An Introduction to Forex Trading
Key Takeaways:
- Trading forex is the act of buying and selling currencies in the global marketplace
- Forex is the biggest market in the world and offers many opportunities to make a profit
What is Forex?
Forex trading is the biggest and most liquid market in the world. It boasts a daily turnover of more than $7 trillion and is worth over $2.4 quadrillion (that’s $2,400,000,000,000). For reference, the US stock market is worth $51 trillion.
Now, what does forex actually mean? The term forex is a portmanteau of the words ‘foreign’ and ‘exchange’. Foreign exchange, on that note, is used to describe the currency market. So, forex represents the currency market where people from all over the world exchange money.
With this in mind, forex, as the biggest market, hosts participants ranging from small retail traders to multi-billion-dollar corporations. Institutional investors like banks and funds go to forex markets where they swap one currency for another. And retail traders conveniently do the same from their own homes, just on smaller scales.
How to Trade Forex?
Trading forex could easily be done simply by opening a trading account and funding it with the minimum amount required from your broker. In the past, however, trading would be done only by institutions and large-scale investors.
Fortunately, with the arrival of the Internet, accelerating technologies have made it possible for anyone to join the currency trading space. You can now go ahead and simply purchase your favorite currency while you sell another, as they always go in pairs.
Moreover, you can employ the so-called leverage which allows you to control positions way bigger than your initial capital. But more on that later.
Forex Trading Strategies
Forex trading strategies allow you to get exposure to currencies with proper risk management and money management. In other words, by using a strategy, you make sure your trades are rational and based on objective factors and not emotional decisions.
Forex trading, according to some analysts, is the market in which you can execute trades with highly-accurate precision and risk management tactics. Because of the elevated volatility and constant buzz, there is always a trading opportunity in the wide currency market.
In order to take advantage of the opportunities, you need to have a well-defined forex trading strategy. Trading strategies are different approaches you would take when you want to enter the market and open a trade. Your trading strategy will be composed of two main types of analysis: fundamental and technical.
Fundamental Analysis in Forex Trading
Fundamental analysis studies how economic news, reports, and statistics affect the forex market. Since currencies are traded on a multinational level, global economic events play a role in their valuation. In other words, when creating your trading strategy, you need to incorporate monitoring the global news so you would stay in the know. Major news and reports include:
Interest rate decisions:
The US Federal Reserve and the European Central Bank are the most powerful central banks in the world. If they signal an interest rate hike is coming, the currency market will react to that.
US nonfarm payrolls:
Released every first Friday of the month, the US nonfarm payrolls are perhaps the most important monthly report. It’s closely monitored by forex traders as it reveals the pace of the US economy. The nonfarm payrolls show how many new jobs were created in the US for the previous month. A lower-than-expected reading could pressure the US dollar. And a strong report could boost the value of the greenback.
Gross domestic product (GDP):
The GDP report, released quarterly, or monthly, represents the size of an economy as a whole. The most common measure is on an annual basis. If the report indicates growth year-over-year, this is considered positive news and may fuel the national currency to new heights.
Other keenly-watched economic news and reports include:
- Inflation data (consumer price index)
- Initial jobless claims
- Central bank meetings
- Unemployment rate
- Retail sales reports
All of this could be tracked in the economic calendar. These reports are crucial for the health and progress of any major economy. For that reason, forex market participants observe them and base their trading decisions on what the readings show.
Technical Analysis in Forex Trading
Technical analysis is the study of trading charts and price patterns showing the movement of a given financial asset. When it comes to currencies, analysts say technical analysis could be used to make precise and unbiased trading decisions. Let’s find out how.
There are a number of technical trading strategies that a market participant could use. They depend on two main determinants: time horizon and chart formations.
Time Horizon
Price movements in currencies are highly volatile and could yield handsome returns even in a matter of a few minutes. To this end, there are three main strategies defined by a time range:
1. Scalping
Scalping is the quickest trade you could have in the forex market. The aim of scalping is to take advantage of short-term but significant fluctuations. For example, during news time, the EUR/USD becomes aggressive and begins to swing wildly. A scalper might jump into it and try to make profits from the short-term momentum. This strategy, however, is very risky and it is difficult to predict its outcome.
2. Day trading
Day Trading is essentially the act of opening and closing positions in a single day. This is done to eliminate any risks of holding positions overnight. However, day trading could only grasp the intraday move and this could be riskier than leaving your positions for longer periods of time.
3. Trend trading
Trend Trading is the technical trading strategy with the longest duration. It aims to take advantage of long-term trends, both to the upside and to the downside. Trend trading assumes the trader is going with the dominant trend in the market. This could also mean an upside trend, for example, could take a slight dip and then continue higher.
Chart Formations
Technical trading relies heavily on chart reading. In other words, technical analysts aim to identify certain models and patterns that occur on the trading chart. Technicians, as technical traders are called, believe prices draw certain models that tend to repeat over time. And spotting these models allows you to have an edge in trading as you could predict how this model will unfold.
Support and resistance lines are key aspects of trading forex based on technical analysis. Let’s see what they mean and how you can use them.
The support line is where the dominant trend meets a previous bottom. And the resistance line is where the same trend meets a previous high. The trend between these two lines could be expected to stay in its current range as bulls and bears navigate through the motions. Correctly identifying tops and bottoms, also called inflection points, could serve as entry and exit points for your forex positions.
Trading Forex with Leverage
Trading forex with leverage is the use of borrowed funds from your broker so you could get bigger exposure to forex markets. In more detail, leverage is a powerful tool that can magnify your potential profits but also your potential losses.
In this light, a small number of funds could be used to represent much larger positions. Leverage varies between 30:1 and 500:1. What this means is, that you can go into the market with 30 times to 500 times more capital than your invested amount. Let’s see how this works in practice and what risks it carries.
Forex Risk Management
Trading forex comes with certain risks that you need to be aware of, especially because of the leverage involved. In this light, it is highly recommended that you design a proper risk management strategy when you approach forex markets.
An example of a solid risk management strategy would be trading under a strict set of rules or a trading setup. This includes having stop-loss orders and taking profit orders.
In more detail, a stop loss is a level you set at which your trade will be automatically closed. On the other hand, a take profit is a level you set where your positions will be closed in profit. This is the most basic but the most efficient risk management strategy.
Example of risk management in a trade
Let’s see an example: you believe the USD/JPY will rise in value and you want to buy the pair. You will be using the leverage of 100:1, meaning you control 100 times more than your capital. And your position will be $100 while your whole account is worth $1000. This 10% of your equity will be magnified to $10,000 because of the leverage.
Essentially, this means your position will yield $1 for every one-pip movement in the USD/JPY pair.
Having said this, the levels at which you set your stop loss and take profit will determine your risk management. You can decide to use a tight stop of 21 pips, or $21, and a wide take profit of 210 pips, or $210. In other words, your risk/return ratio would be 1 to 10. More specifically, you could be wrong 9 times out of 10 and still break even.
Adjusting your stops and taking profits is key to determining the level of risk you want to take in any given trade.
Summary
Trading forex is a highly profitable and attractive market niche. It is the biggest global marketplace comprising hedge funds, investment banks, brokers, and retail traders. But going into it is not an easy feast.
You need to be certain you have a robust trading strategy with reliable rules and structure, including stop-loss orders and take-profit orders. In addition, you may want to observe what is happening in the world’s biggest economies so you could understand what drives currencies. And finally, your chart reading skills could be used to help you assess where your entries and exits will be.
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