Introduction to forex trading For beginners

The FOReign EXchange market (forex or FX for short) is one of the most exciting, fast-paced markets around. Until recently, forex trading in the currency market had been the domain of large financial institutions,corporations, central banks, hedge funds and extremely wealthy individuals.

The emergence of the internet has changed all of this, and now it is possible for average investors to buy and sell currencies easily with the click of a mouse through online brokerage accounts.

An illustration will help you understand forex trading. Let’s suppose you visit South Africa and you have some US$ in your pocket. The first thing to do is to exchange your US$ for the Rand and you can do this in a bank. This process is itself participation in Forex market- exchange one currency for another. However, the forex trading we are discussing here is not done physically, rather it is done online.

The foreign exchange market is the most traded financial market in the world. In forex trading, traders hope to generate a profit by speculating on the value of one currency compared to another. This is why currencies are always traded in pairs—the value of one unit of currency doesn’t change unless it’s compared to another currency.

Exchange rates are always changing and fluctuating, and this happens because of different factors. Due to these fluctuations, it becomes possible to make a profit from speculative trades.

Foreign Exchange is the World’s largest and most active market. It operates every day except the weekends, and its volume reaches up to US$5 trillion a day. This volume is larger than all the other markets combined!!

For example, in 2013 the average daily trade volume on wall street was a paltry US$169 billion. The forex market is very liquid, one can buy and sell currencies instantly i.e. there are always buyers and sellers at any given time when the markets are open.

There are a number of reasons for trading forex.

1.) A 24-hour market five days a week.
From the Monday morning opening in Australia (11 pm Sunday GMT+2) to the afternoon close in New York (11 pm FridayGMT+2), the forex market never sleeps. This is awesome for those who want to trade on a part-time basis (even if you are employed full time), because you can choose when you want to trade.

2.) Leverage
In forex trading, a small deposit can control a much larger total contract value. Leverage gives the trader the ability to make nice profits, and at the same time keep risk capital to a minimum. For example, a forex broker may offer 50-to-1 leverage, which means that a $50 dollar margin deposit
would enable a trader to buy or sell $2,500 worth of currencies. Similarly, with $500 dollars, one could trade with $25,000 dollars and so on. While this is all presents a chance for increasing profit let me warn you that leverage is a double-edged sword. Without proper risk management, this high degree of leverage can lead to large losses.

3.) High Liquidity.
Because the forex market is so enormous, it is also extremely liquid. This is an advantage because it means that under normal market conditions, with a click of a mouse you can instantaneously buy and sell at will as there will usually be someone in the market willing to take the other side of your trade.

You are never “stuck” in a trade. You can even set your online trading platform to automatically close your position once your desired profit level (take profit order) has been reached, and/or close a trade if a trade is going against you (a stop loss order).

4.) Low Barriers to Entry
Getting started as a currency trader does not require lots of money. Online forex brokers offer “mini” and “micro” trading accounts, some with a minimum account deposit just of $1!(We will look at different brokers in later sections or you can see them here). This makes forex trading much more accessible to the average
individual who doesn’t have a lot of start-up trading capital.

6.) You can practice trading using virtual money

Most online forex brokers offer “demo” accounts to practice trading and build your skills, along with real-time forex news and charting services.
And guess what…. they’re all free!

Demo accounts are very valuable resources for those who are “financially hampered” and would like to hone their trading skills with “play money” before opening a live trading account and risking real money. Demo accounts allow you to get a feel of the trading process without using your real money. Every trader should start trading with a demo account before risking real money.

You can open your demo account here

7.) You can trade from anywhere in the world

With forex trading you can trade from anywhere in the world as long as you have a device with internet connection! This means that with forex trading you choose to settle in any part of the world and still continue your trades. You can trade at home in your pyjamas, report to no boss and not have to keep up with those nosy and irritating co-workers. Forex trading can offer one a possibility of being their own boss and if done well it can pay handsomely.

These are the most traded currencies with their symbols

These are the currencies with the highest volatility. Volatility measures the overall price fluctuations over a certain time and the higher the volatility, the more the chances of profiting from trading those currencies. High volatility means that the exchange rate changes very fast. Next, we look at
the most traded currency pairs.

The following are the most traded pairs
• EUR/USD.
• USD/JPY.
• GBP/USD.
• AUD/USD.
• USD/CHF.
• USD/CAD.
• EUR/JPY.
• EUR/GBP.

Most currency traders stick to these pairs because they generally have high volatility, I would suggest that you start out with these pairs too.
To illustrate volatility, let’s use two charts. The chart below shows a currency pair with high volatility.

The chart below shows low volatility in the circled area. This is called a ranging market (because the price movement stays within a certain range) and is a bit tricky to trade.

Exchange rates float freely against one another, which means they are in constant fluctuation. Currency valuations are determined by the flows of currency in and out of a country. A high demand for a particular currency usually means that the value of that currency will increase. Demand for a currency is created by tourism, international trade, mergers and acquisitions, speculation, and the perception of safety in terms of geo-political risk.

If, for example, a company in Japan sells products to a company in the United States and the U.S.-based company would have to convert dollars into Japanese yen to pay for the goods, the flow of dollars into yen would indicate a demand for Japanese yen. If the total of currency flow led to a net demand for the Japanese yen, then the yen would increase in value.

Currencies are traded around the clock – 24 hours per day. Even though morning in Tokyo occurs during U.S. night-time, trade and banking continue around the world.

Therefore, as banks around the world buy and sell currencies, the value of currencies remain in fluctuation. Interest rate adjustments in different countries have the biggest effect on the value of currencies because investors typically look for safe investments with the highest yields. If an investor can earn 8.5% interest on deposits in England, but can pay 1% interest for the use of money in Japan, then the investor would pay to borrow the Japanese yen in order to buy the British pound. Such trades take place all the time and in very large numbers.

The forex market is always open 24 hours a day, 5 days a week. How is this possible? Well, this is because of time differences. At any given time during the week, one of the important trading centres will be open for business.

These 9 places shown below are the important world trading centres because  most of the forex currency transactions and or speculations take place at these centres (or through these centres):

• London,
• Zurich,
• New York,
• Tokyo,
• Hong Kong,
• Frankfurt,
• Singapore,
• Sydney,
• and Paris.

There are three main forex market trading sessions (or you may call it forex market hours)

1. the London/Europe trading session
2. The New York Trading Session
3. And the Asian Trading Session (that includes Sydney, Hong Kong, Tokyo)

As you can see in the table below, there is a bit of overlap in the forex market trading sessions. 

What this means is that the forex market follows the sun around the world…

When London is getting into the evening in London and Europe, the New York Trading Session is on.

When New York sleeps, Sydney and Tokyo Trading Session begins for the day.

One of the biggest sources of confusion for those learning forex is the standard for quoting currencies. In this section, we’ll go over currency quotations and how they work in currency pair trades. Currencies work in pairs.

Let’s simplify it: lets suppose $1 is equal to R15? The quote would look like this USD/ZAR=15

The currency to the left of the slash is the base currency, while the currency on the right is called the quote or counter currency. The base currency (in this case, the U.S. dollar) is always equal to one unit (in this case, US$1), and the quoted currency (in this case, the South African Rand) is what that one base unit is equivalent to in the other currency. The quote means that US$1 could buy 10 South African Rand.

Since the base currency (USD) is always equal to $1 in the quote, if the rand gets stronger the quote would look like this.

USD/ZAR=13

Which means that you now need fewer Rands to buy one dollar.

If the Rand becomes weaker against the USD, the quote would read something like this. USD/ZAR=18

Meaning you now need more Rands to buy one dollar

The forex quote includes the currency abbreviations for the currencies in question. Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of the Japanese yen (JPY), which is quoted out to two decimal places.

When you are learning forex as a beginner you probably wonder how a small investor like you can trade such large amounts of money. Think of your broker as a bank who basically fronts you $100,000 to buy currencies. All the bank asks from you is that you give it $1,000 as a good faith deposit, which he will hold for you but not necessarily keep. Sounds too good to be true? This is how forex trading using leverage works.

Currency rates move very slowly. This makes small trades unfashionable as they only return small profits and losses for every pip rate changes. Therefore, leveraging helps one to trade in larger deals and hence amplifying their potential profits…. & losses.

The amount of leverage you use will depend on your broker and what you feel comfortable with. Typically, the broker will require a trade deposit, also known as “account margin” or “initial margin.” Once you have deposited your money you will then be able to trade. The broker will also specify how much they require per position (lot) traded.

For example, if the allowed leverage is 100:1 (or 1% of position required), and you wanted to trade a position worth $100,000, but you only have $5,000 in your account, your broker would set aside $1,000 as down payment, or the “margin,” and let you “borrow” the rest. Of course, any losses or gains will be deducted or added to the remaining cash balance in your account.

The minimum security (margin) for each lot will vary from broker to broker. In the example above, the broker required a one per cent margin. This means that for every $100,000 traded, the broker wants $1,000 as a deposit on the position. Leverage is a double-edged sword, it can help you get higher profits but if your forecast is wrong, you will incur heavier losses. Most brokers will give you the option to choose your leverage when you sign up for a demo or real account. The lesser the leverage ratio the safer it is.

This is how you profit from opening a buy position. It makes no difference which currency pair you are trading. If the price of the currency you are buying goes up from the time you bought it, you will have made a profit.

So now you have an idea of what forex trading is, lets tackle the one burning question that everyone who is interested in a new business venture asks…… Where is the money?

Trading currency in the Forex market centers around the basic concepts of buying and selling. Let’s take the idea of buying first.

How do you profit from a buy trade (going long) in forex?

What if you bought something (it could literally be almost anything…a house, a piece of jewellery or a stock) and it went up in valHue. If you sold it at that point, you would have made a profit…the difference between what you paid originally and the greater value that the item is worth now.

Currency trading is the same way…

Let’s say you want to buy the AUDUSD currency pair. If the AUD goes up in value relative to the USD and then you sell it, you will have made a profit. A trader in this example would be buying the AUD and selling the USD at the same time.

For example, if the AUDUSD pair was bought at 0.74975 and the pair moved up to 0.76466 at the time that the trade was closed/exited, the profit on the trade would have been 149 pips*. (See the chart below…) 0.76466-0.74975=149 (disregard the fifth digit)

* A pip is a number value. In the Forex market, the value of a currency is given in pips. One pip equals 0.001, two pips equal 0.002, three pips equals 0.0003 and so on. One pip is the smallest price change that an exchange rate can make. Most currencies are priced to four numbers after the point.

So what is the value of the 149 pips in money terms? Well, this depends on the lot size. And I hear you ask, ‘What is a lot?’. Let me break it down for you.

What is a Lot in Forex?

In the past, spot forex was only traded in specific amounts called lots. The standard size for a lot is 100,000 units. There are also a mini, micro, and nano lot sizes that are 10,000, 1,000, and 100 units respectively.

If one micro lot of the AUD/USD is being traded, each pip would be worth $0.1, as opposed to $10 for a standard lot. We have calculated the profit in the table above using the 149 pips from our example above. Such a movement (of 149 pips) can take place within minutes during very volatile periods! So, depending on your lot, you could have made a profit of $1,49 to $1490 in ten minutes!

Quite exciting stuff, right? However, this is not always the case, sometimes such movement can takes hours to get or the currency pair can start falling before it reaches that number of pips. This is just an illustrative example of the potential profits of forex.

Here is another example using the AUD; In this case, we still want to buy the AUD but let’s do this with the EURAUD currency pair. In this instance, we would sell the pair. We would be selling the EUR and buying the AUD simultaneously. Should the AUD go up relative to the EUR we would profit as we bought the AUD.

(Remember you always buy or sell the base currency. If you buy the base, you are selling the quote currency simultaneously and vice versa)

In this example if we sold the EURAUD pair at 1.2320 and the price moved down to 1.2250 when we closed the position, we would have made a profit of 70 pips. Had the pair moved up instead and we closed out the position at 1.2360 we would have had a loss of 40 pips on the trade.

Now let’s take a look at how a trader can make a profit by selling a currency pair. This concept is a little trickier to understand than buying. It is based on the idea of selling something that you borrowed as opposed to selling something that you own. In the case of currency trading, when taking a sell position, you would borrow the currency in the pair that you were selling from your broker (this all takes place seamlessly within the trading station when the trade is executed) and if the price went down, you would then sell it back to the broker at the lower price.

The difference between the price at which you borrowed it (the higher price) and the price at which you sold it back to them (the lower price) would be your profit.

For example, let’s say a trader believes that the USD will go down relative to the JPY. In this case, the trader would want to sell the USDJPY pair. They would be selling the USD and buying the JPY at the same time. The trader would be borrowing the USD from their broker when they execute the trade. If the trade moved in their favour, the JPY would increase in value and the USD would decrease.

At the point where they closed out the trade, their profits from the JPY increasing in value would be used to pay back the broker for the borrowed USD at the now lower price. After paying back the broker, the remainder would be their profit on the trade.

For example, let’s say the trader sold the USDJPY pair at 122.761. If the pair did in fact move down and the trader closed/exited the position at 121.401, the profit on the trade would be 136 pips.

In a nutshell, this how you can make a profit from selling something that you do not own.

When you buy a pair, like in the first illustration, you would have gone ‘long’ on that pair. When you sell a pair, you open a short position. So, remember this, buying a pair=going long: selling a pair=going short.

This is the technical jargon of the trade.

In wrapping up, if you go long on a currency pair and it moves up, that trade would show a profit. If you open a short position on a currency pair and it moves down, that trade would show a profit. Simple, right? Not by a long shot!

Making the forecast on the movements of the pairs is by no means an easy task. By now, I hope I have impressed it upon your mind that making accurate forecasts of the currency movements is where the profit lies, doing wrong forecasts leads to losses.

So how do traders make the forecasts?

This is a critical part of trading as we highlighted above. Since this section is directed to beginners, we would just highlight the methods of analysis without going into great detail because there is a lot to cover on analysis and we don’t want to give you an information overload at this point. Now let’s look at analysis in brief.

There are two broad ways of analysing exchange rate movements 1. Fundamental analysis and 2. Technical analysis.

1.) Fundamental analysis in Forex trading

Fundamental analysis is the interpretation of statistical reports and economic indicators. Things like changes in interest rates, employment reports, and the latest inflation indicators all fall into the realm of fundamental analysis. Forex traders must pay close attention to economic indicators which can have a direct – and to some degree, predictable – effect on the value of a nation’s currency in the forex market.

Given the impact these indicators can have on exchange rates, it is important to know beforehand when they are due for release. It is also likely that exchange rate spreads (we will look at spreads later) will widen during the time leading up to the release of an important indicator and this could add
considerably to the cost of your trade.

Therefore, you should regularly consult an economic calendar which lists the release date and time for each indicator. You can find economic calendars on Central Bank websites and also through most brokers. You can read more about fundamental analysis here.

2.) Technical analysis in forex trading

In finance, technical analysis is a security analysis methodology for forecasting the direction of prices through the study of past market data, primarily price and volume.

Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is “likely” to happen to prices over time.

Technical analysis uses a wide variety of charts that show price over time. I used two charts above to illustrate how to profit in forex and another two to highlight volatility. Technical analysis other tools like candle charts and technical indicators like MACD, oscillators etc. You can read more about technical analysis here.