What is Forex market?
Forex is the largest and most liquid financial market in the world, with volumes topping $6 trillion every single day. The word ‘forex’ is basically an abbreviation for foreign exchange, and the concept is as simple as it gets. That is, forex involves using one currency to buy another, and by doing so, you have made an exchange. There are many practical cases for participating in the forex market, such as visiting a new country or purchasing goods from another country, but forex market is largely speculative; participants expect to profit out of currency rate fluctuations.
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The forex market is the most accessible market in the world, as the average investor is now able to participate. Forex operates as an over-the-counter market (no physical location). It runs round the clock, making it possible for virtually any investor to take advantage of the ever-fluctuating rates of forex prices.
Who Participates in the foreign exchange Market?
Forex trading is traded at such sheer volumes that it is difficult to classify the different types of participants in the market. Still, participants broadly fall into two main categories: institutional traders and retail traders.
Institutional traders account for a big chunk of the volume traded. They include entities such as commercial and investment banks, central banks, hedge funds and multinational corporations. Retail traders are investors that sign up with various brokerage platforms in a bid to get a slice of this lucrative market. Retail traders account for volumes of less than 10%, a figure that is likely to increase with more investors interested in this incredible opportunity.
Why is Forex Important?
While most financial markets are investor oriented (or rather need investors to operate), forex is a market that serves a number of purposes that enable the efficient working of the global economy. At present, it is almost impossible to imagine a world without a proper system of determining the currency exchange rate.
Here is why the forex market is so important:
- Controlling Inflation
Central banks across the world hold large amounts of reserve currencies, such as US dollars (USD) and euros (EUR) to support the stability of their economies. During economic slowdowns, central banks will lower interest rates. This will weaken their respective currencies and encourage domestic spending. A weaker currency will also boost the export sector, and trigger an overall spur in economic activity. When economic conditions improve, central banks can raise interest rates and consequently increase the attractiveness of their market to foreign investors. The ability to intervene in the currency market makes it possible for central banks to control inflation virtually at all times.
- International Trade
Forex is the cornerstone of international trade, enabling effective importation and exportation of goods, as well as creating additional demand. Exporters need to convert foreign currencies into local currency, while importers have to convert local currency into the currency required to pay for international goods and services, like cryptocurrencies. Investors also require the forex market in order to be able to buy or sell international assets.
Companies use the forex market to lock in an exchange rate, and thus, they are able to hedge their risks. In most cases, companies are not able to deliver or receive goods and services immediately as they make an order. Meanwhile, currency exchange rates continue to fluctuate, which may lead to an overall loss or even a profit when a transaction is completed. But the forex market allows hedging against such volatility or fluctuation risks.
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Here are more of the many benefits of trading forex:
- No Middlemen
As stated above, forex is an OTC market; and spot trading completely eliminates middlemen so you can trade directly with the pricing of the market.
Leverage allows for a small capital amount that can control a larger trade position in the market. Leverage allows you to earn amplified profits with limited capital. For instance, a 500:1 leverage means that a $1,000 margin capital can control a $500,000 trade position. Still, it is important to note that leverage works both ways; it boosts profit potential but also increases risk exposure. It is, therefore, important to use leverage effectively.
- High Liquidity
The sheer size of the forex market makes it extremely liquid. High liquidity simply means that at any given time, there are more than enough buyers and sellers for practically any financial currency pair. This means that you can easily get in and out of trade positions, even with large amounts.
- Low Entry Barriers
Forex is one of the most accessible markets in the world, with most brokerage companies offering minimal capital requirements of even less than $100. While it is not necessarily prudent to start trading with extremely low capital amounts, the option to trade ‘mini’ and ‘micro’ accounts makes it possible for almost anyone to participate in the forex market.
- Low Transaction Costs
Forex brokers in Australia typically charge a spread (the difference between the bid and ask price) when you enter trade position in the market. Spreads are usually less than 0.1% under normal market conditions and represent the only trading costs in the forex market. There are no brokerage fees, no government fees, no clearing fees and no exchange fees.
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How Does foreign exchange market Work?
The mechanics of forex is similar to any other financial market. In the forex market, the tradable commodity is money. Participants exchange one currency for another, with the expectation that the value of one currency will change relative to the other. If the exchange rate changes in your favour, you make money; and if it changes against you, you lose money.
Consider this: A British tourist visits the United States and has to exchange his 10,000 British pounds to US dollars. At the exchange rate of 1.2, he will have 12,000 US dollars (10000*1.2). If after a few days the rate becomes 1.1 and the tourist wishes to exchange his 12,000 US dollars as he heads back home, he will now have 10,909 pounds (12000/1.1). He will have made a profit of 909 British pounds for that short period. That is exactly how money is made in the forex market.
The above illustration shows how fluctuating currency exchange rates create huge trading opportunities in the forex market. To take advantage of such opportunities, it is important to understand how to read the prevailing exchange rates or forex quotes.
Reading a Forex Quote
Price quotes are the language of the forex market, and every trader should strive to be fluent in order to maximise their success. Currencies are usually quoted in pairs, with the first currency in a quote representing the base currency, and the second currency being the counter currency. For instance, in the EURUSD pair, the euro (EUR) is the base currency, while the US dollar (USD) is the counter currency. The exchange rate, at any given time, represents the amount of the counter currency equal to one unit of the base currency. If the price of the EURUSD is 1.2500, it means that one would need 1.2500 US dollars to acquire 1 euro. When you buy EURUSD, you will pay 1.2500 US dollars for 1 euro; and when selling, you will receive 1.2500 US dollars for every 1 euro.
Understanding Bid, Ask and Spreads in Forex
On forex platforms, such as the platforms offered at AvaTrade, forex prices are always displayed as a two-way expression. The first quote represents the bid price, while the second quote represents the ask price. The bid price is always lower than the ask price.
For instance, a typical EURUSD price quote will be expressed as follows: 1.2500/1.2503. In such a case, 1.2500 is the bid price, while 1.2503 is the ask price.
The bid price is the price at which your broker is willing to buy euros in exchange for US dollars, while the ask price is the price at which the broker is willing to sell euros in exchange for US dollars. When trading, traders buy an asset at the ask price, and sell at the bid price.
The spread is the difference between the bid price and the ask price and represents the cost of placing a trade in the market. In the above price quote, the spread is 3 pips (1.2503-1.2500). Popular currency pairs, such as the EURUSD usually offer low spreads, whereas exotic or illiquid currency pairs, such the USDJPY, feature relatively higher spreads.
With most brokers, spreads are variable. It is therefore important to watch spreads and ideally trade when they are low. Spreads vary depending on the liquidity of the underlying financial assets. When there is high liquidity, spreads are low; and during low liquidity periods, spreads widen. Some of the factors that influence liquidity in the forex market include trading hours and the release of economic and political news and events.
Pips and Lot Sizes in forex market
Pips and lot sizes are important when trading forex, particularly when assessing potential profits or losses. A ‘pip’ (point in percentage) represents the minimum movement a price can make in forex. Most forex brokers quote currency exchange rates up to the fourth decimal, in which case 1 pip will be equal to 0.0001. However, in Japanese yen (JPY) pairs, 1 pip equals 0.01. Profit (or loss) in the forex market is determined by the amount of pips the price moves. Pips are ascribed different values depending on the currency pair you are trading as well as the ‘lot’ size.
A lot represents the amount of currency units you wish to trade. A standard lot represents 100,000 units of a currency. This means that if you are trading one standard lot of the GBPUSD pair, you will require $100,000. Thanks to leverage available in the forex market, this is not the practical case. There are also other popular lot sizes, such as ‘mini’ (10000 units) and ‘micro’ (1000 units). Some brokers also offer ‘nano’ (100 units) lot sizes. Usually, the value of 1 pip when trading 1 standard lot size is $10. This means that if the price moves in your favour by 100 pips, you will have gained a profit of $1,000 (100*$10).
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Forex Order Types
The term ‘order’ in forex refers to how you can enter, exit or manage trade positions in the market. There are different types of orders available in different brokerage firms, but here are some of the most basic and popular ones:
- Market Order
As the name suggests, a market order is an order to buy or sell a financial asset at the current market price. The market order is the most popular order type used by retail traders. If the prevailing EURUSD price is 1.2560, and you decide to buy or sell the pair at that prevailing rate, you have placed a market order.
- Pending Order
A pending order is an order to buy or sell a financial asset at a specified price in the future. When you place a pending order, the trade will be executed in the market when the price meets the specified conditions. There are two broad types of pending orders: limit and stop orders. Traders use limit orders when they expect to get a better trading price in the future. For instance, a limit order is used when a trader wants their order to be filled at a cheaper price than the current one. On the other hand, traders use stop orders when they expect the current market trend to continue well into the near future. For instance, a sell stop order will ensure that an asset is sold at a cheaper price than the current one, with the trader expecting prices to continue falling further.
- Stop Loss and Take Profit Orders
Stop loss and take profit orders are an instruction to exit your trade positions at a predetermined price level. A stop loss order will close your trade position at a specified price point when the price is moving against you, thus it will limit your overall loss; whereas take profit will close your trade position at a predetermined price point when the price is moving in your favour so you can lock in your profits.
Types of Analyses in Forex
After understanding the different types of orders you get in the forex market, it is important to learn ‘when’ and ‘why’ to actually place them. Money in the forex market is made out of price movements, and it is important to analyse what the price is likely to do next. Forex traders utilise two primary analysis types when trading the financial markets online:
Forex Technical Analysis
Technical analysis involves the study of the historical price action of an underlying financial asset in an attempt to forecast its future price movement. Basically, technical analysts believe that history repeats itself. As a result, the purpose of technical analysis is to identify a pattern of price fluctuation and to take advantage of any arising opportunities. When undertaking technical analysis, the assumption is that the price is absolute (the current price takes into account all underlying factors of a particular financial asset) and price movement is patterned (the price of any financial asset is not random and chaotic, there is a trend in motion).
To perform efficient technical analysis, traders need the following key tools or resources:
- Forex Charts
Price and Time are the most important variables to a technical analyst, and these are what are plotted on a forex trading chart. For this reason, charts are arguably the foundation of technical analysis in the forex market. There are 3 main types of charts available to forex traders: tick, line and candlestick charts. Tick charts help traders to clearly view the price action of financial assets over extremely short time periods, such as 10 seconds or even lower. Line charts smooth out the price action of financial assets, making it easier for traders to observe the overall price action of a particular asset, as well as identify definitive support and resistance zones. Still, candlestick charts remain the most popular chart type in forex as they give detailed price information of an underlying asset over different time periods. There are also numerous candlestick types such as ‘Pin Bars’ as well as candlestick patterns, such as head and shoulders, that traders look out for in the market to discern price patterns in an underlying financial asset.
- Forex Indicators
Indicators are mathematical tools that help traders analyse the price behaviour of financial assets. There are two types of technical indicators: leading and lagging. Leading indicators provide trading signals before a price movement has occurred while lagging indicators deliver confirmation signals after a price movement has occurred. There are numerous indicators available for traders to use, and they are classified according to the price element they help traders to decipher, such as trend, volume, momentum, volatility and market cycles.
Forex Fundamental Analysis
Fundamental analysis involves the study of how an underlying asset’s economic, social and political factors impact its prevailing price. The goal of fundamental analysis is to determine the intrinsic or fair value of an asset based on all available information. Fundamental analysts believe that in the long run, the price of an asset will be a reflection of its ‘fundamentals’. A trading opportunity for fundamental analysts arises when the price of a particular financial asset is not consistent with its fair value. The major fundamental indicators that forex traders watch out for include Interest Rates, the labour market, GDP (Gross Domestic Product) and Inflation figures. In addition, the most important tool for fundamental forex traders is the Economic Calendar which allows for the tracking of scheduled releases of major economic and political news and events that may have a high impact on various financial assets.
Forex Money Management
While identifying high probability trading opportunities is very important, it is money management that will determine the long-term success (or failure) of a trader. You are trading to make money after all.
Here are two of the most important elements of a money management plan:
- Risk Per Trade
This refers to the maximum amount of risk you are willing to take on in a single trade. By defining this, you prevent a potential scenario where a possible drawdown period can wipe away your trading capital. It is always advisable not to risk more than 5% of your available capital on any single trade.
- Risk/Reward Ratio
This refers to the ratio between your maximum loss on any trade, and your potential maximum profit. As a general rule, you should never enter a trade where the maximum possible loss is greater than the potential maximum profit.
There are numerous money management tools and tips available for traders to ensure that they can effectively manage their trading risks. They include the use of stop losses, utilising certain pending order types, avoiding trading during high impact data releases, understanding correlated assets, and using appropriate leverage at the right times. Ultimately, money management not only limits risks but also promotes capital growth.
Foreign exchange market Psychology
This is a big thing in the trading world. Psychology is considered to be the biggest source of individual mistakes performed during trading activity. Trading psychology refers to the emotional state of a trader when conducting trading activities. Real money is on the horizon (also on the line) when you are trading, and there is bound to be some emotional attachment. Some of the emotions that can lead to bad decisions during your trading activity include fear, greed, overconfidence, euphoria and revenge. If you succumb to such emotions, you can commit major trading sins, such as overtrading, bias and anchoring.
While emotions come naturally to us humans, it is important not let them interfere with your trading activities. This is possible through learning about your personality and psychological profile, as well as coming up with a solid trading plan and sticking to it with religious discipline.
As mentioned earlier, forex is one of the most accessible financial markets in the world. To get in on the action, you can sign up with AvaTrade, an award-winning, reputable and regulated broker in the industry. This will be your first forex trading decision, and you better get right; since a top-notch forex broker, such as AvaTrade, will ensure that you have the best environment as well as the right resources and conditions to achieve success when trading financial assets online. AvaTrade will also provide you with direct access to powerful and advanced trading platforms, offers competitive spreads, as well as provide effective resources and excellent customer support.
After signing up with AvaTrade, you can decide to trade on a demo account before risking money on a real account. This will help you to familiarise yourself with AvaTrade’s platform features as well as test whether you have a working trading plan or strategy. If you are consistent enough on a demo account, you can make the transition to live trading and start participating in the largest financial market in the world. Being a fast and dynamic market, it is important to always continue your forex education so you can always stay on top of your game and guarantee the long-term success of your trading endeavours.
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