Home > Introduction to Forex Trading – What It is and How It Works

Introduction to Forex Trading – What It is and How It Works

Foreign exchange (or “forex”) is the largest market in the world. Trillions of dollars worth of currency change hands each day between traders, banks, corporations and countries. Its size and global reach make it the most accessible market to individual traders. People can open a forex trading account with as little as $100 with some brokers, although starting with at least $1000 is recommended.

Introduction to the Forex Market

Currencies are available for trade 24 hours a day, 5 days a week. Since currencies are a global market, during the week there is always a major financial center open for business (called a session, such as the New York session, or London session) somewhere in the world. In the US, that means trading begins Sunday night, when Asian markets open, and then trading continues throughout the week until the US market closes on Friday. After that Friday close, there is no trading until Sunday. The following chart shows major financial centers and when they are open throughout the day. All times are Eastern Standard. Currencies behave differently during the various sessions, as some centers are bigger than others which affects how many transactions occur.

forex market hours
Courtesy: http://www.forexmarkethours.com/markethours.php

The Bank of International Settlements regularly publishes reports on the dollar volume of currency transactions that occur each day. As of 2016, average daily volume exceeded $5 trillion dollars. For comparison, the dollar volume of all stocks traded in a single day on the NYSE may range from about $25 to $90 billion.

When you trade in currencies you are trading in pairs (one currency relative to another). Currencies always trade in pairs, because when you exchange currency you need to exchange it for another currency (otherwise no transaction takes place). Examples of currency pairs include the EUR/USD, USD/JPY and USD/CAD, or a combination of any two currencies. Some common currencies are the euro (EUR), US dollar (USD), Canadian dollar (CAD), New Zealand dollar (NZD), Australian dollar (AUD), Japanese yen (JPY), British pound (GBP) and each currency has a symbol (in brackets).

How Currencies Move and How Money is Made

For trading purposes, when you buy a currency pair you are buying the first currency listed in the pair and expect it to appreciate versus the latter currency. If you sell the currency pair, you expect the first currency listed to depreciate relative to the second. If you buy the EUR/USD you are expecting the Euro to appreciate versus the US dollar (Euro rise).  If you sell the EUR/USD you are expecting the US dollar to appreciate versus the Euro (Euro fall).

Each currency pair has a price associated with it, and that price is how much of the second currency it takes to buy the first. For example, if the USD/CAD is at 1.2500, that means it costs 1.25 CAD to buy 1 USD.

Since currencies trade 24 hours a day, these prices are always changing. Price movements occur in “pips”. A pip is the fourth decimal place of the price (except with JPY pairs, in that case it is the second decimal place). Therefore, if the price goes from 1.2500 to 1.2501, that is one pip of movement. If we are talking about a JPY pair, like the GBP/JPY, then a move from 150.51 to 150.50 would be a one pip move. One pip isn’t a very big move, but currencies trade in big quantities, so even small pip movements can add up to big profits or losses.

Currencies trade in micro, mini and standard lots. A micro lot is 1000 worth of currency, a mini lot is 10,000 and a standard lot is 100,000. On a pair like the EUR/USD (or any pair where the USD is listed second), each pip movement is worth a fixed dollar amount. For a micro lot, a 1 pip move equates to $0.10. Meaning, if you buy at 1.2500 and sell at 1.2501, you will make $0.10 on your $1000 (micro lot) position. For mini lots, each pip equates to a $1 gain or loss, multiplied by how many mini lots you have bought or sold. On a standard lot, each pip of movements equates to $10, per standard lot. For example, if you bought 5 standard lots, and the price moved in your favor 5 pips, you would make $250 ($10 per pip X 5 pips X 5 standard lots).

As indicated, the gain or loss on each lot is fixed if the USD is the second currency listed in the pair. That won’t always be the case. For example, in the USD/CAD the USD is listed first, and in the EUR/JPY the USD isn’t involved at all. With pairs like these, the pip value will fluctuate. That is, how much you will make or lose on a one pip movement when trading a micro, mini or standard lot will change over time as the price of the currency changes. Pip values can be calculated using a pip value calculator. To understand why this occurs, see Calculating Pip Value for Different Forex Pairs and Account Currencies.

Forex Leverage

Traders can buy or sell multiple lots. This means day traders can capture small movements and still make good returns. As indicated earlier, accounts can be opened for small amounts of capital. This is possible because of leverage. Many forex brokers provide up to 50:1 leverage (and sometimes higher outside the US). That means a trader who deposits $1000 can trade up to $50,000 worth of currency. So instead of only being able to trade 1 micro lot (making/losing $0.10 per pip movement), that trader could take up to a 5 mini lot positions (making/losing $5 per pip movement). Since many currency pairs move between 50 and 100 pips per day, there is a lot of profit potential, even for a small account.

Leverage comes with risks as well. A large position where the price moves against the traders means their capital can disappear very quickly. To control risk forex traders use stop loss orders, to get them out of a losing trade before it causes too much damage. They also control their position size, so they don’t end up with too big of a position for their account size.

Bid/Ask Spread and Commissions

bid ask spread forexAll markets have two prices at a given time. These prices are the bid and ask, which reflect the price traders are willing to buy at and sell at, respectively. If you want to buy right now you will need to purchase at the ask price, and if you want to sell you will need to do so at the bid price. To the left is an image showing the bid and ask price of the EURUSD. To buy right now, means buying at the price on the right (the ask). If you wanted to sell right now, that could be done at the price on the left (the bid). Of course, we won’t need to buy or sell right now. We can try to buy or sell at any time and at any price we want, by placing an order at that price. We will only get into that trade, and get that price, if the currency moves to the price of our order and someone is willing to take the other side of our trade (buy if we are selling or sell if we are buying).

The difference between the bid and ask is called the “spread”. In the image on the left, the spread is 0.4 pips. The spread is a trading cost. If you buy at 1.19383 (the firth decimal place is called a “fractional pip”), and decide you need to get out, even if the price hasn’t moved, the only price to sell it at right now is 1.19379. You lose 0.4 pips without the price even moving. You could attempt to sell it at another price, higher perhaps, but then the price will need to move up to that price and someone will need to buy that position off of you (because you are selling to get out). In order for a trade to take place, both a buyer and seller must meet at the same price.

Some forex brokers charge a commission on each trade. These brokers typically have small spreads, since they are making their money off the commission. Other forex brokers do not charge a commission, but they tend to have higher spreads. These brokers make their money off the increased spread. For the trader it is imperative to find a broker that offers small spreads and/or low commissions, as over time larger spreads or high commissions will significantly eat into profits.

Forex Rollover (swap) and Interest Rate Differentials

If you went to Canada, got some Canadian dollars and put them in a bank, you would get a different interest rate than if you did the same thing in the US, Australia or New Zealand. Each country, and by extension each currency, as an interest rate attached to it. When you make a forex trade, you can potentially participate in these interest rate differentials. Each evening, at 5 PM EST positions experience rollover or swap. This is when the interest rate differential is either credited or debited from your account, depending on the positions you are holding at that time.

Assume the interest rate for the NZD is higher than the USD. You bought the NZD/USD forex pair, and are holding that position 5 PM one evening. Your position means you own NZD and have sold USD. Since you own the higher interest rate currency, at 5 PM you will be credited the interest rate differential between the New Zealand and the US. Quoted interest trades are yearly rates. So if the NZD has a rate of 1.75% and the US has a rate of 1.25%, the difference is 0.5%, and will be paid out over the course of year (a tiny bit each day), for as long as you hold the trade. Keep in mind though, interest rates can change over time, causing the differential (and your credit or debit) to also change.

Since interest is not paid on weekends, when the market is closed, Wednesdays are triple-interest days. On Wednesday (if holding a position at 5pm EST) you are credited or debited the interest for Wednesday, Saturday and Sunday. With some currency pairs the interest rate differential can be massive, especially between emerging economies/currencies and established currencies. Sometimes the differential can be as much as 20%, and that can mean a pretty big debit or credit each day the position held. In my Forex Weekly Charts Course, which is focused on longer-term trades, I usually only wait for trades that allow me to collect interest each night (as well as likely make a profit on the actual trade).

You do not need to calculate what the swap payments will be. Your broker or trading platform should let you know how much you will debited or credited each night. Basically though, if you bought the higher interest rate currency in the pair, you will receive interest. If you sold the higher interest rate currency, you will be debited interest. The bigger the interest rate differential, the bigger the credit or debit. Current interest rates for major currencies can be seen on the Forex Stats page. Interest rates for most countries/zones in the world can be found on Trading Economics (under Interest Rates)

While you could calculate the swap rate by hand, it isn’t worth it. Brokers all pay/charge different swap rates anyway. Just like brokers take a spread, they also typically take a tiny bit of your credits for themselves, and add a little bit to your debits. The swap is another way brokers may make money, if they so choose. In MetaTrader 4 (MT4), you can see the credit or debit amount by right-clicking on a currency pair in your Market Watch list (Ctrl+M). Click on Specifications. Scroll down and you will see Swap Long and Swap short. If you are long (bought it) then you will look at the Swap Long number. If it is a positive number, you will receive a credit. If it is negative you will be debited. The same concept applies if you are short. Check these numbers before a trade to see if it affects your trading decision.

As mentioned, brokers provide different swap rates. MyFXBook shows the wide-ranging swap rates provided by forex brokers.

What Causes Currencies to Move

Currencies are what we use to buy things, and each country or global zone has a currency. That means currency markets are affected by changes in the economy, as well as how traders position themselves for those economic changes. Interpreting the economic data that affects currencies falls under fundamental analysis,

usdjpy chart example
USD/JPY Candlestick Daily Chart

while what traders are doing (visible by the price movements on a chart) fall under the realm of technical analysis. The chart to the left, for example, shows the price movements of the USDJPY. Each “candlestick” represents the price movements of one day.

Short-term traders are mostly concerned with technical analysis. This is the study of how price itself moves (with less concern for the reason behind it). For example, if using a trending strategy, a trader may simply isolate trends in various currency pairs, and then trade in the direction of that trend when their strategy dictates. They pay little attention to fundamental analysis, since a trade that only lasts 5 minutes or even several hours is likely to be just noise in terms of the much bigger movements caused by fundamental or economic conditions.

Longer-term traders are more likely to consider both technical and fundamental analysis. They may look at the major events in the world, how that is affecting the various countries and currencies, and then use technical analysis to find entry points based on their outlook.

While not everyone tracks economic and fundamental data, nearly every day major economic reports and statistics are released by various countries. These scheduled news announcements typically cause large price moves, as soon as the data is released. Therefore, all traders should check a forex economic calendar every day before starting to trade.  Make a note of any high-impact news releases that are coming out that day, or in the near future. Traders can then decide if they need to alter their positions before the news announcement. For day traders, it is recommend all positions are closed prior to a high-impact news release.

High-impact news releases cause big price movements for a couple of reasons. As mentioned above, most short-term traders stop trading right before major news announcements. Even major banks and hedge funds may stop trading. This means there isn’t as much volume (people willing to bid, offer or trade) right before a news announcement. When the news is released, orders come flooding back into a “thin” (low volume) market. This in itself can cause big price swings. The news itself is also acted on. If the news is very positive for the USD, then the EUR/USD may plummet as everyone jumps in to buy USD and sell EUR. The big moves can happen instantaneously. This is why day traders typically avoid holding trades through these announcements. It is very hard to control risk when something moves a large amount instantaneously. Right after the announcement, traders and orders flood back in. That is when day traders can start trading again, after the news is released.

Swing traders (traders who take trades lasting a couple of days to a couple of weeks) may not necessarily exit before a news announcement, but they should be aware of when the major releases are, and should monitor or adjust their positions accordingly.

How to Start Trading Forex

If forex seems interesting, one of the best ways to start learning–without risking any money–is to open a demo account. A demo account provides play money for trading in a forex market environment. You get to buy and sell currencies, see how it works, but all without losing any money. Demo accounts are like a testing ground, where traders can work on strategies, test things out and experiment with things they are unsure of. Experiencing and actually clicking buttons and seeing the results is one of the quickest ways to get a feel for the forex market.

After grasping the basics, begin to work on creating strategies, or learning someone else’s strategies. During this process, create a trading plan for exactly how you will trade the markets. The strategies and trading plan should be tested for profitability in the demo account before making the switch to real capital. If the trading plan is followed and produces a profit for several months in a row, then consider depositing capital with a broker and trading with real money.

By Cory Mitchell, CMT

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