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88% of forex trades involve the U.S. dollar on one side or the other of the currency pair. That’s pretty impressive considering the sheer number of currencies exchanged in the fx market. But what does it actually mean?
How do forex trades work? And what do all those terms mean? Being new to forex trading can be massively overwhelming. There is so much to take in and seasoned traders rarely slow down long enough to explain what they’re saying.
But fear not! You absolutely can learn and begin confidently investing in the forex market!
Keep reading as this guide helps you learn the basics about forex trading as a retail investor.
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The forex market is the global marketplace where investors buy and sell international currencies. Forex stands for the foreign exchange market and is also sometimes abbreviated as FX market. It is the largest financial market, significantly larger than the stock market.
Unlike the stock market, the forex market has no centralized exchange. Examples of a centralized exchange for the stock market are the NASDAQ or NYSE. Instead, trades happen online on computer networks between investors all over the world.
This type of setup is referred to as over-the-counter (OTC).
In FX trading, traders buy and sell currency in what is called a currency pair. This is a quote that tells the relative value of one currency compared to another. We will cover more on that later.
The forex market has long been dominated by institutional investors but has recently been becoming much more accessible to retail investors.
If you’re reading this post you are likely a retail investor.
A retail investor, also called an individual investor is an individual who is investing with their own money, on their own behalf.
On the other side of that is the institutional investors. These are groups such as banks, financial institutions, hedge funds, and even governments central banks that trade on a large scale, usually with other people’s invested money.
Institutional investors still have some advantages over retail investors. Institutions have access to more investment options as well as more bargaining power when it comes to negotiating fees.
However, with the increase in online brokerage firms individual investors have been able to invest in more diverse options that they did not have before.
Before you go any further it will be helpful to have a clear definition of some important forex trading terms.
Currency pairs are sets of two different currencies that are frequently traded together such as EUR/USD. The first currency listed is the base currency, and the second listed is the quote currency.
These pairs show how much of the quote currency is currently needed to buy one unit of the base currency. This is commonly referred to as an exchange rate.
There are many different forex pairs, you can pair any two currencies you want. Typically, the U.S. dollar will be part of the transaction. There are 6 currencies that are traded the most against the U.S. dollar. They are:
When using leverage and margin to invest you are able to borrow money from your brokerage in order to have a larger investment than you actually have the capital for. Forex trading has a high availability of leverage for investors.
Margin is essentially the required down payment to use leverage.
In FX markets, leverage can often be as high as 100:1. Meaning that if you have $1,000 to put towards an investment, you would be able to trade up to $100,000 worth.
The $1,000 is the required margin you must put down as collateral in order to borrow the brokerage’s money.
The amount of leverage available and margin required will change from brokerage to brokerage.
A lot is the standard unit size for trading currencies, for both individual and institutional investors.
There are three sizes of lots. The first is the standard lot which represents 100,000 units of the base currency. A mini-lot represents 10,000 units and a micro-lot represents 1,000 units of the base currency.
These are the amounts that currencies are typically bought and sold in.
Although people have been exchanging currencies since ancient times, it hasn’t always been as it is now.
In the 1600s in Amsterdam, there was an official forex market with trades taking place between England and Holland.
From the mid-1800s the forex market was backed by the gold standard. This meant that the government would redeem any paper money for its value in gold. However, by the time World War 1 came along, this was no longer sustainable for the government.
After the deterioration of the gold standard near the end of World War 2, came the Bretton Woods system. This made it so the currencies of the world would have a pegged or fixed exchange rate to the U.S. dollar, which continued to be pegged to gold.
The Bretton Woods system was ended in 1971 by President Richard Nixon. In 1973 the world officially switched to a free-floating system, which is the basis of what we have today. Even with this system, it was still limited to institutional investors.
During the 90s as technology made massive strides the first online forex trading emerged. By 1996 this made way to finally allow retail investors to get in on the action.
The first step to any new venture is making sure you do your research. You’re here so you’re ahead in that category.
When you feel ready to move past research your first step should be to find a brokerage to set up your account online.
Once you choose a brokerage, you can open and fund a brokerage account with them. When you are all set up you will have access to the currency markets in the world in real-time.
Before you make any trades you need to analyze your options. There are two main methods to do this, fundamental analysis and technical analysis. These methods can be used for any kind of investment from forex trades to choosing mutual funds.
After doing your analysis and choosing an investment to make you need to remember one of the most important things in forex trading. You can’t continue trading if you run out of money to invest.
You have to have a good defense if you still want to be trading at any date in the future.
One way to maintain a strong defense is by using the stop-loss feature. When that is all set, it’s time to invest!
There are many benefits to trading in forex markets and there is also great potential for profit. Arguably the greatest benefit of forex trading is the availability of leverage.
With leverage commonly available as high as 100:1, it is easy to make a big investment even when you don’t have a large chunk of capital upfront.
The benefit of leverage goes hand in hand with the benefit that the market is volatile. While this can be either good or bad, it means that you are more likely to make a great return in a shorter time period than if you invested in the stock market.
Another great benefit of forex trading is that it is a large and liquid market. Because it is open 24 hours a day Monday to Friday, you can almost always make a trade.
While there is a lot of potential for profit, FX trading is not without its risks. Some of the risks are even the same as the benefits.
The high availability of leverage means that you have the potential to make a greater return, but it also means you’re at risk for a much worse loss. If you don’t pay attention, make smart trades, and utilize stop-loss orders, you can wind up losing more money than you invested in the first place.
This also makes the volatility of the market a risk. It is just as possible that the exchange rate will change in a negative way for your investments, as it is that it will change in a positive way.
You can try to mitigate these risks by doing a thorough analysis but market movements can be extremely difficult to predict. On top of that, it is sometimes difficult to understand and interpret market data, and that can lead to making mistakes with your investments.
This is of course not to say not to invest in forex, only to make sure you know the risks and are prepared to handle them.
It’s a lot to take in, but hopefully, you are now feeling better prepared to take on the forex market. If you are, check out our forex calculators to help you with your financial analysis.
Are you ready to put your forex knowledge to the test? Get started today with a risk-free demo or a live account!
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