Forex Trading Definition & Guide


Currency trading, also called FX or forex, means that you buy one currency at the same time as you sell another.

What is forex trading

Forex trading is simply explained by buying one currency in exchange for another. Currencies are always traded in pairs of two, where one currency is called the base currency and the other the counter currency. For each currency pair, there is a buy and sell price that tells you how much of one currency you must exchange or pay for the other currency in the pair.

As a trader, you buy and sell currencies in order to hopefully be able to take advantage of differences in exchange rates. Unlike other financial markets, the foreign exchange market has more generous opening hours, and forex can be traded 24/7 five days a week – all year round.

This is how forex trading works in 5 simple steps

Trading currencies can sound difficult for most people. But Forex trading is one of the most common forms of trading. It is easily accessible through many brokers.

The most common form of currency trading is to take a position for a currency to strengthen or weaken against another currency.

It could be that the Australian dollar strengthens against the Canadian dollar or that the Singapore dollar weakens against the Japanese yen.

1. Decide which underlying asset you want to speculate on

It is most common to trade in some of the world’s largest currency pairs. These are, for example, Euro / USD, USD / Japanese Yen and British Pound / USD.

The largest currency pairs in the world are usually called major. Even the slightly smaller currency pairs called “mines” are popular to trade in.

These are, for example, the Euro / British Pound or the Euro / Australian Dollar.

The currencies that belong to major or minor are good to start trading. They have large volumes and are usually traded in smaller spreads.

Many people also like to trade currency pairs called “exotic”. It can be Euro / Turkish lira or USD / South African Rand.

2. Decide how much you want to invest

Trading in currency has a great risk. The biggest reason for this is that you use very little equity in every trade. This means that in a profit transaction you get a good return on the capital you have invested.

If you make a loss, you instead make a large loss in relation to the capital you have invested. You can shop that way because the brokers offer products where you only need to provide security for a small part of the deal when you take it.

When you start with Forex trading, it is wise to do so with a small amount of money.

It is important to understand how the market works and how you trade currencies. Understanding what risk you are taking is crucial to whether you will succeed or not.

Always use stop loss when trading forex.

3. Decide how much you think the asset will go up or down

Forex trading involves taking a position for a currency to strengthen or weaken in value against another currency. To get an idea of this, you need to analyze a currency pair.

The most common way to analyze currencies is through technical analysis. Then you analyze how the price moves in a price graph.

There are other methods of analyzing and trading currencies such as interest rate announcements from various central banks or when new statistics on economic development are released.

4. Decide which course you want to buy and sell to

Whatever technology you use to analyze a currency must have a strategy when making a deal.

In technical analysis, it may be after a confirmed reversal of a trend or a breach of previous support or resistance.

If you analyze currencies according to other parameters, it may be different facts in statistics or information from central banks that make you think that a certain currency should be strengthened or weakened against another.

Central banks’ interest rate announcement is an event that greatly affects the foreign exchange market.

5. Take the last step and execute your trade

When you know what you want to trade, in which direction and at what price, it is time to place orders. Maybe you are ready to take position immediately.

Otherwise, you can set alarms at different levels and receive a signal when the course has reached a point you want to act on. Another option is to place an order with your broker that is activated when the price reaches it.

It is important that you simultaneously make a stop loss and take profit. Stop loss is where your position is sold if it goes against you.

Remember to take very limited risk. Take profit is the level where your position is automatically sold and you make a profit.

Who trades forex?

As previously mentioned, the majority of active traders are central banks, commercial banks, hedge funds, investment banks and large companies engaged in international trade.

But in addition, there are also traders who speculate in currencies and individual investors.

The foreign exchange market as an investment platform for private traders has grown significantly in recent years, as forex brokers and online trading platforms have made their entrance and contributed to making forex currencies a trading instrument accessible to all.

There are many successful traders who have succeeded well with their currency trading, and whose experiences and lessons can very well inspire others to take the step into the foreign exchange market.

A tip, use the method copytrading. Copytrading means that you can follow successful traders and adopt their strategies for free, in order to easily get started and learn how it works.

Frequently asked questions about forex trading

Below I have listed the most common questions about forex trading.

1. Why invest through forex trading?

The vast majority of people who engage in forex trading do so to make money on short-term movements in a currency pair.

The position is usually held from an hour to a week. It is also possible to have a more long-term perspective on currency trading.

2. How risky is forex trading?

Short-term currency trading is associated with very high risk. It is very important to understand that and learn to manage the risk.

If you do, you have a good foundation to make money on forex trading.

3. Where can you trade / invest in forex?

There are many brokers around the world that offer forex trading. I strongly recommend choosing a well-known broker.

An example of such a broker is eToro.com. They are well known and have more than 10 million customers worldwide (by the way I am not sponsored by them).

How does forex trading affect your everyday life?

Exchange rates and their movements affect many parts of the economy – both the global and your own everyday economy.

The foreign exchange market has a major impact on key factors such as inflation, how much international companies earn and the balance of payments – ie the financial transactions that are made between a country and the rest of the world during a certain period, usually a quarter.

What happens in the forex market is something that affects everyone – but if you are currency trader yourself, it will of course be more hands on, than for the average person.

For profits on currency trading, it is a requirement that you report the effect on your tax yourself.

Important forex trading terms

Pips and spread

When you trade currency, a currency is broken down to many decimal places. At the time of writing, USD / SEK stands at 8.7580. The fourth decimal is called pips. If the USD / SEK rises to 8.7590 more, it has risen by 10 pips.

Whether you trade in currency or something else, each product has a buy and a sell price. There is a slight difference between them.

It’s called spread. If it is a leverage product, it is part of the broker’s margin. As a trader, you want the spread to be as small as possible.

Leverage and stop loss

There are various products for trading forex in the short term. Most have some form of built-in lever. Usually it is quite large. This means that you use a small amount of equity to take a position.

In principle, you borrow the remaining part from the broker.

This creates a leverage that allows you to get a good return on your invested capital if your business is profitable. The opposite happens if you make a loss.

One of the most important tools in forex trading is stop loss.

This means that you set a level in advance where the position is automatically sold if it goes against you. You do this because you want to minimize your losses as much as possible.

Carry trading – how and why?

Forex through carry trading is the most common strategies in currency trading and something you will sooner or later become familiar with if you start buying and selling forex.

In short, carry trading aims to take advantage of interest rate differences between two currencies in a currency pair, where you sell low-interest currency and buy high-interest currency.

In currency trading, you are always paid to pay an interest expense for the currency you sell, while when buying currency you can credit an income instead in the form of a return.

By selling low-interest currency and investing in a high-interest currency, you can sell a positive interest return every day, as long as the position is kept open.

Carry trading is a classic strategy in currency trading that can enable fairly fast income – but not completely risk-free, of course.

More in-depth information on carry trading can be found in the video below:

What affects the foreign exchange market?

There are various factors that affect exchange rates in the foreign exchange market, such as political and economic stability, as well as monetary policy in different countries, but since foreign exchange transactions are immediate, it is speculation that mainly affects price changes in the market.

If traders speculate that a currency will strengthen or weaken due to a particular reason or event, they will trade and change the price in the market, as supply and demand for the current currency will change within the market.

The more people who believe that a certain trend will happen, the greater the effect it will have on market prices.

Pros and Cons of forex trading

1. Pros of trading forex

There are several advantageous features that characterize forex trading with Forex, including the leverage effect which means that the user can invest relatively little capital to get a relatively high return.

Trading is also open around the clock and usually goes fast because the foreign exchange market has such high liquidity – that is, there are always plenty of both buyers and sellers.

Other properties are that the trade can be carried out completely digitally through various so-called Forex trading platforms.

Several of these platforms offer training through programs such as “simulated Forex trading” which allows those who are new to learn how to trade, how the platform works and what Forex trading strategies are available.

There are also specific software that can do complex calculations and help the user navigate the all-changing currency market.

By using a Forex trading platform, trading is made possible and also facilitated by software developed for currency trading.

In other words, there are good conditions for educating yourself before you start trading.

2. Cons of trading Forex

The risks of Forex trading are in many cases the same as the potentially beneficial properties. The leverage effect can yield large gains on a relatively low investment, but it also means that the relationship can be reversed – that the losses will be significantly greater than the effort.

This, in combination with the large volatility that prevails for several large currencies and which means that the market can fluctuate rapidly, means that risk management is an important part of currency trading.

A good Forex broker offers risk management tools such as price alerts and guaranteed stops.

It also applies to the user to have control over their maintenance margin, which must not be less than the specified amount.

If this happens, the entire position can be liquidated with immediate effect, resulting in lost profits. But before this happens, a so-called “margin call” can occur which acts as a barrier so that the user does not lose all the assets he has in the FX account.

With sharp variations in the market, which are admittedly not entirely common but still occur, it may in exceptional cases be that ‘margin call’ does not have time to be triggered before the loss is already a fact.

This causes the trader to lose relatively much money.

Forex Bank vs forex trading

A fairly common misconception is that the bank Forex is the same as forex trading, and vice versa. This is of course a clear misunderstanding, which is probably noted by everyone involved in currency trading.

Forex Bank is certainly usually abbreviated “Forex” in the vernacular, but is something completely different from forex trading in reality.

This company provides physical exchange of currencies, usually before or after a trip abroad.

Forex trading, on the other hand, is trading currencies online and thus has no closer connection with the foreign exchange market than other pure exchange players have – despite the name.

Conclusion & Video Guide to Forex Trading

Profit or loss in forex trading?

How well your online currency trading works depends largely on how much you train and what you trade. Furthermore, it is important to keep track of your leverage and of course also the use of a reasonable stop-loss.

Maybe you have read about some who make millions on forex trading. Nice for them! But the road there is seldom straight.

Take it easy and start with a demo account to work out.

In this way, you can discover everything at your own pace and get tips from the currency broker in question in the meantime.

Sources

https://www.sciencedirect.com/science/article/abs/pii/S1568494618305349

https://www.sciencedirect.com/science/article/abs/pii/S0378426617302327

https://link.springer.com/article/10.1007%2Fs10732-012-9201-y

https://www.sciencedirect.com/science/article/abs/pii/S0957417415008301

https://link.springer.com/chapter/10.1007/978-3-642-13526-2_5

https://www.researchgate.net/profile/Algirdas-Maknickas/publication/263469084_Application_of_Neural_Network_for_Forecasting_of_Exchange_Rates_and_Forex_Trading/links/5732e30008aea45ee83650ee/Application-of-Neural-Network-for-Forecasting-of-Exchange-Rates-and-Forex-Trading.pdf

https://link.springer.com/article/10.1007/s11469-017-9788-1

https://www.sciencedirect.com/science/article/abs/pii/S037843710400932X

https://books.google.se/books?hl=en&lr=&id=lWn3CQAAQBAJ&oi=fnd&pg=PP1&dq=Forex+Trading+&ots=zW4D4eDFNz&sig=m6M6tvfouE-2TL-vMmbT5Q9aL4U&redir_esc=y#v=onepage&q=Forex%20Trading&f=false

https://ieeexplore.ieee.org/abstract/document/1562920

Kevin

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