This forex beginners guide is going to introduce you to the exciting world of spot Forex, the largest traded market there is, with a daily trading volume of over $5 trillion.
In the past, this market was for an elite few but with high-speed internet, super-fast chip processing, and state of the art trading platforms now any Tom, Dick or Harry who is bold enough to back their opinions are able to play.
The different types of Forex trading
When we talk foreign exchange, we also mean forex, spot FX, or the currency market. They all refer to one and the same market thing.
But there are other ways to speculate on currencies, including futures, options, CFDs, financial spread betting, and exchange-traded funds.
Of all the instruments at your fingertips, CFDs and financial spread betting come closet to how forex trading works.
FX Trading Platforms
Despite the name, in foreign exchange, there’s is no actual exchange or location where trading takes place.
In the stock market, there’s the New York Stock Exchange and the LSE.
The commodities futures markets are also traded on exchanges, such as the Chicago Mercantile Exchange, or London Petroleum Exchange.
But the forex market’s different.
It’s a network of interconnected banks, market makers, dealers, and clientele all trading with each other via electronic trading platforms or portals.
Think of the FX markets as hierarchical.
The most important of these platforms is the interbank market. This is where the largest of the world’s banks come to trade with each other.
There are two interbank trading platforms.
You’ll find the best price quotes and tightest spreads here. All banks who use the interbank market have established credit lines with each other.
Non-banking financial institutions such as hedge funds, MNCs, and forex brokers don’t trade on the interbank market. Instead, they trade on portals owned by their respective banks (who in turn trade on the interbank market).
Many smaller banks don’t have established credit facilities on EBS or Reuters at all. And are unable to access the best price quotes and pass them on to clients.
The retail forex brokers that small capped traders deal with either, have their own trading portal and act as a market maker, or will have orders routed through an ECN.
Either way us, small-timers like ourselves, tare not having our orders going into the deep liquidity pools of large portals or interbank market.
Spot forex is traded in pairs.
The first currency is known as the counter, or quote currency.
The second currency is the base currency.
When you go long, you’re buying the first currency and selling the second. When short, you’re selling the first and buying the second.
These are the four major pairs with the most trading volume in spot FX.
These days trading volume in the Yuan is also strong.
London is a major clearing centre for the Chinese currency; and with the Middle Kingdom the second-largest economy in the world, the trend will be towards increased volume in that currency.
One day it may too be considered a major pair.
Below the majors come the cross pairs.
Yen crosses include:
Euro crosses include:
Crosses are not as heavily traded as the majors, meaning spreads are wider.
Finally, the exotics are the real low liquid pairs with large bid-ask spreads. These typically include emerging market currencies and are not in high demand. The list of minor crosses is extensive but include:
Fundamentals – supply and demand
Like all markets, currency prices move on supply and demand.
Demand takes many forms.
It can be MNCs needing currency to purchase raw materials, or a finished product from an exporting country.
Or investment demand from either individuals or financial institutions purchasing stocks on an overseas bourse.
Also, it can be short-term speculative demand, for example, prop trading firms placing orders at critical technical breakout levels.
The raising and lowering of interest rates within a country is also of huge significance.
Money goes where it gets the highest rate of interest, so high yielding currencies are often (though not always) the beneficiary of massive fund flows.
I say, not always because there are cases where no matter how the interest rate, investors won’t go near the currency.
The Venezuelan interest rate is pushing 30% but it would take a brave investor indeed to risk their investment being devalued overnight.
Investors look to countries with stable governments, ease of doing business, low corruption, and the rule of law – before looking at interest rates.
A country exporting more than importing is a net exporter, and has a trade surplus.
A country importing more than exporting is a net importer, and runs a trade deficit.
In theory, a country running a surplus sees high demand for the currency; as foreigners buy currency to purchase export products. This is what has happened with the Yuan over recent years.
The country running a trade deficit (such as the UK) sees the currency fall, as there’s isn’t such a high demand for its currency. And, as locals sell their own currency to purchase a foreign one
These are the investment flows into a country.
Money can go into the stock market, real estate or government bonds.
Another form of capital inflow is foreign direct investment (FDI).
This is when a company in one country sets up operations in another, taking advantage of cheaper labour, as has happened with US manufacturer in China.
Another reason to relocate is to be closer to raw materials or manufacturing supply chains.
What moves the currency markets short-term
All the above is what goes to move the FX market on a daily basis.
I mention trade and capital flows not due to some need to trade with long-term fundamentals.
Simple pattern trading has little use of purchase price parity, the real effective exchange rate, the fundamental equilibrium exchange rate or my favourite, the Big Mac index.
But these data releases concerning trade or capital flows come over the newswires and can have a pronounced short-term effect on markets.
I would never advise a neophyte to trade news specifically, but technical price patterns that form prior to important news releases can significantly add to profits.
If you’re a statistics nerd, you could monitor releases coming out well ahead or well below expectations. These readings not only can affect the market immediately but in the following weeks or even months ahead.
The spot FX trading session
As a 24 hour market, there are many opportunities for the astute FX trader Monday to Friday. Even on a bank holiday, you’ll find some pocket of the market moving.
The trading day starts in Auckland, moves to Tokyo, Hong Kong and Singapore. This is referred to as the Asian session.
The European session starts in Frankfurt. Then London opens (the biggest FX market in the world) followed by New York. The highest liquidity time of the day is when both London and New York are open simultaneously.
When New York closes for the day, the baton is handed back to New Zealand, and then the rest of Asia.
Don’t think it’s only Asian currency traded during an Asian session. Or, only the Euro traded in Europe. All currencies can be traded at all times.
With that said, the highest liquidity times for any currency will be when its own geographical region is open for business.
The best moves in the Yen do occur when Tokyo is open, or in the Singapore Dollar, when Singapore is open. If you’re living in Asia (as I do) then the mornings are woefully quiet for the GBP/USD – which only comes alive 3.00 pm Bangkok time.
Leverage and margin
Spot forex is a leveraged trading vehicle. Which is one of the reasons it’s so popular with small capped retail traders. But what does leverage mean?
Simply put, leverage is the ability to own a large investment by depositing a small fraction of that amount.
If that’s still double Dutch to you, then let’s use a quick example.
You want to buy one mini lot of GBP/USD, costing £10,000.
Rather than using a full 10K, you have through the option of using a forex broker, the ability to deposit £100 only.
This means you are leveraged 100:1.
For every one £1 deposited you control £100.
The difference between leverage and margin
Leverage is the ratio between the cash deposited and the cash you control. 100:1, for example.
Margin is simply the cash you deposit. £100 in the example above.
The margin is separated in your account from the rest of your equity. However, this money is not deducted permanently. Margin is not a fee, it is a good faith deposit, returned when the trade is closed.
The margin can be expressed as a %. So in the case of putting down £100 to trade £100k you are putting up 1% margin.
2% margin is 50:1 leverage, 3% margin is 33:1 leverage. And so on.
The benefits and drawbacks of leverage
The benefit is that for a small sum you get a large sum. Most of us just haven’t the capital to stump up £10k on every trade.
But let’s see how leverage affects our trading results.
Using the GBP/USD example again let’s say the value of our mini lot rises from $10k to £11k, meaning a £1k profit.
For the £100, you put up in margin you’ve made 10 times your money or 1000%
If you’d have put up the full amount then a £1000 profit would work out as a 10% profit. Respectable, but not hitting it out of the ballpark type of stuff.
Leverage really can be a beautiful thing.
It’s why we hear of such fantastic claims forex trading can make you rich.
But there’s a caveat. Things can go the other way too.
You can lose similar sums of money – which is why you need to protect yourself with stop losses.
Letting small losses get out of hand is a recipe for disaster.
The regulators spend a lot of time worrying about whether retail traders know the dangers of leverage or not. And brokers are forced to go to great lengths to reinforce the dangers of it on company websites, account application forms etc
Yes, leverage can be dangerous, but so can lying in the middle of the road in the oncoming traffic
Hopefully, readers of Tradeneophytes.com are not going to be so dumb;
Learning to use leverage wisely through appropriate money management is essential for trading success.
I’m going to talk a little of FX futures – they’ll crop up time to time as you monitor the markets.
Currency futures (unlike spot FX) are traded on a futures exchange; the same place you’d buy pork bellies or bushels of wheat for delivery to your front door.
The quote currency for FX futures contracts is always the US dollar.
And tradeable currencies are the Japanese Yen, British Pound, Euro, Aussie, Canadian dollar and Swiss Franc.
There is a level of transparency in the futures market not present in spot forex.
This transparency has led to the publishing of the weekly, Commitment of Traders report – the only reason I really mention FX futures at all.
This report is an excellent little report, highlighting the positioning of both smart and dumb money trading currency futures.
It’s specifically for futures positions but has immense value in spot forex too.
The COT acts as a good sentiment indicator – telling you where and in what direction smart traders are positioning.
Other than this, the FX futures market is not really worth knowing much about.
Trading times are confusing, trade execution is erratic, and should you forget to close or rollover before expiry, you’ll end footing the bill for a full currency contract – around $100k.
Leave the FX futures markets to the big boys, and concentrate on spot forex instead.
Spot forex CFD trading
One thing forex beginners guides fail to mention is the difference between FX CFD trading and forex.
This doesn’t affect US citizens because they do not have Contracts for Difference as a trading option. But CFDs are big in the UK, Europe and parts of Asia.
For all intents and purposes FX CFDs and spot forex trade the same.
But, CFD brokers make synthetic markets in a range of stocks, indices, commodities, FX, interest rates and now even cryptos.
Their trading platforms are advanced. Technology is state of the art. The prices they quote for markets follow almost exactly the price in the underlying market.
But, it’s not they are not the real market. They are derivative markets. In some cases, they are derivatives of a derivatives market.
CFD Broker or Forex broker?
To FX purists (of which there are many) the idea of not having your orders routed through to the real market is sacrilege.
Personally, I’m not bothered at all.
I cut my teeth financial spread-betting, which is an even less refined version of CFD trading.
My need is to speculate on markets, I’m not fussy if it’s through a glorified bucket shop or not.
Never once have I had an issue with a CFD or financial spread-betting firm.
I do understand though, those who wish to trade the real market.
So here’s the advice I’d give.
If your sole aim is to trade forex then choose a real forex broker.
On the other hand, if you want access to a range of markets, then choose a CFD broker.
The characteristics of the Forex market
When I talk characteristics I’m referring to the specific manner in which prices move.
Each currency has it’s own personality, and it’s beyond the scope of this forex beginners guide to go into that.
But the foreign exchange market isn’t for the faint of heart.
Typically it’s hyper volatile, reacting to the various economic releases coming out during the day in an extremely bipolar kind of way.
Let’s say you went long the GBP/USD in the morning. You’re surprised to find yourself up 100 pips to the good by lunch. Back at breakeven come afternoon, and up once more by 150 pips at the US close.
While the said profit isn’t a bad thing, the emotions experienced to get it can be exhausting.
I could talk forever about trade flows, capital flows, trendlines, or big mac indexes, but none of this means diddly squat if you can’t get a grip on your emotions.
The best thing is to avoid looking at the screen more than absolutely necessary but in reality, we struggle.
We get hooked easily on all the blips up and blips down. It’s like one giant slot machine.
I am against day trading in most circumstances, but this hyper volatility is a godsend for those skilled at it.
Stock indices are not nearly as erratic during the course of the day. And if I’m being completely honest, forex trading is much harder for me on the emotions than trading indices such as the Dow 30 or even NDX100.
Short-term trading on Forex
As I’ve said elsewhere on this blog, I believe short-term trading works best for newbies.
Day trading is a tough business, and I am not ashamed to say I’m very bad at it. Meanwhile holding positions for weeks or months is also a problem for many.
Moves measured in days, and at most two weeks fit well with forex. With so much whipsaw in FX, the majority are doomed trading intraday and doomed trading longer term.
One of my favourite strategies in spot forex is the Harami Inside Bar. It brings at least a semblance of order to a market that has little.
What to do next?
If you’re reading this forex beginners guide there’s a good chance you haven’t yet taken the plunge and opened a forex or CFD trading account.
That isn’t a bad thing.
You need to think seriously about how you’re going to trade the market and develop the skillset required. I’m hoping this blog can be part of that journey.
What I will say, is the first step you need to take now is open a demo account and do nothing but play around.
You’re under absolutely no obligation to put money into it or provide any sort of bank details as a first step.
Each broker is different regarding demo accounts; some allow you to continually practice, provided you place regular trades.
Others may close the account after one or two months; either way, it’s a great first step in familiarising yourself with charting and placing orders.
For myself, I didn’t t take the advice I give you now and sincerely regret that.
If I’d had the awareness to practice and develop my skills first before putting money on the line, my journey from neophytes to adept would have been that much smoother.
I hope this forex beginners guide has been of value, please leave a comment if you think it has.