Foreign exchange (forex or FX) trading involves buying one currency and selling another while attempting to profit from the trade. According to the latest reliable data, global daily trading in 2022 was $7.5 trillion, making forex the largest financial market in the world, dwarfing even the global stock market. Trading currencies online has become far more accessible in the last decade, attracting droves of newer traders wanting a piece of the action.
In forex markets, currencies trade against each other as exchange rate pairs. For example, the EUR/USD would be a currency pair for trading the euro against the U.S. dollar. This is straightforward, but the market lingo comes fast at beginners and can quickly become overwhelming. Assets traded in FX include currencies, contracts for difference (CFDs), indexes, commodities, spreads, and cryptocurrencies. There are also forex spot and derivatives markets for forwards, futures, options, and currency swaps, all to speculate or hedge on forex prices. If all this weren't enough, jargon like "pips," "lots," and "leverage" mean that, without a good introduction, newer traders can quickly feel they are in over their heads.
That's why we've put together this detailed guide to help you start trading foreign currencies the right way. We'll break down the essential concepts and guide you through the most critical steps, from choosing a broker and placing your first trade to developing a solid strategy and, most importantly, managing your risk.
Key Takeaways
- The foreign exchange (forex or FX) market is a global marketplace for exchanging national currencies.
- Because of the worldwide reach of trade, commerce, and finance, forex is the world's largest and most liquid asset market.
- Currencies trade against each other as exchange rate pairs. For example, EUR/USD is a currency pair for trading the euro against the U.S. dollar.
- Forex markets exist as spot (cash) and derivatives markets, offering forwards, futures, options, and currency swaps.
- Market participants may use forex to hedge against international currency and interest rate risk, speculate on geopolitical events, and diversify portfolios, among other reasons.
What Is the Forex Market?
The foreign exchange market is where currencies are traded. Its most striking aspect is how it has no central marketplace. Instead, currency trading is done electronically over the counter (OTC). All transactions occur via computer networks that connect traders worldwide.
The main markets are open 24 hours a day, five days a week (from Sunday, 5 p.m. ET until Friday, 4 p.m. ET). Currencies are traded worldwide, but a lot of the action happens in the major financial centers. A 24-hour trading day begins in the Asia-Pacific region, starting with Sydney, followed by Tokyo, Hong Kong, and Singapore. It then continues through Europe, including Paris, Frankfurt, Zurich, and London, before moving on to North America and ending with the U.S. trading session. The forex market is highly dynamic at all times, with price quotes changing constantly.
You’ll often see the terms FX, forex, foreign exchange market, and currency market. These terms are synonymous, and all refer to the forex market.
How Does the Forex Market Work?
The FX market is one of the two truly continuous, 24-hours-a-day (during weekdays) trading markets, the other being cryptocurrencies (although crypto markets don’t pause even on weekends). Traditionally, the forex market was dominated by institutional firms and large banks, but its popularity among retail traders has significantly grown over the past decade. There's a caveat: Newer traders in the market have lured in fraudsters looking to take advantage of less knowledgeable investors.
Where Is It?
An interesting aspect of world forex markets is that no physical buildings serve as trading venues. Instead, markets operate via a series of connected trading terminals and computer networks. Market participants are institutions, investment banks, commercial banks, and retail investors worldwide.
Who Trades on It?
Currency trading used to be complicated for individual investors until it made its way onto the internet. Previously, most currency traders were large multinational corporations, hedge funds, or high-net-worth individuals. While commercial and investment banks still conduct most of the trading in forex markets, there are also prospects for professional and individual investors to trade one currency against another.
What Is Forex Trading?
At its core, forex trading is about capturing the changing values of pairs of currencies. For example, if you think the euro will increase in value against the U.S. dollar, you may buy euros with dollars. If the euro's value rises on a relative basis (the EUR/USD rate), you can sell your euros back for more dollars than you initially spent, thus making a profit.
In addition to speculative trading, forex trading is also used for hedging purposes. Individuals and businesses use forex trading to protect themselves from unfavorable currency movements. For example, a company doing business in another country might use forex trading to insure against potential losses caused by fluctuations in the exchange rate.
By securing a favorable rate in advance through forex trades, a firm can reduce financial uncertainty and ensure more stable costs in its domestic currency. Hedging FX risks is an essential part of international business today.
Forex trading has high liquidity, meaning it's easy to buy and sell many currencies without significantly changing their value. In addition, traders can use leverage to amplify the power of their trades, controlling a significant position with a relatively small amount of money. However, leverage can also amplify losses, making forex trading a field that requires knowledge, strategy, and an awareness of the risks involved.
Forex trading is also quintessentially global, encompassing financial centers worldwide. This means that currency values are influenced by a variety of international events. Economic indicators such as interest rates, inflation, geopolitical stability, and economic growth can significantly impact currency prices. For instance, if a country's central bank raises its interest rates, its currency might rise in value due to the higher returns on investments made in that currency.
Similarly, political uncertainty or a poor economic growth outlook can depreciate a currency. These interlocking exchange relations—some currencies growing stronger, others not—means forex trading reflects worldwide economic and political developments.
How to Start Trading Forex
Here's a to-do list to get you started.
- Learn about forex: You now have the basic concepts, but you'll need to understand more of the terminology and how the forex market operates. This includes learning currency pairs, market patterns, and the factors influencing currency prices.
- Develop a trading strategy: Learn the different trading strategies, such as various technical analysis strategies, fundamental analysis, and news trading. Choose a strategy that aligns with your trading style and risk tolerance. For more, see Forex Trading Strategy and Education.
- Develop a plan: Create a trading plan that includes your goals, risk tolerance, strategies, and the criteria you'll use to assess trades. The most crucial part is not just making a plan but sticking to it in the heat of trading when emotions run high. Successful traders are disciplined traders.
- Set up a brokerage account: Select a broker regulated by a reputable financial authority, such as the Commodities Futures Trading Commission (CFTC) in the U.S. Ensure the broker offers a user-friendly trading platform, good customer support, and low fees. For ideas, see Best Forex Brokers.
- Practice with a demo account: Many forex platforms provide the ability to paper trade before you put skin in the game. This is a time to ensure you've locked down all the mechanics of trading and tested your strategies. It's better to identify your mistakes and weaknesses in practice mode than when your money is on the line.
- Start slowly: Once you feel confident with your practice trading, start trading with real money. Start off small to manage risk and gradually increase your trading size as you gain experience.
- Stay on top of your holdings: Regularly check your positions and ensure you have enough funds in your account. Use stop-loss and take-profit orders to manage risk and protect your profits.
- Monitor and adapt: Keep up with market news, economic indicators, and geopolitical events likely to affect currency prices. Be prepared to adjust your strategies as market conditions change, which is not the same as adapting your strategy with every price move.
Types of Markets
Forex is traded primarily via spot, forwards, and futures markets. The spot market is the largest of all three markets because it is the underlying asset (the money) on which forwards and futures markets are based. When people talk about the forex market, they are usually referring to the spot market.
The forwards and futures markets are more likely to be used by companies or financial firms that need to hedge their foreign exchange risks.
Spot Market
In the spot market, currencies are bought and sold based on their trading price. Prices are determined by supply and demand and reactions to factors such as:
- Interest rates
- Economic performance
- Geopolitical events
- Price speculation
A finished deal on the spot market is known as a spot deal. It's a bilateral transaction in which one party delivers one currency amount to the counterparty and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, it's settled in cash. Trades take two days to settle.
Forwards and Futures Markets
A forward contract is a private agreement to buy a currency at a future date and a predetermined price. Forwards are traded on the OTC markets. Futures contracts are based on the same principle but are standardized. Futures trade on exchanges, not OTC.
In the futures market, futures contracts are bought and sold based on a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange (CME). Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments that can't be customized. The exchange acts as a counterparty to the trader, providing clearance and settlement services.
Both types of contracts are binding and are typically settled in cash at expiry, although contracts can also be bought and sold before they expire. These instruments can offer protection against risk when trading.
In addition to forwards and futures, options contracts are traded on specific currency pairs. Forex options give holders the right, but not the obligation, to buy or sell a currency pair at a specified price on a specified future date.
Unlike the spot, forwards, and futures markets, the options market doesn't involve an obligation to purchase the currency. Options contracts give you the right to buy or sell the currency, but it's a choice.
Using the Forex Markets
There are two features of currencies as an asset class.
- You can earn the interest rate differential between two currencies: When you hold a currency pair position overnight, you'll either receive or pay interest based on the interest rate differential. You'll earn interest if the currency you bought has a higher interest rate than the currency you sold. This strategy is sometimes called a carry trade.
- You can profit from changes in the exchange rate: In forex trading, you can profit by buying a currency pair when you anticipate the exchange rate will rise and selling it when you expect the exchange rate to fall. The difference between your entry and exit prices determines your profit or loss.
Forex for Hedging
Companies doing business in foreign countries face currency risks due to fluctuations in currency values when they buy or sell goods and services outside their domestic market. Foreign exchange markets provide a way to hedge currency risk by fixing a rate at which the transaction will be completed. A trader can buy or sell currencies in the forward or swap markets in advance, and lock in a specific exchange rate.
Locking in an exchange rate helps firms plan ahead, reduce losses, or even increase gains, depending on which currency in a pair is strengthened or weakened.
Types of Forex Accounts
There are four types of forex lots: nano lots are 100 currency units, micro lots are 1,000 units, mini lots are 10,000 units of currency, and standard forex lots are 100,000 units of currency.
Forex for Speculation
Interest rates, trade, political stability, economic strength, and geopolitical risk all affect the supply and demand dynamics for currencies. This creates prospects to profit from any situation that may increase or reduce one currency’s value relative to another.
A forecast that one currency will weaken is essentially the same as assuming that the other currency in the pair will strengthen. So, a trader anticipating a currency change could short or long one of the currencies in a pair and take advantage of the shift.
Basic Forex Trading Strategies
The most basic trades are long and short trades, with the price changes measured in pips, points, and ticks. In a long trade, the trader bets that the currency price will increase and expects to sell their position at a higher price. A short trade, conversely, is a bet that the currency pair’s price will decrease. Traders can also use trading strategies based on technical analysis, such as breakouts and moving averages (MA), to fine-tune their approach to trading.
Depending on the duration and numbers for trading, we can set out four types of trading strategies:
- A scalp trade involves positions held for seconds or minutes at most, and profits are generally limited to pips.
- Day trades are short-term trades in which positions are held and liquidated on the same day. The duration of a day trade can be hours or minutes.
- In a swing trade, the trader holds the position for longer than a day, like days or weeks.
- In a position trade, the trader holds the currency for a long period, sometimes months or even years.
Pros and Cons of Trading Forex
Pros
Largest market in terms of daily trading volume in the world
Traded 24 hours a day, five days a week
Starting capital can rapidly multiply
Generally follows the same rules as regular trading
More decentralized than stock or bond markets
Cons
Leverage can amplify loses
Leverage in the range of 50:1 or higher is not uncommon
Requires an understanding of economic fundamentals, macro factors, and indicators
Less regulated than other markets
No income-generating instruments
Pros Explained
- Largest market in terms of daily trading volume in the world: Forex markets have the largest daily trading volume globally and, thus, the most liquidity. This makes it easy to enter and exit a position in any major currency within a fraction of a second for a small spread in most market conditions.
- Traded 24 hours a day, five days a week: The forex market starts trading each day in Australia and ends in New York. The major forex market centers are Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich.
- Starting capital can rapidly multiply: This is due to the leverage available in forex trading.
- Generally follows the same rules as regular trading: Forex rules are similar to other trading, and forex requires much less initial capital than other forms of trading.
- More decentralized than traditional stock or bond markets: No centralized exchange dominates currency trade operations, and the potential for manipulation—through insider information about a company or stock—is lower.
Cons Explained
- Leverage can amplify losses: Leveraged trading amplifies losses in forex trading just as it amplifies gains. Banks, brokers, and dealers in the forex markets allow a high amount of leverage, meaning traders can control large positions with relatively little money, increasing the risk of catastrophic losses.
- Leverage in the range of 50:1 or higher is not uncommon: Even greater amounts of leverage are available from certain brokers. Still, leverage must be used cautiously because many inexperienced traders suffer significant losses using more leverage than necessary or prudent.
- Requires an understanding of economic fundamentals, macro factors, and indicators: A currency trader needs a big-picture understanding of the economies of various countries and their connections to grasp what drives currency values and trade currencies productively.
- Less regulated than other markets: Forex markets are decentralized. The extent and nature of regulation in forex markets depend on the trading jurisdiction.
- No income-generating instruments: Forex markets lack instruments that provide regular income, such as regular dividend payments.
Forex Terminology
The best way to get started in forex is to learn its language. Here are a few terms to get you started:
| Forex Terms Cheat Sheet | ||
|---|---|---|
| Term | Definition | Example |
| Ask | The lowest price at which someone is willing to sell a currency | If the EUR/USD ask is 1.2345, it's the lowest price someone will sell you one euro for. |
| Base Currency | The first or left-side currency listed in a currency pair | In EUR/USD, the euro is the base currency. |
| Bid | The highest price at which someone is willing to buy a currency | If the EUR/USD bid is 1.2345, it's the highest price someone will pay you for one euro. |
| Bid/Ask Spread | The difference between the buying (bid) and selling (ask) price of a currency pair | If the EUR/USD bid is 1.2345 and the ask is 1.2348, the spread is 3 pips. |
| Contract for Difference (CFD) | A derivative that lets traders speculate on price movements without owning the underlying asset | Trading EUR/USD CFDs means betting on price changes, not owning euros or dollars. |
| Currency Pair | A quote for two different currencies, with the value of one expressed in relation to the other | EUR/USD, GBP/JPY, USD/CHF, etc. |
| Leverage | Using borrowed capital to increase potential returns (and risks) | Trading with 100:1 leverage means controlling $10,000 with only $100 of your own money (the rest is borrowed). |
| Long | Buying a currency pair with the expectation it will increase in value | Going long on EUR/USD means you expect the euro to strengthen against the dollar. |
| Lot | A standardized unit of currency traded in forex | A standard lot = 100,000 units, a mini lot = 10,000 units, a micro lot = 1,000 units, and a nano lot = 100 units |
| Margin | The amount of money required to hold a leveraged position | Your broker may require a 5% margin, meaning you have to pay 5% of the total position value in your account. |
| Pip | The smallest standard unit of price movement in a currency pair, typically the last decimal place | A pip in EUR/USD is 0.0001. |
| Quote Currency | The second currency in a currency pair | In EUR/USD, the U.S. dollar is the quote currency. |
| Short | Selling a currency pair with the expectation it will decline in value | Going short on GBP/JPY means you expect the pound to weaken against the yen. |
Charts Used in Forex Trading
Three types of charts are used in forex trading.
Line Charts
Line charts are used to identify big-picture trends for a currency. They are the most basic and common type of chart used by forex traders. They display the closing price for a currency for the periods the user specifies. The trend lines identified in a line chart can be used as part of your trading strategy. For example, you can use the information in a trend line to identify breakouts or a trend reversal.
Remember that the trading limit for each lot includes margin money used for leverage. This means the broker can provide you with capital at a predetermined ratio. For example, they may put up $50 for every $1 you put up for trading, meaning you will only need to use $10 from your funds to trade $500 in currency.
Bar Charts
Bar charts provide more price information than line charts. Each bar on a bar chart represents the trading activity for a chosen time frame, such as a day, hour, minute, or any other period the user selects. Each bar contains the trade's opening, highest, lowest, and closing prices. A dash on the left of the bar represents the period’s opening price, and a similar dash on the right represents the closing price. Colors are sometimes used to indicate price movement, with green or white for rising prices and red or black for declining prices.
Bar charts for currency trading may help traders identify whether it is a buyer’s or seller’s market.
Candlestick Charts
Japanese rice traders first used candlestick charts in the 18th century. They are visually more appealing and easier to read than the charts above. The upper portion of a candle is used for the opening price and highest price point of a currency, while the lower portion indicates the closing price and lowest price point. A down candle represents a period of declining prices and is shaded red or black, while an up candle is a period of increasing prices and is shaded green or white.
The formations and shapes in candlestick charts are used to identify market direction and movement. Some of the best-known are the hanging man and shooting star.
Forex: Trading vs. Investing
Investing and trading are two distinct approaches to participating in financial markets, each with different goals and strategies. Investing typically involves a long-term approach, where the goal is gradually building wealth over time. Investors may hold assets for months, years, or even decades, aiming to benefit from the appreciation of the asset's value or regular income through dividends or interest payments.
Meanwhile, trading involves a shorter-term approach, seeking to profit from the frequent buying and selling of assets. Traders seek to capitalize on short-term price trends and may hold positions for a few seconds (scalping), minutes, hours (day trading), or days to weeks (swing trading). They often rely on technical analysis, studying charts and patterns to identify trading prospects.
Forex trading is far more common due to the market's high degree of leverage, liquidity, and 24-hour accessibility. Forex traders typically use shorter-term strategies to capitalize on frequent price fluctuations in currency pairs.
Forex Scams, Frauds, and Hucksters
Forex trading scams are fraudulent schemes that prey on unsuspecting traders and investors in the $7.5 trillion-per-day foreign exchange market. Charlatans exploit the market's complexity, high stakes, and lack of centralized regulation to deceive victims, often with false promises of easy profits and low risk.
Over the years, common scams have included Ponzi schemes that misused investor funds and scams peddling worthless trading advice. The forex scandal of 2013, in which traders at some of the world's largest banks colluded to manipulate exchange rates, highlighted the potential for large-scale fraud even among established financial institutions. The scandal led regulators to ramp up scrutiny in the area. However, given the many scams since, vigilance is undoubtedly called for.
Here are some of the best-known recent forex cons.
| Notable Scams in Forex Trading | |||
|---|---|---|---|
| Scandal | Year | Description | Key Players |
| Forex Scandal (Forex Probe) | 2007-2013 | Years-long collusion between major banks to manipulate exchange rates on the forex market | Barclays PLC (BCS), JPMorgan & Chase & Co. (JPM), UBS Group AG (UBS), Citi Group (C), and others |
| Black Diamond Ponzi Scheme | 2007-2010 | A Ponzi scheme promising high returns from forex trading, which never materialized | American (fake) hedge fund managers |
| IB Capital FX Scam | 2012 | A forex scam that solicited funds from at least 960 customers without proper registration | Unlicensed forex traders |
| FXCM | 2009-2014 | The company colluded with market makers and was secretly involved in betting against its clients' trades | FXCM, now owned by Jefferies Financial Group Inc. (JEF)—continues to operate globally, but is banned from accepting U.S. clients |
| Israeli/German Forex Scam | 2023 | Suspects allegedly posed as financial traders dealing in cryptocurrencies and forex, targeting individuals worldwide through call centers in Bulgaria, Serbia, Ukraine, Georgia, Kosovo, and Israel | German nationals and Israeli crime syndicates |
These are just a few of the frauds in this area of finance. Here are common types of scams:
- Signal seller scams: Fraudsters sell trading signals or advice, often with false promises of guaranteed profits.
- High-yield investment programs: Scammers lure in investors with promises of high returns from nonexistent or worthless investments.
- Fake brokers: Unregistered or offshore brokers manipulate trading conditions, refuse withdrawals, or disappear with investors' funds.
- Automated trading systems: These scams involve selling "forex robots" that the cons claim can trade profitably on behalf of the user but often result in losses instead.
Social media and messaging apps have played a notable role in these scams. Fraudsters often use these channels to build a trustworthy relationship with an audience before promoting questionable trading schemes.
Tips on Avoiding Forex Scams
Experts emphasize the importance of education and due diligence in mitigating the risk of falling victim to scams. Here are some tips:
- Verify broker credentials: Ensure that a broker you're considering working with is registered with reputable regulatory bodies like the Commodity Futures Trading Commission (CFTC) or Financial Conduct Authority (FCA). Check its regulatory status and history of compliance. There are just six CFTC-registered forex dealers in the U.S. Avoid trading with any others.
- Charles Schwab Futures and Forex LLC
- Gain Capital Group LLC (Forex.com)
- tastyfx LLC
- Interactive Brokers LLC
- Oanda Corporation (Oanda, FXTrade.com)
- Trading.com Markets Inc. (Trading.com)
- Be skeptical of high returns: Avoid investment prospects that promise high returns with little or no risk. Legitimate investments always have risk, and the best forex brokers emphasize the risks to ensure you understand what you're getting into.
- Do your research: Investigate the company, its management team, and its track record. Look for reviews and testimonials from credible sources. Be aware of common scam tactics, like fake accounts, impersonations, and misleading marketing materials, and choose brokers with transparent fee structures, clearly defined trading conditions, and accessible customer support.
- Use security tools: Employ VPNs, password managers, and antivirus software to protect your trading accounts and personal information.
Forex fraud will likely become more innovative as markets evolve and sophisticated technology enables even more advanced scam schemes. But with vigilance and prudence forex trading can be navigated more securely.
Frequently Asked Questions (FAQs)
Is Trading Forex Legal in the US?
Yes, forex trading is legal in the U.S., but it is regulated to better protect traders and make sure that brokers comply with financial standards.
How Much Money Do I Need to Start Trading Forex?
You can start trading forex with as little as $100 to $500 funded in a mini account, but will need significantly more capital for a standard account. Leverage from brokers can allow you to trade much larger amounts than your account balance. Brokers may provide capital at a predetermined ratio, such as putting up $50 for every $1 you put up for trading. This means you may only need to use $10 of your own funds to trade $500 in currency.
The specific minimum deposit will depend on the brokerage you use and the amount of leverage it allows.
Are Forex Markets Volatile?
Forex markets are among the most liquid markets in the world. The volatility of a particular currency is a function of multiple factors, such as the politics and economics of its country of issue. Unexpected events like a payment default or an imbalance in trading relationships with another currency can result in significant volatility.
Are Forex Markets Regulated?
Forex trade regulations vary by jurisdiction. Countries like the United States have sophisticated infrastructure and robust regulation of forex markets by organizations such as the National Futures Association and the CFTC. Developing countries like India and China have restrictions on the firms and capital to be used in forex trading. Europe as a whole is the largest forex market in the world, but regulations still vary among different member states. In the U.K., the Financial Conduct Authority monitors and regulates forex trades.
Which Currencies Can I Trade in?
Currencies with high liquidity have a ready market and tend to exhibit a more smooth and predictable price action in response to external events. The U.S. dollar is the most traded currency in the world. It is paired up in nine of the world's 10 most traded currency pairs. Currencies with low liquidity, however, cannot be traded in large lot sizes without causing a market movement.
The Bottom Line
Forex trading offers the potential for significant profits but also carries substantial risks. The foreign exchange market's vast size, liquidity, and 24/5 accessibility make it attractive to traders worldwide. However, the inherent volatility, leverage, and complexity of forex trading can quickly lead to significant losses, especially for inexperienced traders.
To succeed in forex trading, you must develop a deep knowledge of the markets, economic fundamentals, and technical analysis. Managing risk is essential, including proper position sizing and stopping losses. Traders should also remain vigilant against the many frauds that pervade the forex market.
Aspiring forex traders should start with a solid education, practice with demo accounts, and only risk capital they can afford to lose. Partnering with a reputable, well-regulated broker and maintaining realistic expectations are also crucial.
