FX trading for beginners
FX, also known as Forex, foreign exchange or currency trading, is carried out through networks of banks, dealers and brokers who trade currencies between each other at agreed prices and at rapid speed. There is more money transacted daily for foreign exchange purposes than for any other asset class. This fact, together with the ease with which FX can be traded makes it a favourite with speculators around the world.
Who trades FX?
Many FX transactions are carried out for trade and business purposes. But the majority are done purely for speculation, with both parties in the deal hoping to make a profit. There are lots of different ‘players’ in the FX market. For example, you have the giant investment banks and multinational corporations who trade millions of dollars every day. Alongside these are financial brokers, smaller banks and individual traders like you. As long as you’re willing to take a risk, it’s easy to get involved in the exciting and fast-paced world of FX. But while you don’t need to have a lot of money to get started, it’s vital that you only speculate with money you can afford to lose. FX can be extremely volatile and large price swings are a regular occurrence. You need to consider carefully how much you’re willing to risk before entering into an FX trade, and it’s crucially important to have a trading plan before you do.
The biggest market
FX is the world’s biggest financial market. In a triennial report released at the end of 2019, the Bank for International Settlements, known as the ‘central bankers’ central bank’ estimated there were, on average, $6.6 trillion-worth of currencies traded daily that year (1). As a comparison, the total value of stocks traded globally in a whole year hit an all-time high just below $100 trillion in 2015 (2).
With FX, currencies are quoted in pairs, with the price representing the exchange rate relationship between the two. You sell one currency in order to buy another and the price of a pair is determined by how much one unit of the ‘base’ currency (the first currency listed in the pair) is worth against the ‘quote’ currency (the second currency in the pair). On trading platforms, each currency is represented by a 3-letter code. For example, the GBP/USD pair involves trading the British pound (with GB standing for Great Britain) against the United States’ dollar.
Other examples of currency pairs include:
● Euro versus US dollar - EUR/USD
● US dollar versus Japanese yen - USD/JPY
● Australian dollar versus US dollar - AUD/USD
● Euro versus British pound - EUR/GBP
The US dollar is by far the most heavily traded currency in the world. Again, the Bank for International Settlements estimates that in 2019 a daily average of $5.8 trillion-worth of US dollars (or 88% of the $6.6 trillion market) were traded as one half of a currency transaction. The euro was next at $2.1 trillion, or 32% (the total volume adds up to 200% as there are two currencies involved in every transaction).
How does forex trading work?
Spread trades and CFDs
At Trade Nation we offer spread trading and CFDs (Contracts for Differences) on more than 30 different currency pairs. These range from the majors, like the EURUSD and GBPUSD to the more exotic such as the NZDJPY (New Zealand dollar versus the Japanese yen). When you ask for a quote on an FX pair, you will be given two prices. The difference between these is called the spread. You sell at the lower end of the price and buy at the higher end. You sell (go short) if you expect the first-named ‘base’ currency to fall, and you buy (go long) if you expect the first-named ‘base’ currency to rise.
Let’s say that you want to trade the euro against the US dollar. The EUR/USD rate represents the number of US dollars that one euro can buy. If you think that the euro will increase in value against the USD, you will buy euros and simultaneously sell US dollars. If the exchange rate rises, you’ll be able to sell the euros back at a higher rate, while buying the US dollars back at a lower one and make a profit.
Working out your exposure
To work out your exposure or risk, you need to understand what a ‘point move’ in a currency pair actually means. This is the minimum price fluctuation that can take place, and it can vary from one pair to another. Once you understand this you can decide on a suitable stake – how much you will make or lose for every point that the currency pair moves. Multiplying your stake by the dealing price gives you your overall exposure to the market. Here’s an example:
You believe that the euro will rise against the US dollar. Our quote is: 1.09250 – 1.09256 which means you can buy, or go long, at 1.09256.
The stake is how much you are prepared to make or lose per point movement in the currency pair and starts at just 0.10 (£, AUD or $ for example).
Now, a point, or 'tradable unit', on the EURUSD currency pair is 0.0001. So, if our price moves from 1.09256 to 1.09266 that is one tradable unit, or point. If you had bought £1 per point at 1.09256 and sold it at 1.09266 you would have made £1 profit. And as you can see from the example quote above, our spread on this currency pair is 0.6 of a point.
Let’s say you decide to buy £1 per point. This means that your total exposure to the EURUSD is £10,925.60 (10925.6 x 1) but as this is a leveraged product, you are only required to hold a small percentage of this exposure in your account as a deposit (or margin) to open the trade (see ‘Leverage and margin’ below).
In this example, you’re correct and the euro rises against the dollar. You decide to close your position and we give you a quote of 1.09364 – 1.09370. As you bought £1 to open the trade, you sell £1 to close it, and you do this at the lower end of the quote at a price of 1.09364.
This gives you a profit of £10.80
10936.4 – 10925.6 = 10.8
10.8 x £1 = £10.80
Leverage and margin
Spread trades and CFDs are leveraged products. This means that you only have to deposit a small percentage of the value of the underlying currency pair to control all of it.
In the above example the total value of the opening trade was £10,925.60
For UK account holders the margin rate on the EURUSD is 3.33% so the initial margin requirement (the money you would need on your account to open this trade) is £363.82 (££10,925.60 x 3.33/100). For holders of accounts regulated outside the UK, the corresponding margin rate is 0.50%. This means that the initial margin requirement for the same trade is just £54.63.
What affects prices in the FX market?
As with other financial markets such as individual equities and stock indices, the FX market is affected by the supply and demand for one currency compared to another. Much of this will depend on the difference in interest rates, as investors are more attracted to currencies of countries with a higher interest rate than a lower one. But this isn’t the only driver of currency moves. A country’s relative stability is also important, both political and economic, although the two are often linked. Then global issues, geopolitical events and ultimately market sentiment all have an influence on how currencies move relative to each other. Many traders find it useful to think of a currency like a nation’s stock price, going up on good news, and down on bad.
When it comes to FX, there’s a lot to take in, but it’s worth the effort. Watching currency moves and working out the reasons behind them helps to open up an in-depth viewpoint on world events. But please bear in mind that FX can be volatile. It’s important to decide how much you’re willing to risk before opening a trade, not once you’re in it. Then you can carry out proper money and risk management to protect yourself against excessive losses should prices move against you. But as long as you plan your trades diligently, and never speculate with money you can’t afford to lose, FX trading can be an exciting and fascinating activity.