What is the FX market?
The Forex market is a decentralised market where traders and investors exchange currencies from almost every country globally. In Forex, it is possible to transact currencies at the current market price, determined by factors such as the supply and demand of the particular currency and financial and political reasons affecting the issuing countries.
What does 'Forex is decentralised' mean? The FX market is decentralised because, unlike other financial assets listed in the stock market, for example, the transactions carried out in Forex do not have an intermediary (a specific space) that is in charge of regulating or evaluating them. For this reason, Forex is an OTC market (Over The Counter) because the transactions directly involve the participating agents (buyers and sellers) without the need to go through a centralised entity (like a stock exchange). These transactions are called trades. The users participating in this market are traders, and exchanging financial instruments between traders is called trading.
What is a Currency Pair or Forex Pair?
Currencies (such as the Euro, the Dollar, the British Pound, etc.) interact in pairs at the Forex market. For example, the EURUSD pair represents the Euro's interaction (measured in relative value or price) against the US Dollar. The GBPUSD pair represents the British Pound against the Dollar, and so on. Thus, the first currency would be the "base currency", while the second is the "quoted" one.
Forex pairs get classified according to their importance level. In the first level, there are the so-called Major pairs:
EURUSD (Euro - US Dollar): The world's most popular currency pair with the highest operations volume. Around 70% of every Forex transaction globally involves this pair.
GBPUSD (British Pound - US Dollar)
USDJPY (US Dollar - Japanese Yen)
USDCHF (US Dollar - Swiss Franc)
The remaining three Major pairs are still strong and involved in a huge transaction volume, although they are much more volatile. Hence, they allow traders to benefit from the wide swings in their prices, although they also pose a greater risk if you are a beginner.
Secondly, after the Major Pairs, we may find the Secondary pairs that involve major currencies with major currencies alternative to the ones presented previously, such as the Australian Dollar (AUD), Canadian Dollar (CAD), or the New Zealand Dollar (NZD).
Third, we find the exotic pairs, including all the rest of the global currencies. Exotic pairs have a considerably lower trading volume, and much higher volatility, with a consequent increase in financial risk due to the difficulty in predicting the behaviour of the pair's price. Among these pairs, we find currencies like the Mexican Peso (MXN), the Russian Ruble (RUB), the Swedish Krona (SEK), and the Brazilian Real (BRL), among others.
Something which is not crucial, but it's a nice-to-know fact, is that in everyday foreign exchange market trading and news reporting, the currency pairs are often referred to by nicknames. They are used to simplify the pronunciation of each currency pair (try saying out loud 'GBPUSD' or 'NZDUSD'):
The GBPUSD pair is known by traders as "cable", having the nickname origins when a communications cable under the Atlantic Ocean synchronised the pair quotation between both markets.
"Swissy" or "Euro-Swissy" for EURCHF.
Fibre for EURUSD, because the GBPUSD pair is called Cable, so, being the EURUSD a newer FX pair, traders upgraded the old Cable to a fibre one.
Chunnel for EURGBP, after the common English nickname for the undersea train tunnel linking the UK with France (or in other words, the Eurozone), is formally called the "Channel Tunnel".
Loonie for USDCAD, from Canada's $1 coin, has a picture of a loon (a bird) on the backside.
Aussie for AUDUSD.
Kiwi or The Bird for the New Zealand Dollar NZDUSD pair.
So, if you attend a Forex webinar and the presenter talks about Kiwis or Loonies, he is not talking about going to a zoo. There are more nicknames. We won't list all of them; you get the picture.
How does Forex trading work?
Forex trading involves transactions (buying and selling) of currency pairs. That is, one user buys, and the other one sells. To better understand how Forex works, it should be clear that the main objective is to speculate on the movement that the currency pair's price may present. Hence, you are not saving when you trade, nor investing: you are speculating on the pair's price movement in the hope of making a profit if the currency pair moves in the way you have forecasted.
Specialised Forex trading platforms display currency pairs as a financial instrument. The user "buys" a certain number of "lots" units of the base currency, and a counterpart "sells" the equivalent value of the quoted currency occurs. For example, in the case of the EURUSD pair, a trader buys the Euro price compared to that of the US Dollar, and he does this because he believes that its price will rise. In the opposite case, those who forecast that the value of the Euro will decrease will sell lots of the EURUSD pair, which ultimately implies a Sale of Euros and Purchase of US Dollars transactions.
A key aspect to remember is that despite talking about buying and selling currencies, you do not acquire the value of the quoted currency. For example, when you trade the EURUSD pair, you are not effectively buying Euros to spend on a trip to Paris. What happens effectively is a transaction on the exchange rate; no user obtains the Dollars, Euros, Pounds, or Yens. Therefore, FX trading focuses mainly on transacting pairs in a relatively short term to (try to) forecast the price movement and make a profit with the accurate ones.
All trades are executed electronically through broker's apps that offer Forex trading, although other alternatives, such as banks or exchange houses, act as the intermediary. This one is a much more expensive option, though.
MT4 is the most popular Forex tool among professional traders. If you wish to try a free demo, try one of the top brokers presented before.
Forex trading through CFDs
How would you carry out Forex transactions in the real world if you want to become a Forex trader?
You would have to go to a bank or a foreign exchange shop with a briefcase full of cash nominated in different currencies, Euros, Dollars, Pounds, Swiss Francs, and Yen. Then, whenever you see that the price of one of the exchange rates is low, and you forecast that there will be a short-term move in the exchange rate, you would buy the currency with another currency you hold in your briefcase. For example, suppose you intend to acquire Pounds with Yens.
Do you know how complicated and expensive this transaction could be? Therefore, there has to be an easy option to fulfil this transaction, and the answer is financial derivatives called CFDs.
CFDs are financial derivatives (assets that replicate the price of the underlying financial instrument). Traders use CFDs to represent a particular currency pair of the exchange rate. So, CFDs allow them to speculate over the short-term price changes of the underlying asset (the one the CFD tries to replicate) without actually having to buy the underlying asset. An example: Investing in a CFD on the Euro-Dollar involves buying the CFD EURUSD, which is the instrument that replicates the exchange rate between these two currencies.
Forex Trading platforms have excellent graphic interfaces, where it is not required to transact with a briefcase full of money. Instead, clients can trade anywhere through their phones. To buy a CFD, search for it at the brokers' app and press Buy.
An Example of a CFD transaction
Let's assume that a trader starts trading the EURUSD pair.
To determine whether to buy or sell, he performed a technical and fundamental analysis of the pair's potential price variation, allowing him to predict the decline of the US Dollar price against the Euro. This prediction means that the user assumes that the USD price will decrease and that the EUR will increase relative to the USD. When the order is opened, the exchange rate is 1.1 euros.
Trade: Sell
He monitors his trade; as time passes, the price of the US Dollar falls, and on the other hand, the Euro price rises, reaching the exchange rate of one USD equivalent to 1.12 Euros. So, the trader would have generated two pips in favour of the executed order:
Initial Price: 1.1
Final Price: 1.12
Difference: 2 pips
And how much profit does this difference of 2 pips represent in real money? To calculate the equivalent of pips in cash, you must calculate the CFD contract size combined with its leverage. >>> But what is leverage? A "loan" allows you to multiply the initially invested capital to have extra firepower in the account. It is a loan provided to you by the Broker. If the leverage level is 1:100, it means that for every dollar or Euro you deposited, you will have 100 available for trading. That sounds great, right? You might think: I invest 1 and get the profit multiplied by 100. The downside is that leveraged trading bears multiplied losses, leading to the total loss of the amount invested. Yes, all of it.
How long should a Forex trade stay open?
A Forex trade stays open until the reversal transaction is completed (if your order was a Buy, then a Sell order should come after), and the profit or loss gets calculated. Completing a transaction could take you from a few seconds (buying a CFD and then closing it) to hours. The duration of a trade will depend on each trader's objective, strategy and trading plan, and available capital.
There are different categories of traders based on the duration of their trades:
Scalpers are traders who keep orders open for minimal periods. The opened trades are maintained for 15 minutes or less before the position is closed. After a minimum movement in the price, the scalper closes the trade.
Day traders tend to liquidate all their trades before the trading hours end. It does not imply that the day trader leaves their transactions open until the end of the day. It means that yes or yes, he goes to sleep without having an open position at the end of the day.
Swing traders deal according to the medium-term trend, for example. They can maintain the same trade for a week to a month.
These are not the only classifications, although they are the most common ones.
What is the cost of Trading Forex?
To calculate the cost of each trade, we (again) use the lot size. A lot represents 100,000 units of the base currency. So, the size of the lot has to be multiplied by the price of the acquired contract. Then:
2 EuroDollar Lots * 100.000 (units of the base currency) = € 200.000
As we mentioned before, through leverage, you do not need to deposit (at an exchange rate of 1.1) $ 220,000 to buy € 200,000, but you must keep something like $ 2,200 in the account (because if the leverage is x100, multiply the value of your real money x100).
When does the Forex market open and close?
The Forex market operates all day, year-round, since somebody around the globe is trading, although it closes on weekends. To understand better how Forex works, trading hours are one of the most important aspects to consider since they are affected by the opening and closing of the most important financial centres in the world. They, in turn, have different time zones, which allows transacting Forex 24 hours a day.
Following are the opening and closing hours of each financial centre, described in GMT:
Tokyo: opens at 00:00 GMT and closes at 9:00 GMT.
New York: Opens at 13:00 GMT and closes at 22:00 GMT.
London: opens at 08:00 GMT and closes at 17:00 GMT.
Sydney: opens at 21:00 GMT and closes at 06:00 GMT.
During the day, the trading time of one major financial centre intersects with those of another territory, such as Tokyo and London and London and New York, for example. During these hours, the tradeable liquidity (the amount and volume of operations) is much higher.
How to open a Forex account and start trading?
To start trading Forex, you must open an account on a trading platform offering Forex CFDs. The alternatives we have detailed before are some of the best locally available. Opening an account with one of these Brokers is straightforward, involving registering personal info (an ID and proof of address) and depositing money through different payment methods. Once the account is open, start trading in the currency market.
Am I allowed to Trade Forex if I'm Muslim?
An Islamic Forex account is a halal trading account available to clients who respect the Quran and wish to invest while following the principles of Islamic finance. Islamic trading accounts differ in several ways from regular Forex accounts.
Sharia law prohibits the accumulation of interest; traders with Islamic accounts do not pay or receive interest rates. Also, transactions in Islamic accounts must be completed without delays, so currencies must be transferred from one account to another immediately, and transaction costs must be paid simultaneously. Islamic accounts are also known as swap-free accounts because of this, and they follow four basic principles to be considered Halal:
Prohibition of payment and receipt of any interest rate (Riba)
Immediate exchanges in the context of trading operations
Prohibition of gambling
Distribution of risks and benefits
Glossary of terms that you must know when starting Forex Trading
Forex broker: An intermediary through which the exchange of assets between buyers and sellers occurs. By acting as a third party, they charge a commission and must have a license issued by some government watchdog.
Pip: It is the minimum variance that the price of a pair can present.
Lots and mini lots: The amount defines the contract's volume, the amount that has been "bought" or "sold" of a pair.
Leverage: A tool that allows multiplying the initially deposited funds.
Spread: The broker collects the commission when a trader buys or sells. Each Broker applies spreads on Bid and Ask orders and the chosen asset type.
Central bank: Central banks are government entities controlling the monetary policy. Their decisions directly affect their currency prices, so keeping up with them is essential when you are interested in investing in currencies.
Interest rates: Amount paid to acquire or transfer a specific amount.
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