forex transactions have been made via banks, but with the rise of online trading, you can take a buy or sell position on the currency pairs using derivatives like CFD (Contract for Differences).
CFD trading is leveraged, enabling you to open a position for just a fraction of the full value of the trade. By using a leverage of 1:30, every $1 you invest is worth $30, so with your $1000 margin, you can open a $30,000 deal.
Unlike non-leveraged products, you don’t take ownership of the asset, but take a position on whether you think the market will rise or fall in value.
Although leveraged products can magnify your profits, they can also magnify losses if the market moves against you.
The Basics of Forex Trading for Beginners
The best way to get started on the forex journey is to learn its terminology. Here are the basics of forex trading for beginners:
1. What is a base and quote currency?
A base currency is the first currency listed in a forex pair, while the second currency is called the quote currency. Forex trading always involves selling one currency to buy another, which is why it is quoted in pairs – the price of a forex pair is how much one unit of the base currency is worth in the quote currency.
Each currency in the pair is listed as a three-letter code, which tends to be formed of two letters that stand for the region, and one standing for the currency itself. For example, EUR/USD is a currency pair that involves buying the Euro and selling the US dollar.
So, in the example below, EUR is the base currency and USD is the quote currency. If EUR/USD is trading at 1.11875, then one Eur is worth 1.11875 dollars.
This forex price quote means you could do one of the following:
- Buy the EURUSD pair at the (higher) ASK price.
That means: You buy Euros and pay for them by selling dollars, paying the higher ask price. For every 1 EUR you buy, you’re selling $1.11885 USD, regardless of whether your account is funded with JPY, GBP, EUR, and so on. Amounts are converted as needed.
- Sell the EURUSD pair at the (lower) BID price.
That means: You sell Euros and get U.S. dollars in exchange for them at the lower sell or bid price. For every 1 EUR you sell, you are being paid $1.11875 USD.
In general, it means that you buy at a higher price and sell at a lower price.
2. What is traded in forex?
Three types of currency pairs are available, categorized by the size of their average trading volume or liquidity:
- The majors
- The minors
- The exotic
The most liquid pairs, that is, those that have the highest average daily trading volume (and lowest risk of slippage), are generally some combination of the USD and one of the other majors, that is, the EUR, JPY, GBP, Swiss Franc (CHF), CAD, NZD, and the Australian Dollar (AUD). Speciﬁcally, here are the major currency pairs, ranked by trading volume: EURUSD, USDJPY, GBPUSD, AUDUSD, USDCHF, USDCAD, and NZDUSD.
The minor-currency pairs are pairs of major currencies that don’t include the USD. By removing the USD’s direct inﬂuence, the minor currencies reveal much about other currencies’ strengths. The most popular are EurGbp, EurJpy, or GbpJpy.
The exotic currency pairs are those comprised of at least one emerging market currency. Though these can be proﬁtable given the growth in some emerging market economies, they are less liquid, usually much more volatile, and traded in much lower volumes Examples of the exotics include USDZAR, USDTRY, USDMXN.
3. What is the spread in forex trading?
The spread is the difference between the buy and sell prices quoted for a Forex pair. Like many financial markets, when you open a forex position, you’ll be presented with two prices. If you want to open a long position, you trade at the buy price, which is slightly above the market price. If you want to open a short position, you trade at the sell price – slightly below the market price.
The size of the spread is influenced by many factors. Some of them are the size of your trade, demand for the currency, and its volatility.
With CAPEX.com you can trade Forex with spreads as low as 0.0001.
4. What is a pip in forex?
Pips are the units used to measure movement in a forex pair. A forex pip is usually equivalent to a one-digit movement in the fourth decimal place of a currency pair. So, if EUR/USD moves from $1.115111 to $1.11521, then it has moved a single pip. The decimal places shown after the pip are called fractional pips, or sometimes pipettes.
The exception to this rule is when the quote currency is listed in much smaller denominations, with the most notable example being the Japanese yen. Here, a movement in the second decimal place constitutes a single pip. So, if EUR/JPY moves from ¥106.452 to ¥106.462, again it has moved a single pip.
The forex pip value can change depending on the standard lot size offered by the CFD & Forex broker. Because currency markets use significant leverage for trades, small price moves—defined in pips—can have an outsized effect on the trade.
5. What is Leverage in forex trading?
Leverage in forex is a way for traders to borrow capital to gain a larger exposure to the FX market. With a limited amount of capital (known as margin), they can control a larger trade size. This could lead to bigger profits and losses as they are based on the full value of the position.
Leveraged trading, therefore, makes it extremely important to learn how to manage your risk.
Example: A trader might put up just $1,000 of their own capital and with leverage 1:30 he will be able to open $30,000 worth of position, for example on EurUsd. Since he has used little of his own capital, the trader stands to make significant profits if the trade goes in the correct direction. The flipside to a high-leverage environment is that downside risks are enhanced and can result in significant losses. In the example above, the trader’s losses will multiply if the trade goes in the opposite direction.
6. What is the margin in forex trading?
Margin is a key part of leveraged trading. It is the term used to describe the initial deposit you put up to open and maintain a leveraged position. When you are trading in the margin, remember that your margin requirement will change depending on your broker, and how large your trade size is.
Margin is usually expressed as a percentage of the full position. So, a trade on USD/JPY, for instance, might only require 3.34% of the total value of the position to be paid for it to be opened. So instead of depositing $100,000, you’d only need to deposit $3340.
7. What is a lot in forex trading?
Currencies are traded in lots – batches of currency used to standardize forex trades. As forex tends to move in tiny amounts, lots tend to be exceptionally large: a standard lot is 100,000 units of the base currency. So, because individual traders won’t necessarily have 100,000 pounds (or whichever currency they’re trading) to place on every trade, forex trading is leveraged.
The choice of a lot size has a significant effect on the overall trade’s profits or losses. The bigger the lot size, the higher the profits (or losses), and vice versa.
8. What is rollover in forex trading?
Rollover is the interest paid or earned for holding a currency spot position overnight. Each currency has an overnight interbank interest rate associated with it, and because forex is traded in pairs, every trade involves not only two different currencies but also two different interest rates.
Rollover refers to the interest either charged or applied to a trader’s account for positions held “overnight”, meaning after 5 pm ET.
When a forex position is open, the position will earn or pay the difference in interest rates of the two currencies. These are referred to as the forex rollover rates or currency rollover rates or swaps. The position will earn credit if the long currency’s interest rate is higher than the short currency's interest rate. Likewise, the position will pay a debit if the long currency’s interest rate is lower than the short currency's interest rate.
For example, consider a long trade on NZD/JPY, and if the JPY overnight interest rate is lower than the NZD overnight interest rate you will earn the difference.
Changes in interest rates can lead to big fluctuations in rollover rates, so it is worth keeping up to date with the Economic Calendar to monitor when Central Bank events occur.
The Benefits of Forex Trading
There are more reasons to have forex market exposure beyond currency diversiﬁcation.
Once you do some homework, you will realize that forex is among the most rewarding asset classes for traders and investors. Even though the forex market is dominated by short-term, high-risk speculators, there are investing/trading styles suitable for both:
- More conservative active traders use longer-term holding periods and speciﬁc methods and instruments to reduce risk.
- Long-term investors who know how to:
– Ride stable, proven, long-term forex trends.
– Involve in carry trade.
Here are the 8 main advantages of the forex market that make it one of the most attractive for traders and investors worldwide.
1. The Highest Risk/Reward Potential
Forex market offers some of the best risk/reward opportunities of any ﬁnancial market IF (big if here) you learn how to control the risk. The availability of leverage in forex trading, meaning the use of borrowed funds to control large blocks of currencies and thus magnify gains and losses, creates the unmatched proﬁt potential for those with limited trading capital IF (again, big IF here) they learn how to control the downside risk. For example, with 30:1 leverage, a 1 percent move means 33.33 percent proﬁt. It also means a 33.33 percent loss.
This allows substantial proﬁts but also substantial losses on small price movements, because:
- For every $1 you have at risk, you control $30
- For every $1,000, you control $30,000.
2. The Most Flexible Hours
One unique aspect of this international market is that there is no central marketplace for foreign exchange. Rather, currency trading is conducted electronically over the counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange.
Forex market trade in a seamless 24-hour session, 5.5 days a week, from Sunday 5:15 P.M. EST until Friday 5:00 P.M. EST. So, those with work or family commitments can trade a fully liquid market whenever convenient.
3. The Lowest Start-up and Trading Costs
Forex trading has among the lowest entry or start-up costs in money and time of any ﬁnancial market, in terms of trading capital and training/equipment costs, as follows: Unlike most markets, you do not need many thousands of dollars to get started. That’s because, in the forex market, we can trade with leverage (borrowed funds), typically 30:1.
In theory, you can often start with as little as $100. However, you’ll learn that the larger the account the larger the stop loss you can use to keep risk per trade at 1-3% of your trading capital. As explained in the risk and money management course, the small forex position sizes available from mini and micro-accounts allow those with limited funds to trade smaller positions, which keeps the percentage of capital risked per trade low.
- Training and equipment costs: Forex brokers typically provide free full-featured trading platforms and data feeds, and the best Forex brokers offer extensive archives of free training materials and market analysis. With online stockbrokers, traders typically need to maintain minimum balances or minimum trading volumes to get free quality charting and trading apps from their brokers or get access to worthwhile research.
- Free Practice Accounts: Even better, they typically provide full-featured practice or demo accounts that allow smart beginners to simulate most of the trading experience and practice with play money until they feel ready to risk their capital.
- Low transaction costs: Most forex brokers charge no fees, commissions, or hidden charges. They earn their money on the difference, called spread, between the buy and sell price, typically a few ten-thousandths, called pips, of the price. Depending on the lot sizes traded, a typical one-pip spread to open and close a position can cost anywhere from $0.10 (micro-lot) to $10 (standard lot).
4. The Best Liquidity
A liquid market is one that has many buyers and sellers. The more buyers and sellers at any given moment, the more likely you are to get a fair market price when you buy or sell. The more liquid a market is, the less likely it is that a few otherwise insigniﬁcant orders or players can move prices in wild, unpredictable movements.
Indeed, unlike in stock markets, even the biggest players will have trouble manipulating the price action in major currency pairs beyond a matter of hours. Two exceptions to that, are a few central banks and crooked forex brokers. Fortunately, dishonest brokers can be identiﬁed and avoided with some research, and central bank intervention risk is usually known or soon uncovered after the ﬁrst incident, putting markets on guard. The more liquid the market, the easier it is to get in and out at the stated price or very close.
Prices are fairer and more stable, less subject to sudden unpredictable movements. You should avoid trading in illiquid markets, except on rare occasions when trying to enter positions at bargain prices offered by those desperate to close a position. Forex market trading volumes dwarf those of equities. The latest estimates put average daily forex turnover at around $6.59 trillion per day in 2019, according to the 2019 Triennial Central Bank Survey of FX and over-the-counter (OTC) derivatives markets (Forex Turnover), of which individual retail traders alone account for about $2 trillion. That huge trading volume, going on 24 hours a day, means abundant buyers and sellers are usually present at any given time. That means you are more likely to get a fair price no matter when you buy or sell. It means that you rarely see partial ﬁlls, which are cases in which you can only buy or sell part of your intended order.
5. Less Slippage
Slippage is the difference between the stated price on your screen and the actual price you pay or receive. The less liquid the market, the more often slippage happens because fewer traders are present to take the other side of your trade. For example, let’s say you buy 1,000 shares at $30, and to protect yourself in case the price falls, you place a protective stop-loss order to sell the shares at $29. However, if there are no buyers at $29, then the price “gaps” lower until it hits the next buy order, so you incur a greater loss.
Because forex markets are:
- typically running at full speed in at least one if not two continents 24 hours a day, over five days a week
- have no specialists controlling prices, and trade at larger volumes than equities,
forex traders face a lower risk of slippage. Indeed, many forex market makers provide some kind of “no slippage” policy that lessens the degree of price uncertainty.
6. Advanced Warnings of Changes in Other Markets
Forex markets often react to changing conditions before other markets, providing valuable advanced warning of trend changes. As detailed later, certain currencies tend to move in the same direction as “risk assets” like stocks or industrial commodities, and others tend to act like “safe haven assets” like bonds. When these correlations break down, that too can often be a warning of a change in direction for other markets.
7. No Centralised Exchange with Specialists Holding Monopoly Power to Regulate Prices
In most stock markets, the specialist is a single entity that serves as buyer and seller of last resort and controls the spread, which is the difference between the buy and sell price for a given stock. Though in theory they are regulated and supervised to prevent they are abusing that power to manipulate prices at the expense of the trading public, specialists are experts at knowing when they can get away with a degree of this and force you to buy higher or sell lower. In forex, no single specialist regulates the prices of individual currency pairs. Rather, multiple exchanges and brokers are competing for your business. Though the lack of centralized exchanges can complicate regulation, competition and easy access to pricing information have brought competitive pricing.
8. No Uptick Rule: Possible to Proﬁt in a Falling Market as in a Rising One
Just as it is easier to row with the current than against it, it’s easier to proﬁt by trading in the direction of an established market trend. Unlike with stocks (and other ﬁnancial markets), in forex, it’s as possible to trade the falling markets as is to trade the rising ones. This is a huge advantage of forex markets. During an uptrend, when prices are rising, most traders go long, meaning they buy the asset with the hope of selling it at a higher price. They are attempting to buy low and sell high, the classic way most people view investing.
During a downtrend, when prices are falling, it’s more possible to proﬁt by trading with that downtrend. So, the more sophisticated equities traders try to exploit that downward momentum and sell short; that is, sell borrowed shares with the hope of buying them back later at a lower price, returning the borrowed shares, and proﬁting on the difference—for example, sell borrowed shares for $100 per share, buy them at $80, return them to a broker, and pocket $20 per share. However, most stock exchanges are controlled and regulated by those who have an interest in keeping stock prices high with short-selling restrictions and huge costs.
The Risks of Forex Trading
The end goal of forex trading is to yield a net profit by buying low and selling high or vice versa. Forex traders have the advantage of choosing a handful of currencies over stock traders who must parse thousands of companies and sectors.
In terms of trading volume, forex markets are the largest in the world. Due to high trading volume, forex assets are classified as highly liquid assets. However, there are plenty of risks associated with forex trades as leveraged products that can result in substantial losses.
1. Leverage Risks
In forex trading, leverage requires a small initial investment, called a margin, to gain access to substantial trades in foreign currencies. Small price fluctuations can result in margin calls where the investor is required to pay an additional margin. During volatile market conditions, aggressive exposure can result in substantial losses more than initial investments.
A trader must understand the use of leverage and the risks that over-exposure introduces to an account.
2. Interest Rate Risks
In basic macroeconomics courses, you learn that interest rates influence countries' exchange rates. If a country’s interest rates rise, its currency will strengthen due to an influx of investments in that country’s assets putatively because a stronger currency provides higher returns. Conversely, if interest rates fall, its currency will weaken as investors begin to withdraw their investments. Due to the nature of the interest rate and its circuitous effect on exchange rates, the differential between currency values can cause forex prices to dramatically change.
Trading currencies productively requires an understanding of economic fundamentals and indicators. A currency trader needs to have a big-picture understanding of the economies of the various countries and their interconnectedness to grasp the fundamentals that drive currency values.
3. Counterparty Risk
The counterparty in a financial transaction is the company that provides the asset to the investor. Thus, counterparty risk refers to the risk of default from the dealer or broker in a particular transaction. In forex trades, spot and forward contracts on currencies are not guaranteed by an exchange or clearinghouse. In spot currency trading, the counterparty risk comes from the solvency of the market maker. During volatile market conditions, the counterparty may be unable or refuse to adhere to contracts.
Make sure you research your broker and select one authorized and regulated in your jurisdiction.
4. Country Risk
When weighing the options to invest in currencies, one must assess the structure and stability of the issuing country. In many developing and third world countries, exchange rates are fixed to a world leader such as the US dollar. In this circumstance, central banks must sustain adequate reserves to maintain a fixed exchange rate. A currency crisis can occur due to frequent balance of payment deficits and result in the devaluation of the currency. This can have substantial effects on forex trading and prices.
Due to the speculative nature of investing, if an investor believes a currency will decrease in value, they may begin to withdraw their assets, further devaluing the currency. Those investors who continue trading the currency will find their assets to be illiquid or incur insolvency from dealers. With respect to forex trading, currency crises exacerbate liquidity dangers and credit risks aside from decreasing the attractiveness of a country's currency.
5. Regulation risk
The decentralized nature of forex markets means that it is less accountable to regulation than other financial markets. The extent and nature of regulation in forex markets depend on the jurisdiction of trading.
To avoid dealing with an unscrupulous forex broker, choose a firm regulated by a government entity. In the EU., look for a broker authorized and regulated by the Cyprus Securities and Exchange Commission (CySEC).
Tips for Mitigating Risk
Forex trading has gotten a reputation for being excessively risky due to a combination of:
- High failure rates due to beginners who failed to do their homework and understand the risks associated with the high leverage commonly used in forex trading.
- Forex brokers who failed to provide sufﬁcient forex trading for beginners' type of education to deal with the risks of using leverage.
Part of forex’s reputation for excessive risk comes from stories appearing in the mainstream media. The typical plotline runs like this: Some gullible novices believed a broker’s get-rich-quick pitch about how they would score fast money with little effort or background in forex trading. These novices were shocked (shocked!) to find out otherwise. The conclusion: Forex trading should either be avoided altogether or is unsuitable for most people.
If you have had the right preparation and have the discipline to practice proper trade planning risk and money management, you can keep the risk to acceptable levels, just as with any other investment. As with other activities, there are ways to simulate the experience (forex demo) until you are ready for the real thing, and ways to then start slowly under less challenging conditions (small account starting from $100) until you are ready for more challenging conditions (larger account starting from $5.000).
Nevertheless, there is always a risk when investing in any type of security, though you can try to mitigate it with a few smart moves.
Start forex trading with a small amount of money you can afford to lose. If you make winning trades early on, take that money off the table. Do not let early success fuel overconfidence and bigger, riskier trades. Consider using a risk-free practice account prior to entering actual forex trades with real money.
Take Common Sense Precautions
When you initiate real trades, employ some of the protective tools. Use small size positions, the easiest way to control your exposure. Do not risk more than 1-3% of your capital (free equity) in a trade. Use stop-loss protections and spread your available cash across several trades rather than just one pair.
Have a Broader Plan in Place
Before you dive into forex trading, ensure it’s part of a well-thought-out and diversified personal finance and investing plan. Don’t let a misstep in the newish world of forex trading damage your near- and long-term financial health. You do need to do your homework, especially if trading with leverage, which adds risk as well as reward.
What moves the forex market?
The forex market is made up of currencies from all over the world, which can make exchange rate predictions difficult as there are many factors that could contribute to price movements. However, like most financial markets, forex is primarily driven by the forces of supply and demand, and it is important to gain an understanding of the influences that drives price fluctuations here.
Let’s look briefly at each fundamental factor that drives currency prices. For a more in-depth understanding visit CAPEX Academy.
1. Overall Risk Appetite
The most influential fundamental factor that determines the fate of a currency pair in a given period is overall risk appetite, otherwise known as market sentiment or, in plain English, whether markets are feeling optimistic or pessimistic. If they’re feeling optimistic, be it over a period of hours, weeks, or longer, risk assets tend to rise and safe haven or safety assets tend to fall, and vice versa.
These major currencies are classiﬁed as one of two kinds: risk and safety or safe-haven currencies. For now, just know that in general:
- AUD, NZD, CAD, GBP, and EUR are considered risk currencies because they tend to appreciate in times of optimism and depreciate in times of pessimism like other risk assets such as stock indexes or industrial commodities.
Depending on the challenge the market is facing, CHF, USD, and JPY are considered safe havens or safety currencies that tend to depreciate in times of optimism and appreciate in times of pessimism like other safety assets that are in demand when markets are fearful, such as investment-grade bonds.
Here’s a table showing how these currencies rank on the risk-to-safety spectrum.
In other words, the AUD is the currency that tends to rise the most when markets feel optimistic and want risk assets, and the JPY tends to fall the most. In times of fear, when risk assets are selling off, the opposite occurs.
These labels refer solely to how these currencies behave relative to other assets. These categories do NOT refer to the safety of these currencies as a store of value. For example, the JPY generally behaves as the ultimate safety currency, however, few would dispute that the CAD is a better long-term store of value given Canada’s better ﬁscal health. While the above general ranking works over a given period of weeks or months, it rarely applies perfectly on a daily basis. For example, even if markets are feeling very optimistic, and classic risk barometers like the S&P 500 are trending higher, currency speciﬁc news events can cause lower-ranked risk currencies to outperform the AUD and NZD.
They are not guaranteed to maintain their value and statute during periods of market volatility. Furthermore, what constitutes a safe haven may change over time.
Here are the obvious questions:
- What creates this overall market sentiment?
- How do traders and investors gauge it? What do they watch to determine whether markets favor risk or safety assets at a given moment or planned holding period?
The purported causes of market optimism or pessimism are debated and discussed daily in the financial media. Over time, you’ll develop your own preferred sources of news and will form your own opinions or at least a core group of analysts you trust. Sometimes the causes of the market’s mood are clear, other times they aren’t. However, the actual mood of the market is typically quite clear, even when its underlying cause is not. Look at the charts of the following risk appetite barometers, note the price action and trend, and you’ll have a picture of whether markets are optimistic (showing risk appetite) or pessimistic (showing risk aversion).
Risk Appetite Barometers
There are many, of varying degrees of effectiveness and sophistication. Here we’ll provide just a few that are quite easy to use and find. They usually provide a reliable picture of whether markets are feeling optimistic or pessimistic. That information in turn can tell you a lot about how almost any asset class should be performing in a given period.
- The S&P 500 Index (S&P 500) and other stock indices
- Major sovereign bond prices or Credit Default Swap (CDS) spreads
- Indexes of the major currencies, like the US Dollar Index
- Growth-related commodity prices like copper and oil
- Gold and silver for gauging confidence in the most widely held forms of cash, the USD and EUR
2. Short-Term Interest Rates
After overall market sentiment, the single most influential driver of currency prices is central bank benchmark interest rates and any data that change expectations about the direction, timing, or size of increases or decreases in these benchmark short-term rates. Indeed, one could argue that most of the other fundamental drivers of currency prices that follow below are influential only to the extent that they influence interest rate expectations or the rates themselves. They are influential because rising yields allow traders to capitalize in two ways:
- “Carry Trade” profiting from interest rate differences between currencies.
- Capital appreciation (much of that driven by carry-trade).
What Drives Short-Term Interest Rates?
Why do central banks change short-term interest rates? They lower them to stimulate growth, and they raise them to keep inflation low. Their benchmark overnight lending rate is typically an attempt to strike a balance between these two needs. Economic conditions determine which need takes priority. In bad times, promoting growth is usually the main concern hence lower rates. In good times, cooling inflation is the priority, hence higher rates. It’s common to see nations with stronger economies have stronger currencies because their central banks will be raising rates, both to minimize inflation threats and to buy themselves more room to lower rates (which encourages growth) when their economies weaken.
From a trading perspective, forex movements are more influenced by changes in market expectations about the direction or pace of rate change than actual rate changes themselves (which are usually anticipated and already priced in when they actually do occur).
3. Macroeconomic data and indicators
Economic indicators influence currency prices because they’re barometers of the following:
- The health of the underlying economy: That means increased demand for that economy’s currency from exports and foreign investment in local hard assets like businesses and real estate.
- The direction of interest rates and central bank policy: As noted earlier, faster growth makes inflation more likely, and thus further rate increases more likely because:
- Central banks use rate increases to reduce inflation risk
- They like to raise rates in times of growth to allow room to lower rates when their economies start slowing and need a boost.
Which fundamental data are most important? Here are some guidelines:
- Quarterly Gross Domestic Product (GDP): Typically, there is an advanced or preliminary reading about four weeks after the quarter ends, and a final one about three months after the quarter ends. The preliminary reading is what carries the most influence because the final reading rarely deviates from it.
- Monthly jobs report: Again, the more important the economy, the more important the report. Jobs (see Non-Farm Payroll or NFP) take on even greater significance in economies like the United States or the United Kingdom, where consumer spending is a more important component of GDP than manufacturing or exports.
- Monthly retail sales: Same as above.
- Inflation data: Typically, monthly CPI and PPI.
- Purchasing Managers Index (PMI) for both manufacturing and service sectors: The key point is that a reading over 50 suggests expansion, and under 50 suggests contraction. They provide a measure of the health of the manufacturing and service sectors, respectively.
- Housing data: This includes a range of monthly reports like housing starts, new home sales, existing home sales, new building permits, etc. Considered an indicator of what stage the economy is within the current business cycle. It is also a sign of the health of the banking sector and consumer lending, consumer spending, and jobs, given the significant impact housing has for these sectors.
Though all financial markets can be influenced by major geopolitical events like news of political instability in key countries or military actions, few are as sensitive as the FX because of its extremely international nature. Of course, certain currencies and their related pairs will be especially sensitive to related local developments. As stock prices reflect market sentiment about companies, so do currencies for countries. Thus, they are responsive to geopolitical changes insofar as these affect expectations for interest rates, growth, trade and capital flows, and so on for the underlying economies.
Because the professional traders who manage the big money in forex focus first on risk management (take the hint, so should you), the first rule of trading based on geopolitical unrest is that markets tend to sell first and ask questions later. In other words, markets are prone to volatility in times of serious unrest. Remember, whenever professionals fear any threat to their capital, they quickly retreat into cash, especially safe-haven currencies, until the political risk fades.
In sum, a general rule of thumb in all kinds of financial markets including FX is that politics usually trumps economics. In other words, very good or bad geopolitical data tend to outweigh economic data.
5. Capital and Trade Flows
Another key factor in analyzing the demand for a given currency is whether the underlying economy is more dependent on trade flow or capital flow. In other words, is the economy based more on exports or on attracting foreign investment? Trade flow refers to a country’s income from trade, i.e., exports. Capital flow refers to how much investment it draws from abroad. Export-oriented economies depend more on trade flows, and countries more focused on financial industries are more dependent on capital flows.
The export-oriented economies, whose currency strength depends on their trade flows include:
6. Government and Central Bank Special Interventions in Times of Crisis
One of the most enduring lessons of the “Great Recession” that began in the summer of 2007 is that in desperate times governments will take desperate measures that by definition are unique and thus unpredictable.
After the subprime crisis in the United States morphed into a global banking crisis with the fall of Lehman Brothers and global markets appeared to be at the brink of the abyss in early 2009, intensive government intervention produced a rally in risk assets that lasted until late 2009, with the start of the EU sovereign debt and banking crisis.
In the fall of 2010, when risk asset markets might again be in trouble, the U.S. Federal Reserve Bank (Fed) came to the rescue with a new stimulus plan, called Quantitative Easing. Risk asset markets perceived this would provide at least a temporary boost for risk assets.
Types of Forex trades
The most basic forms of forex trades are a long trade and a short trade. In a long trade, the trader is betting that the currency price will increase in the future, and they can profit from it. A short trade consists of a bet that the currency pair’s price will decrease in the future. Traders can also use trading strategies based on technical analysis, such as Japanese candlesticks, chart patterns, Fibonacci retracement, and moving averages, to fine-tune their approach to trading.
Depending on the duration, timeframes, and frequency, forex trades can be categorized into four further types:
A scalp trade consists of positions held for seconds or minutes at most, and the profit amounts are restricted in terms of the number of pips. Such trades are supposed to be cumulative, meaning that small profits made in each individual trade add up to a tidy amount at the end of a day or time period. They rely on the predictability of price swings and cannot handle much volatility. Therefore, traders tend to restrict such trades to the most liquid pairs and at the busiest times of trading during the day.
Day trades are short-term trades in which positions are held and liquidated on the same day. The duration of a day trade can be hours or minutes. Day traders require technical analysis skills and knowledge of important technical trading indicators to maximize their profit gains. Just like scalp trades, day trades rely on incremental gains throughout the day for trading.
In a swing trade, the trader holds the position for a period longer than a day; i.e., they may hold the position for days or weeks. Swing trades can be useful during major announcements by governments or times of economic tumult. Since they have a longer timeline, swing trades do not require constant monitoring of the markets throughout the day. In addition to technical analysis, swing traders should be able to gauge economic and political developments and their impact on currency movement.
Trend traders tend to use technical analysis tools, such as moving averages (MA), trend lines, and momentum indicators, to determine trends in the market. They will look for patterns in price movements and analyze charts to establish areas of support and resistance. Once a trend has been recognized, trend traders tend to enter a trade in the direction of that trend and the goal is to ride the trend for as long as possible and to exit it when it shows weekness.
In a position trade, the trader holds the currency for a long period of time, lasting for as long as months or even years. This type of trade requires more fundamental analysis skills because it provides a reasoned basis for the trade. Position traders are those who will hold a trade for the entirety of the prevailing trend, ignoring day-to-day fluctuations
The purpose of a carry trade is to profit from the difference in interest rates or the “interest rate differential” between two separate foreign currencies in a pair. Basically, you should profit from a higher interest on the currency that you have bought. Most traders will enter a carry position with the hope that the interest rate differential will be flat or increase. However, any drop in the price of the currency you are holding via leverage could outweigh your interest gains.
Examples of Forex Trades
Here is a practical introduction to forex trading with two examples based on the most popular currency pair for beginners and advanced traders.
Forex trading example 1: buying EUR/USD
EUR/USD is trading at 1.12874 / 1.12892
You decide to buy €10,000 because you think the price of EUR/USD will go up. EUR/USD has a margin rate of 3.34% (or 1:30 leverage), which means that you only must deposit 3.34% of the total position value as position margin.
Therefore, in this example your position margin will be $378.83 (3.34% x [€10,000 x 1.12892]).
Remember that if the price moves against you, it is possible to lose more than your collateral of $378.83.
Outcome A: winning trade
Your prediction was correct, and the price rises over the next hours to 1.14592 / 1.14610. You decide to close your long trade by selling at 1.14592 (the current sell price).
The price has moved 1400 points or 140 pips (1.14592 – 1.12892) in your favor.
Your profit is ([€10,000 x 1.14592] – [€10,000 x 1.12892]) = $140.
Outcome B: losing trade
Unfortunately, your prediction was wrong, and the price of EUR/USD dropped over the next hour to 1.13672 / 1.13690. You feel the price is likely to continue dropping, so to limit the losses you decide to sell at 1.13672 (the current sell price) to close the trade.
The price has moved 780 points or 78 pips (1.13672 – 1.12892) against you.
Your loss is ([€10,000 x 1.12892] – [€10,000 x 1.13672]) = –$78.
Forex trading example 2: selling EUR/USD
EUR/USD is trading at 1.12836 / 1.12854.
You decide to sell €20,000 because you think the price of EUR/USD will go down.
EUR/USD has a margin rate of 3.34%, which means that you only must deposit 3.34% of the total position value as position margin. Therefore, in this example, your position margin will be $757.4 (3.34% x [€20,000 x 1.12836]). The platform will automatically convert the position margin amount into your account currency at the prevailing CAPEX conversion rate (USD in our illustration).
Remember that if the price moves against you, it is possible to lose more than your position margin of $754.94.
Outcome A: winning trade
Your prediction was correct, and EUR/USD dropped over the next hours to 1.11368 / 1.11386. You decide to close your short trade by buying at 1.11386 (the current buy price).
The price has moved 1,450 points or 145 pips (1.12836 – 1.11386) in your favor.
Your profit is ([€20,000 x 1.12836] – [€20,000 x 1.11386]) = $290.
Outcome B: losing trade
Unfortunately, your prediction was wrong, and the price of EUR/USD rises over the next hour to 1.13802 / 1.13820. You feel the price is likely to continue rising, so to limit your losses you decide to buy at 1.13820 (the current buy price) to close the trade.
The price has moved 984 points or 98.4 pips (1.13820 – 1.12836) against you.
Your loss is ([€20,000 x 1.12836] – [€20,000 x 1.13820]) = –$196.8.
Buy the EURUSD at the higher ask price IF:
- You want to open a new buy position for the pair (go long the pair), and you are betting that the price of the EURUSD pair (in Dollars per Euro) will rise. In other words, you think the EUR will rise in price versus the USD.
- You want to close an existing short position in which you had bet the opposite, that the pair would drop, (the EUR would fall versus the USD), either to take your proﬁts or to cut your loss on your short position using a stop-loss order or a market order.
Sell the EURUSD at the lower bid price IF:
- You want to open a new sell position for the pair (go short the pair), betting the price of the EURUSD pair (in Dollars per Euro) will fall. In other words, you think the EUR will fall versus the USD.
- You want to close an existing long position in which you had bet the opposite (that the pair would rise in value, meaning the EUR would rise versus the USD), to either take proﬁts or to cut losses on your long position.
Final words about Forex Trading
As with any financial market trading, you need to be able to answer the following question:
How Can I Compete against the Pros and Big Institutions?
Whenever you are trading in global asset markets, most of your competition consists of the top professionals who are responsible for most of the trading volume. They have every advantage over you: skill, experience, and any advantage that money can buy, the best equipment, information sources, whatever.
You have no better chance of beating someone like David Woo or Stephen Jen at short-term forex trading than you do at beating Michael Jordan or Lebron James at basketball.
So how can you compete?
The genuine answer obviously is, do not even try to trade forex as they do.
In the beginning, do not try to be a bad imitation of an experienced pro. Instead, focus on becoming a great forex beginner. That means finding and using the trading techniques, styles, and instruments that even a beginner can, in measured stages, start to implement. You will spend most of your time calmly and persistently searching the charts for those few easier opportunities, rather than spending long hours glued to your computer, frenetically making lots of trades based on rash decisions, based on short time frames in which price movements are harder to predict, with the odds firmly against you.
Learn How to Trade Forex with CAPEX Academy
As we have said before, you have to start somewhere. Welcome to the somewhere. We will teach a variety of ways to harness the power of forex markets. Regardless of your skill level or risk tolerance, there are solutions here to suit you.
A prime focus of CAPEX Academy's online trading courses is to be a trader’s roadmap for finding, planning, and executing trades that beginner to intermediate skill levels can do.
What is the Catch?
There is a catch: Forex trading requires time and effort as with any other competitive, lucrative field. CAPEX ACADEMY's online trading courses will show you some approaches that are easier than the usual forex trading strategies, but even these require study and practice. Like achieving anything else worthwhile, especially a lucrative, stimulating career, you will need the discipline for a sustained investment of time, effort, and money. You will suffer some uncertainty, frustration, and failure, with no guarantee of success, as you would in achieving anything else worth attaining.
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- Foreign exchange turnover in April 2019 – https://www.bis.org/statistics/rpfx19_fx.htm
- Foreign Exchange Rates – https://www.federalreserve.gov/releases/h10/current/
- The FED’s Foray into Forex – https://www.richmondfed.org/publications/research/econ_focus/2017/q2/federal_reserve
- Trading in foreign exchange (forex) – https://www.esma.europa.eu/system/files_force/library/2015/11/2011-412_1.pdf?download=1
- Patterns of Foreign Exchange Interventions – https://www.imf.org/en/Publications/WP/Issues/2020/05/29/Patterns-of-Foreign-Exchange-Intervention-under-Inflation-Targeting-49252
- Foreign Exchange: A Practical Guide to the FX Markets (a review) – https://www.cfainstitute.org/en/research/financial-analysts-journal/2007/foreign-exchange