The Basics of Forex Trading – Part 1
The average daily trading volume in the forex market now exceeds US$5 trillion, making it the most liquid market in the world. Liquidity refers to the ease with which market participants open and close positions without affecting the price of the underlying asset. The concept of liquidity also works hand in hand with volatility, which measures the speed and velocity of buying and selling price changes. The majority of forex traders like volatile markets because they offer greater profit opportunities, especially with short-term strategies like scalping and day trading.
Forex Trading Risks
Most forex traders lose money over time. Lack of preparation, poor leverage, weak skills, and emotional fatigue all take their toll, triggering losses that ultimately force the trader to “go blank,” leaving the forex game to the next participant. The profitable minority learn to ride out these headwinds, often spending hours developing skills, researching, and testing new systems and strategies.
In addition, banks around the world seek to manage sovereign and credit risk through bid and ask prices on the interbank quotation system, triggering frequent supply and demand disruptions unrelated to evolving market events or economic news releases. These present a major risk to the typical newcomer who becomes complacent between scheduled market moves, fails to place stop losses, or takes on too much short-term exposure for their level of experience.
Ironically, the new trader’s greatest risk comes from the broker he chooses. The vast interbank system is a hodgepodge of “regulated brokers,” offering unbiased market access, and “unregulated brokers,” who take advantage of the lack of sophistication of customers. These companies are easy to spot because most are domiciled (headquartered) in offshore tax havens, rather than the US, UK, EU or Australia, which heavily regulate currency trading.
Unregulated brokers cause the most damage when they operate a “dealing desk” that takes the other side of a client’s position and manipulates price through “requoting” to trigger stops and force unexpected losses, especially outside the hours when most active traders are asleep. It can also be difficult to get your money back when you choose to close an account with an unregulated broker.
Key Forex Trading Terms
Currency pair: Currency pairs consist of two currencies, the base currency on the left (top) and the quote currency on the right (bottom). EUR/USD is an example of a currency pair. When buying this pair, the trader buys the Euro and sells the US Dollar. Alternatively, when selling this pair, the trader sells the Euro and buys the US Dollar.
Major Pairs: Currency pairs can be subdivided into major, cross, minor, and exotic pairs. Major pairs include the US Dollar as the base or counter currency, paired with one of seven major currencies: EUR, CAD, GBP, CHF, JPY, AUD, and NZD. New traders focus on major pairs as they are highly liquid and result in lower transaction costs due to tighter spreads, which limits slippage.
Crossed pairs: Cross pairs consist of two major currencies except the US dollar. Unlike major pairs, cross pairs have higher transaction costs, higher volatility, and lower liquidity, which increases the potential for slippage. Examples of cross pairs include EUR/GBP, EUR/CHF and AUD/NZD.
Exchange rate: The exchange rate indicates the price of a base currency, expressed in terms of the countercurrency (quoted currency). For example, if the EUR/USD exchange rate is 1.2500, €1.00 will cost $1.25. A rising exchange rate indicates that the base currency is appreciating against the counter currency, while a falling exchange rate indicates that the base currency is depreciating against the counter currency.
Inquiry: Currency pairs have two exchange rates: the bid price and the ask price. The bid price identifies the current price at which market participants can sell (short), while the ask price identifies the current price that market participants can buy. The bid price is always lower than the ask price and the difference between the two is called the spread.
Spread: The difference between the bid price and the ask price. The spread marks a type of transaction cost for a trade and a source of profit for the broker. This cost can significantly reduce profits or increase losses when engaged in high frequency trading strategies, such as scalping.
Seed: The pip refers to the “point percentage”, or the smallest increase in price of a currency pair. A pip is equal to the fourth decimal place of most currency pairs. For example, if the EUR/USD ask price is quoted at 1.2542 and goes up to 1.2548, the change is equal to six pips.
Hedge: A hedge marks an exchange transaction intended to offset or protect another position from a positive or negative exchange rate risk. Traders, investors and institutions apply hedging techniques to increase profits, limit losses or protect investments.
Margin: Brokers lend money up to a multiple of account equity, called margin, so traders can take leveraged positions. Borrowed funds incur transaction costs through overnight lending rates. For example, a margin of 30:1 allows exposure up to 30 times greater than the capital of the account. Leveraged positions must generate profits that exceed borrowing costs, otherwise they lose money.
Leverage: Leverage allows traders to take positions in excess of account capital through margin loans from brokers. Taking substantial leverage is risky for new traders, but is an appropriate and necessary strategy for experienced traders.
Main types of orders
The forex trader opens a position through a buy or sell order, specifying whether to take the position “at market” or at a specified price. A market order will execute immediately at the current ask price for a buy or at the current bid price for a sell. Both orders can experience slippage when prices move quickly, triggering trade executions at much higher or lower price levels.
A limit order can be used instead of a market order, specifying the price at which a) the limit order converts into a market order or b) the exact price of the entry. The order will be executed when the price is reached with the first technique, which may cause slippage, but the price may “jump” an order with the second technique and never be executed. Similar limit order types, including stop and stop loss orders, are used to open, manage and close open positions.
- Buy Stop: open a long position at the price above the current price or close a short position at the price below the current price.
- Stop sale: open a short position at the price lower than the current price or close a long position at the price higher than the current price.
- Purchase limit: open a long position at the price lower than the current price or close a short position at the price higher than the current price.
- sell limit: open a short position at the price above the current price or close a long position at the price below the current price.
The forex market has become extremely popular with new traders and has never been easier to access. Learning the basics of forex trading isn’t too complicated, but choosing the right way to trade requires self-examination, with a realistic view of personality traits, available time, long-term goals, and current income. It’s a rewarding endeavor that benefits from dedication, patience, emotional control, and a willingness to develop multiple skills and strategies over time.