What is Foreign Exchange aka Forex, FX or currency trading?
What is Forex?
Forex is a globalized decentralized marketplace where currencies around the world are traded. The forex market is the world’s largest and most liquid financial market with trading exceeding USD2b daily. Currency trading is done over the counter (OTC) which means that all transactions occur over computer networks. The forex market for retail investors is open 24 hours a day for 5 days a week from Sunday 5pm EST (Monday 5am Malaysia) until Friday 4pm EST (Saturday 4am Malaysia).
The forex market are traded in three markets:-
- Spot market: where currencies are traded according to current price.
- Futures market: where futures contracts are traded based upon standard size and settlement on public commodities market.
- Forward market: where contacts are bought and sold OTC between two parties with terms both parties agree on.
What Affects Forex Pricing
- Interest rates and monetary policy determined by central banks like the US FED and BNM.
- Economic GDP growth with higher consumer spending leading to domestic currency appreciation.
- Trade balance which is positive with a trade surplus of imports vs exports, or a trade deficit with exports higher than imports.
- Inflation rate with higher growth and higher interest rates leading to domestic currency appreciation.
- Unemployment rate where a high unemployment rate reduces spending and interest rates.
- Political stability where foreign investors prefer save haven currencies such as USD, Euro, GBP and JPY.
- Market factors especially commodities such as oil which affects oil-producing countries positively/negatively.
- Natural disasters or pandemics which affect GDP growth and lead to central banks cutting rates.
- Currency speculation by large institutional speculators betting against the currency of a particular country.
What is Forex Trading?
Forex trading is to exchange one currency for another in the expectation tat the price will change. Forex trading involves simultaneously buying one currency for another (unlike other investments like shares where you must wait for a matched price between a buyer and seller).
All Forex trading is done in pairs between two currencies. Currencies are usually priced to four decimal points where the smallest trading point percentage is known as a pip. Currencies move up and down affected primarily by supply and demand. Information including interest rates, economic data, geopolitical factors, and positive/negative news affect currencies. Forex trading costs are determined by the bid (buying) – ask (selling) spread (price difference).
Forex is quoted in pips (aka percentage in points) with up to 5 decimal points. Lot sizes can be categorized as standard, mini, micro or nano lots.
- Standard Lot (1.00): Each pip will be worth $10.00.
- Mini Lot (0.10): Each pip will be worth $1.00.
- Micro Lot (0.01): Each pip will be worth $0.10.
- Nano Lot (0.001): Each pip will be worth $0.01.
Most Traded Currencies
- US Dollar (USD)
- Canadian Dollar (CAD)
- Euro (EUR)
- British Pound (GBP)
- Swiss Franc (CHF)
- New Zealand Dollar (NZD)
- Australian Dollar (AUD)
- Japanese Yen (JPY)
Most Traded Currency Pairs (aka Majors)
Types of Brokers
- DD (Dealing Desk): Broker does not execute client orders on the prices of liquidity providers, but takes the trade for itself. Broker is essentially betting against traders.
- STP (Straight Through Processing): the broker’s trading commission is included into the spread. Each order is executed on the real market.
- ECN (Electronic Communications Network) broker who uses a network to provide clients direct access to other participants in the market consolidating quotes from several participants to offer tighter bid/ask spreads.
Types of Forex Trading
- Self trade: trading on own
- Copy trade: copying a season trader
- Robot trading: robots run with human supervision
- Fund manager: trading larger portfolios on behalf of client
- Hedge fund: very large fund size of billions
Forex Trading Pros
- Liquidity, market size, and long trading hours available.
- Small trading amount available by trading in micro lots.
- Leveraged trading easily available allowing starting with small capital.
Forex Trading Cons
- Very high volatility which can cause significant losses if not properly managed.
- Small retail traders are at a disadvantage compared to larger players who can set and influence prices.
- Leverage is a double-edged sword which magnifies losses as well as gains.
Why Forex Trading?
- Low transaction costs
- High liquidity (five TRILLION traded daily in the forex market)
- No financial institute large enough to unduly “influence” the forex market
- Forex market is open 24-hours
“The money never sleeps.”
How to Read a Forex Quote
A forex quote is stated in Base Currency/Quote Currency. The forex quote thus shows the cost to buy one unit of the base currency.
For example: EUR/USD = 1.1578
Buying: You pay X units of the quote currency to buy one unit of the base currency.
You have to pay USD 1.1.578 (the quote currency) to buy one unit of EUR (the base currency).
Selling: You receive X units of the quote currency for selling one unit of the base currency.
You will receive USD 1.1.578 (the quote currency) to buy one unit of EUR (the base currency).
Forex Trading Categories
There are a few ways to profit from investing/trading in forex depending on the investor/traders goals and time frame.
Short term trading/scalping (time range from seconds to minutes)
This involves buying and selling currencies within a few seconds to minutes to make quick profits based on small price fluctuations. This involves a very high degree of risk.
Longer term trading range from half hour to few hours or last for days/weeks, and strictly follow the trend. Once the trend is over, close the position and end the trade.
The 2 examples below show different time frame of trend following, one lasting for hours, another lasting for weeks.
Forex can be an instrument to make good money (for short-medium term), or a tool for investment for longer term, that needs to be monitored and managed when major trends change.
Forex Heat Map