What is Forex Trading?
Forex is short for foreign exchange, which designates the trading of one currency for another. For instance one may trade U.S. dollars for British Pounds, USD/GDP, in the currency market.
There are several reasons why someone may wish to do that, for instance to use forex trading as a hedge against currency fluctuations, or to process financial transactions that involve different currencies.
From a personal investment perspective, we’ll be looking at forex trading to simply earn a profit on the trades, involving buying a certain currency and then selling it later, hopefully at a profit.
There are three types of forex markets, the spot market, the forward market, and the futures market. In this article we’ll be looking at the spot market, which comprises the overwhelming majority of forex trades these days, which are contracts that are immediately settled and not on some future date, and are the type that individual investors focus on as well.
Let’s say that you expect the Euro to gain in value relative to the U.S. Dollar. So you would purchase Euros with U.S. dollars, and then look to exchange the Euros back to USD at some point in the future, realizing a profit.
Of course the trade can go the other way as well, just like all financial trades, and forex trading is generally more risky than trading things like stocks, even though currencies are far more stable than stocks are.
This just means that it may not be wise to risk money that you cannot afford to lose in forex trading, like all of your retirement savings for instance. However, one may wish to use a portion of this, an amount that they are comfortable with, to provide some spice to their investing, and forex trading can definitely provide that, for reasons we will soon explain.
The Forex Market Dwarfs All Other Markets
It is estimated that the size of the forex market is about 5 trillion dollars per day. That’s simply a gigantic amount of money changing hands, an amount far bigger than any other financial market, including the worldwide stock market.
The main benefit to traders is that this provides tremendous liquidity to the market, meaning that you can open and close positions at will, 24 hours a day, every business day, at very tight spreads.
While forex markets do not stay open this long, there are several major forex markets located throughout the world, in different time zones, that assure 24 hour a day coverage and availability to traders. This can be a big benefit for casual traders in particular, who may be busy at work during normal market hours in other markets, but can trade forex at whatever time of day they please.
Like all financial transactions, there is a buyer and a seller, a bid and an ask price, and the difference between them is called the spread. This is why the price is different if you go down to your bank and buy a foreign currency, and you will pay a significant spread between what they ask for it and what they give you to redeem it back.
So this is an example of a financial transaction without a lot of liquidity, at least at the point that the transaction is made, the bank. There’s the bank, there’s you, only two parties here, and while you could go to another bank, banks generally don’t compete much on the local level for foreign exchange rates.
However, on the forex market, with these trillions of dollars changing hands each day, this is what you call liquidity, and at any given moment there are a lot of people looking to both buy and sell, so the spreads you see are extremely tight. It’s always to the benefit of investors that spreads be as tight as possible, and this aspect of forex trading is just perfect.
Other Advantages of Forex Trading
Forex trading also has the benefit of not being governed by an exchange, like a stock exchange for instance, and all trading is done directly between traders, electronically, over the counter as they call it. Over the counter markets do exist with other financial instruments, stocks for instance, but often these are instruments that aren’t traded enough to be traded on an exchange. That’s far from the case with foreign currency transactions though, so that’s another benefit to the investor.
What this does is keep transactional costs extremely low, as exchanges do add costs to trading, and you also need to often pay significant brokerage fees. With forex trading, these fees are kept extremely small, and the smaller the fees, the more investors get to keep for themselves.
This is a lot bigger deal than it may appear, as many profitable forex trades involve only very small movements in price, so if transactional costs were higher, this would eat up a disproportionate part of that profit, and make it harder to trade profitably.
Having all this liquidity means that you can trade pretty much instantly, without having to worry about when your trade will be processed, or in a lot of cases, wait for the market to re-open. Forex markets aren’t open on the weekend, and are only open 5 days a week, but due to differences in time zones, this actually works out to being open 5 ½ days a week, not just 5.
Investments will often involve quite a number of different instruments to trade, like for instance the thousands of stocks that are available to be traded in a stock market. Even if you stick to the high volume stocks, that still involves a lot of stocks to look at, and to decide among.
While there are a lot of different currencies out there, most forex trading involves just the major ones. Forex trading involves trading a currency pair, one currency for another, and generally trading U.S. dollars for another currency, or vice versa. There are only a few major currency pairs that comprise the bulk of forex trading, so this limits the field and makes selecting and tracking them much easier and simpler than having to track countless potential plays.
Even More Advantages To Forex Trading
With a lot of financial trading, there is a bias toward going long so to speak, and long means trading with an expectation that an instrument will increase in value. So for instance you may buy a stock hoping to sell it later at a higher price and make a profit that way.
You may also want to short the stock so to speak, meaning pledge to buy it later and sell it now, and this can be a profitable move if you expect that the price of a stock will decline. However, stock markets aren’t that fond of a lot of short selling, and have rules that make it more difficult to short sell than buy.
With forex trading, there is no long and short position, as every forex trade involves going long with one currency and short on the other one. So there are no barriers to this and it’s just as easy to trade a currency that you expect to decline as it is for one you expect to gain in value, and all forex trading is actually a combination of the two, a movement of value between two currencies.
Forex trading also does not involve market risk like many other financial instruments do. Market risk is the tendency for the market in general to decline together, and not all instruments go down, but most can, and they can go down a lot. There is no such market risk with forex trading because you are playing both sides, and both currencies in your currency pair can go down relative to other currencies, but they cannot both go down relative to each other.
The advantage that individual forex traders find most appealing though, although this is certainly a double edged sword, is the amount of leverage that they can have with a forex trade. While one may buy stocks on margin for instance, putting up just part of the purchase price and borrowing the rest, we call that a leveraged trade.
With forex trading, instead of having to put up, say, 50% of the cost of the security, you can put up as little as 1%, and hold positions 100 times larger than you could without the leverage. So for instance, with $1,000, you can do a forex trade worth $100,000.
Then, as the currency pair moves, you make the difference on the $100,000, not the $1,000 you put up. This is only possible due to the extreme stability of currencies versus other types of instruments, and the movements here are much smaller. However, due to all this extra leverage, you can make more money from these small movements.
You can also lose more money as well, and this is why forex trading can be riskier than some other types of investing or trading, and this risk must be accounted for. If your trade is leveraged 100:1, and you lose 1%, you’ve lost all your money.
Now currencies rarely move that much in a short period of time, and you can get out of the trade anytime you want, and holding on to something through this relative big loss would be foolish, and traders that lose tend to do it more slowly than this, but this can happen.
So with all the advantages of forex trading, it does come with a fair bit of risk, especially if you don’t know what you are doing. As with all investments, the more adept you are at investing, in this case trading, the better you will do. Forex trading is as close to a zero sum proposition as you will see, therefore some win, some lose, in pretty close to equal amounts, and you want to do your best to be on the winning side as much as possible.
Forex FAQs
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How do I trade forex?
Getting started in trading forex involves opening an account and making a deposit with a forex broker and then placing trades based upon the future movement of currency pairs. Currencies move in relationship to one another and you can speculate on the movement of one versus another over time.
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What are the benefits of forex trading?
Currencies do not move very much in value against one another percentage wise, and without leverage, forex trading would have little potential for return. However, forex traders can amplify this rate of return by various degrees, where the potential returns can be many times higher than what you could achieve trading stocks.
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How much do you need to start trading forex?
One of the real benefits of forex trading is that you can get started with very small amounts of money. Deposit minimums are very low or there may not even be one, and you can trade very small as well where you may only be risking less than a dollar on a trade. This makes the forex market accessible to even the smallest traders.
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Is it safe to do forex trading?
Forex trading can be conducted quite safely or it can be done in a very reckless manner depending on the skill and strategy of a trader. Some forex brokers offer leverage of up to 1000:1 where both profits and losses are magnified a thousand times. Much more reasonable amounts of leverage can be used though.
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Is forex trading easy?
All forms of trading are fairly challenging and this is especially the case with trading that involves a lot of leverage, because this amplifies your weaknesses and also requires sounder money management. Once a trader has come up with a profitable strategy and has also learned to manage risk properly, forex trading can become fairly easy.
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Is forex a good investment?
Forex trading does not involve what we normally call investments because the holding time with forex trading is much shorter than with investments. The value of currency pairs vacillates over time and does not move in one direction overall like stocks do. With the proper timing though, forex trading has the potential for much higher returns than with investments.
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Can you make a living trading forex?
Many people make their living trading forex and you don’t need anywhere near as much capital to pull this off as you would with stocks or other assets that don’t allow higher leverage. Trading is a profession though and like all professions, it does require that one acquire a lot of skill to practice and isn’t something you just pick up casually.
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Which currency pair is most profitable in Forex?
There are several popular currency pairs that can be traded fairly reliably. Profit potential with forex trading depends more on the amount of leverage that you use more than anything, so you could trade any pair very profitably, but what we also want is pairs with a lot of liquidity and tight spreads, what are called the majors.
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How do I get started with forex?
Aside from opening an account with a forex broker, the next most important thing is to ensure that you are prepared enough to trade with real money with a reasonable expectation of success. This should involve trading with a practice account first until you feel confident enough that you know what you are doing.
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How much does it cost to open a forex account?
It doesn’t cost anything to open a forex account, nor do brokers charge commissions to place forex trades with them. The only cost is the spread, and this is why forex trading is so appealing, because you don’t have to worry about paying too much in commissions. The spread is the price that a pair can be bought and sold at, which differs a bit.
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How is profit calculated in forex?
When you place a forex trade, you purchase a certain amount of a currency at a certain price. This involves buying one or the other in a currency pair and speculating that the price of the one you chose will rise relative to the other. If it does, and you sell at your currency’s higher relative value, you profit by that amount.
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Is forex trading high risk?
The amount of risk involved with trading forex is dependent upon the amount of leverage that you employ. Forex brokers offer high amounts of leverage by default and if you trade with the full leverage that they offer this involves an extremely high amount of risk. By only putting a portion of your balance in play, you can dial down this risk to more reasonable levels.
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How do you pay taxes on forex profits?
All tax jurisdictions require you to declare profits that you earn from trading as taxable income. As a general rule, income from trading forex will be treated as business income, even though investors will usually report their income as capital gains. Traders generally don’t get this tax break though due to the frequency of their trading.
References & Scholarly Articles for Forex
Books on Forex
- Forex for Beginners: What You Need to Know to Get Started (Author: Anna Coulling, Originally published: December 20, 2013)
- Currency Trading for Dummies (Author: Brian Dolan, Originally published: August 6, 2007)
- Forex Trading: The Basics Explained in Simple Terms (Author: Jim Brown, Originally published: September 15, 2015)
Editor, MarketReview.com
Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.
Contact Monica: monica@marketreview.com
Topics of interest: News & updates from the Office of the Comptroller of the Currency, Forex, Bullion, Taxation & more.
