Forex Trading 101

The currency market is the largest and most liquid market in the world, with over $5 trillion trading hands every day. Given its significant liquidity and extended hours relative to traditional equity and futures markets, the foreign exchange (“forex”) market has become increasingly attractive to both institutional and individual traders looking to profit from price movements.

What Is Forex Trading?

Forex traders generate profits by betting on changes in one currency’s valuation relative to another currency – this is known as a currency pair. For example, suppose that a forex trader believes that the USD will appreciate relative to the EUR. They can profit from the relative appreciation by short-selling the EUR/USD currency pair, or in other words, buying large amounts of USDs with EURs.

Movements in currency markets are measured in pips, which represent a fraction of the base currency. For example, one USD pip represents $0.0001 or 1/100th of 1% or one basis point. Pips are designed to be small enough to avoid excessive volatility in the currency markets and depend on the currency in question. For example, one JPY pip is only ¥0.01 given JPY’s currency dynamics.

See also Top 21 Trading Rules for Beginners: A Visual Guide

Pip Comparisons
Figure 1 – Pip Comparisons – Source: YCharts

The majority of forex transactions are now speculative in nature, but commercial and central bank transactions represent other major components. For example, a commercial U.S. company doing business in Europe may need to convert EURs to USDs in the forex market, while a central bank may intervene in the forex market by buying or selling currency in order to influence its valuation.

Leverage in Forex

Forex trading involves large amounts of leverage—or borrowed money—since currency movements tend to be very small. For instance, a forex trader would need many millions of dollars to profit from a “large” 100-pip ($0.01) change in the EUR/USD currency pair in a meaningful way. Leverage can provide everyday retail traders with millions of dollars to speculate in the market.

Be sure to see the 25 Stocks Day Traders Love

Profit Comparison with Leverage
Figure 2 – Profit Comparison with Leverage – Source: YCharts

The problem with leverage is that it acts as a double-edged sword. While traders can make greater returns, they also risk amplifying their losses. For example, a typical broker will provide 100:1 leverage, which means that a trader with $10,000 in cash will be able to trade with $1 million. If they utilize the full $1 million, a modest 1% gain would double their money, but the opposite would result in a complete loss.

Forex brokers may also issue margin calls when a leveraged account balance becomes at risk, since a quick market move below the threshold could result in greater than 100% losses on the account. For example, if there was a 0.8% move lower in the previous example, a broker may require that you put more money into your account or threaten to liquidate the position.

Trading Dynamics

Forex trading is driven by a combination of fundamental events and technical analysis. Often, fundamental events drive large price movements with range-bound technical trading taking place between those events. Many forex traders use fundamental analysis to determine the direction of their trades and then use technical analysis to handle the specific timing of the trades.

Fundamental events driving the forex markets include things like economic indicators, central bank actions, and political events. For example, a lower than expected GDP growth reading might cause a currency’s relative valuation to fall, while a central bank’s move to defend its currency might cause its relative valuation to rise, as was frequently the case with the Bank of Japan in the 1990s and 2000s.

Bank of Japan Intervention
Figure 3 – Bank of Japan Intervention – Source: YCharts

Technical trends and indicators tend to drive the markets between important fundamental events. Common technical indicators like moving averages, stochastic oscillators, and Bollinger bands are frequently paired with chart analysis that looks for patterns like ascending triangles, price channels, and flags to identify high-probability trading opportunities in major currency pairs.

Risks & Rewards

The forex market is generally considered to be riskier than the equity markets, since it involves a larger amount of leverage and volatility. As a result, most forex traders aren’t investing their life savings in currencies like they do blue chip stocks. Those willing to assume the risks, however, are certainly capable of making greater returns than possible with most equities in a market that’s open 24/6.

Forex trading risks include:

• High Leverage. The forex market uses large amounts of leverage, which means that forex traders can quickly rack up losses if they are not careful.
• No Upside Bias. Equity markets tend to have a long-term upside bias, due to the nature of the corporation, but forex markets do not have such a bias.
• Little Regulation. The forex market is far less regulated than markets for other securities, particularly when brokers are located outside of the U.S.

Forex trading benefits include:

• Longer Hours. The forex market is open 24 hours per day from 5pm EST on Sunday until 4pm EST on Friday, offering investors anytime trading hours.
• More Liquidity. The forex market is the most liquid market in the world, which means individual investors can buy and sell without market impact.
• Easier to Start. Forex traders can get started with as little as $1 or even with a credit card, giving them immediate access to begin trading.

In general, most experts believe retail forex trading is more like gambling than trading equities due to the greater risks. A single trade in a leveraged account is enough to lose everything if a market were to move against a trader. That said, there are some professional traders that make consistent profits in the market and many banks and hedge funds speculate for large profits.

Prop Trading & Training

Proprietary trading, or prop trading, occurs when a fund trades with its own money rather than investor money. Over the past several years, forex prop trading firms have sprung up offering to provide individual forex traders with training and capital, letting them trade for a cut of the profits. These firms can be invaluable to those just starting out, but there are some key risks that should be considered.

• Deposits. Many prop-trading firms require some capital to begin, but those funds may be at risk if the prop-trading firm itself goes under. Escrow agreements or other security may be a better option in these cases.
• Fees. Many prop-trading firms require candidates to undergo training programs that may involve the payment of upfront fees. Excessive fees may suggest that the firms are really making the money from training not trading.
• Commissions. Many prop-trading firms charge a commission for facilitating trades and encourage forex traders to make a high number of trades. In some cases, these commissions might be the only source of profits.

In the end, many prop-trading firms are essentially scamming candidates by making the majority of their money on training fees, commissions, and then taking deposits when traders are unsuccessful. Forex traders interested in taking this route should look for firms operating under a profit-payout model, whereby the firm only makes money when its traders are consistently profitable.

The Bottom Line

• The currency market is the largest and most liquid market in the world, trading more than $5 trillion per day 24/6.
• Forex traders generate profits by capitalizing on changes in the relative valuation between two currencies, known as a currency pair.
• Fundamental factors tend to result in large trend-changing moves in currencies, while technical factors drive the trading in between.
• Forex trading involves a number of serious risks and constitutes more gambling than investing in many cases.
• Forex traders should be careful when consider prop-trading firms, since many of them may not have their best interests at heart.