Forex is a term commonly used to mean foreign currency trading. In forex markets, you can buy and sell currencies like dollars, euros, pounds, yen, and pesos with the goal of earning a profit from fluctuations in their exchange rates.
If you are brand new to the world of forex and want to get started, we put together this currency trading for dummies guide to help you learn your way around the markets. Keep reading to find out about forex trading, how it works, and whether or not forex makes sense for your investment portfolio.
What Is Forex Trading?
Forex trading is buying and selling international currencies to earn profits. Just as you can buy and sell stocks and other investments, you can use an investment account to purchase international currencies. Similar to stocks, you have several potential paths to invest in forex. This includes buying and holding foreign currency directly, forex options trading, and foreign currency exchange-traded funds (ETFs).
However, forex isn’t suitable for everyone. As the term trading implies, the forex markets tend to be very active and are best suited for hands-on, active traders who can stomach the risks and volatility of currency trading. Because of this, forex is generally considered a high-risk investment.
What Is the Forex Market?
The forex market is a term for the public marketplaces where foreign currency transactions take place. There is no single forex market that dominates the entire industry. Many banks, governments, large businesses, and individual investors all play a part in the forex marketplace.
The most significant geographic hub for forex is London. The United States, Singapore, Hong Kong and Tokyo also play important roles. Major banks driving forex prices include JP Morgan, Deutsche Bank, Citi, UBS, HSBC, Goldman Sachs and other recognizable powerhouses in international finance.
If you want to get involved in the forex markets, you probably won’t have the billions and trillions of dollars large investment banks do when moving money worldwide. Most individual traders enter the markets through investment or bank accounts, including foreign currency features or specifically-designed products like forex options, forex futures, and forex investment funds.
If you’ve ever used an international ATM, or walked up to a Cambio or other business to exchange dollars into local currency, you already get the basics of what the forex markets do. But the pricing and complexities behind the scenes are a bit trickier and take more effort to comprehend.
What Is Market Pricing?
There’s a popular expression that says anything is worth what someone will pay for it. This is true in the financial markets as well, including forex. The current price to buy a foreign currency, called the spot price, is simply the last transaction price for a currency pair.
For example, let’s say the current exchange rate for the USD/EUR currency pair is $1.10 USD to €1.00 EUR. This would mean that the last time a transaction took place between dollars and euros, that specific exchange rate was used. Based on that, you would expect upcoming trades to be at a similar price point.
However, as we already noted, forex traders are looking to profit from the fluctuations in currency prices. Those prices are influenced by a myriad of factors, including government policies and greater economic forces. When you make a trade in the forex markets, you are betting that a combination of inputs like inflation, government debt and private sector demand will lead the price of a particular currency up or down in relation to another.
If traders call it right, they can walk away with a hefty profit. But, as with other types of trading, it’s very easy to make expensive mistakes and watch your investment value go down the drain.
How Does Forex Trading Work?
Once you’ve weighed the pros and cons and decided to dip your toe into the forex markets to test the waters, you’ll need to decide on a trading strategy. This will lead you to one of the various financial products that give you access to forex.
Spot trading or spot prices is a term for trading forex in the live markets at currency prices. It’s an easy term to remember, as it’s what you would pay if you bought foreign currency on the spot.
Because the sun is always up somewhere, forex spot markets never sleep. You can typically trade forex around the clock with no break in the market action. That also means values can change while you sleep based on news around the world. That’s part of the excitement of the forex markets.
Options markets move a little slower than spot prices, but you’ll want to take care to understand exactly what you’re buying or agreeing to pay in the future. Basic forex call options give you the option to buy a specific amount of a currency at a defined price on a future date.
If the currency values go up before that date, you’re “in the money” and can sell for a profit. If the price goes down, your option expires, and you lose your initial investment. However, your losses are limited to that initial investment amount, so you’re always in control of your total market exposure. There are also put options, which are a bet that the price of a currency will go down, similar to short selling a stock.
There are more types of options contracts as well with additional levels of risk and complexity. Those are best reserved for expert traders who can dedicate significant time to their forex trading strategy. For most people, anything beyond call or put options in forex may be too risky.
Futures are similar to options in that they specify a date, time, and transaction price for a future forex trade. But unlike an option, where you choose to exercise it or not, futures contracts have to be fulfilled. That makes them a riskier instrument than options for forex trading.
Futures contracts are most useful for currency hedging. This is most common when companies are engaged in large international transactions and want to limit their exposure to the forex markets. We will look at forex hedging in more detail below.
Forward contracts are very similar to futures, though they usually take place over the counter between two parties rather than on open futures markets. This also allows for more flexibility than the strict terms set with standard futures contracts.
Main Uses of Forex
Money never sleeps, and the forex markets are churning around the clock as travelers, businesses, banks, and governments shuffle funds around the globe. These are the most popular uses of forex you are likely to encounter:
Forex for Speculation
For most Investor Junkie readers, forex is likely an attractive place for speculation. When you think about currency trading for dummies, you’re likely imagining this type of speculative trading intending to sell for a profit.
Around 10 million people engage in forex trading worldwide, with about 1.5 million forex traders in North America. That breaks down to about one in every 200 adults in the U.S. engaged in the forex markets.
Currency as an Asset Class
Buy-and-hold investors with a long-term outlook may hold foreign currency as an asset in their portfolios. If you live in the United States and think the dollar will decline, owning foreign currency can protect your wealth and maybe even earn you a profit in dollar terms.
Remember that politicians come and go, economic cycles ebb and flow, and currency prices can change quickly based on financial news. Long-term investors can ride out much of that volatility, but it’s essential to consider the risks of forex no matter how long you plan to keep your funds in the market.
Forex for Hedging
In investing, hedging is a term for buying an investment that limits your risk. The simplest example of financial hedging comes from the airline industry, where many airlines hedge their fuel prices with futures contracts, locking in current rates before they go up. Businesses and individual investors can apply the same concept to their forex accounts.
For example, let’s say you buy a large stock potion for an international company based in Japan. While you believe the company will perform well, you’re concerned that the Japanese yen may fall. In this case, you could buy a put option for yen, which would earn you a profit if the yen does, in fact, decline and drag down Japanese stock prices with it.
Most individual investors don’t invest at a scale where this type of hedge is necessary, but it’s always an option if you’re looking to reduce risk for international investments.
How to Place a Forex Trade
If you’re ready to place a forex trade, you’re going to need a brokerage account that supports foreign currency trading. Not all brokers support forex, so you may need to shop around a little to find the best fit. TD Ameritrade, E*TRADE, TradeStation, and Interactive Brokers all support forex trading. With other brokers, you may still have access to forex through ETFs or mutual funds even if you can’t buy foreign currencies or forex options directly.
These are the basic steps for a forex trade:
1. Create and Fund a Forex-Friendly Brokerage Account
Start by picking your brokerage account. Be sure to choose an account with low fees, excellent trading tools, good customer service and anything else you’re looking for in a brokerage. It’s a good idea to look at the number of supported currency pairs and other forex-specific features.
2. Research Specific Markets and Currency Pairs
Next, you’ll log into your account and begin analyzing markets and trade opportunities. Much of active forex trading is based on technical analysis, where you evaluate trades based on recent market patterns and projected price changes. Other strategies include investing around upcoming economic announcements and government actions. How you decide to invest and trade is up to you.
The fun and excitement of a good trade keep many people coming back to forex despite the risks.
3. Enter Your Trade Order
Once you’ve picked your trade, it’s time to enter the order. Whether you’re looking for a spot purchase at the market price or prefer to buy an options contract, order entry should be just a few clicks away.
Risks of Forex Trading
Outside of the U.S., much of the currency trading action takes place using an alternative to options called CFDs (contract-for-difference). IG is an international brokerage popular among CFD and forex traders. At the bottom of its UK website, IG notes that 71% of retail traders lose money on its platform.
While CFDs are not legal in the U.S., other forex products come with plenty of risks. While you may be in the roughly 30% who can eke out a profit, forex is high risk and not appropriate for the average investor.
The price of a currency can fall due to an unexpected political or economic event. For example, when the UK voted for Brexit, sterling slumped to a 31-year low following the results of the referendum.
If you’re going to invest in forex, make sure you’re aware of the risks and avoid investing too much of your portfolio in just forex or any one type of investment.
Find out more>>> Investment Risk 101
- Currency pair: A currency pair is a term used when comparing the rates between two international currencies.
- Pip: A pip is short for “percentage in point.” It’s a term used in forex to describe the smallest decimal point measured for a particular currency trading pair. Most commonly, a change by .0001 in market pricing, or 1/100th of 1%. Pips are commonly referred to in forex spread pricing.
- Bid-ask spread: The bid-ask spread is the difference between what someone is willing to pay and what someone wants to sell an asset for. Some brokers build in a spread as a method of earning profit outside of trading fees.
- Lot: A lot refers to a specific number of units in forex. A standard lot typically refers to 100,000 units of a specific currency.
- Leverage: Leverage is a way to increase your market exposure. You could see 2x, 3x, or more change in your investment value when you make a leveraged trade compared to market changes.
- Margin: Margin is a term for borrowing to invest with credit. When you trade with margin, you can buy and sell more currency than you would be able to with your funds on deposit.
The Bottom Line
Forex is a fun and exciting place to invest and trade, but that excitement also leads to higher risks than other popular asset classes. If you think you have what it takes to succeed with forex, check out our list of the best brokerages, so you know your account is in the best hands.