- What is Forex trading?
- When to trade Forex?
- Why trade Forex?
- Forex Liquidity and Volatility
- Forex Gaps and Slippage
- What are pips?
- Which currencies can I trade?
- Common Forex Mistakes
What is Forex trading?
The foreign exchange market – also known as forex or the FX market – is the worlds most traded market, with turnover of $5.1 trillion per day.* To put this into perspective, the U.S. stock market trades around $257 billion a day; quite a large sum, but only a fraction of what forex trades.
Forex is traded 24 hours a day, 5 days a week across by banks, institutions and individual traders worldwide. Unlike other financial markets, there is no centralized marketplace for forex, currencies trade over the counter in whatever market is open at that time.
History of Forex
Although currency trading has a long history dating back to the middle ages, it is the changes that we have seen during the twentieth century which have created the Forex market we see today. During the first half of the twentieth century the British pound was the worlds principal trading currency and was the currency held by many as their main (reserve) currency. As a result, London was also seen as the leading center for foreign exchange. However, the Second World War severely damaged the British economy and so the United States dollar took over as the worlds principle trading and reserve currency and retains that position today. This said, there are now a number of other currencies, principally the Yen and the Euro, which are also seen as reserve currencies.
Since the Second World War there have been a number of events which have proved instrumental in shaping todays Forex market.
Until the start of the Second World War, as we said the British Pound Sterling was the World most prominent currency.
At the end of the Second World War the Worlds economy, with the exception of the United States of America, was in disarray. Representatives from the United States of America, Britain and France met at Bretton Woods, New Hampshire with the objective of creating an infrastructure that would allow the rebuilding of the World economy. The result was the Bretton Woods Accord. The Accord decided that the US Dollar would become the World benchmark and all other countries would measure the value of their currencies against it. Part of this agreement was the Gold Standard which fixed the price of Gold at $35 an ounce. All other currencies were pegged to the dollar at a certain rate. This rate was not allowed to fluctuate more than 1% in either direction (higher or lower). If a fluctuation greater than 1% did occur then the relevant central bank had to enter the market and restore the exchange rate to within the accepted band. The Bretton Woods Accord also set in motion the establishment of the International Monetary Fund (IMF) which was designed to provide a stable system for buying and selling currencies and to ensure that currency transactions could take place smoothly and in a timely fashion.
In addition, the aim of the IMF was to create a consultative forum to promote international co-operation and to facilitate the growth of world trade, while at the same time breaking down exchange restrictions which hindered international trade.
The Smithsonian Agreement tried to succeed where Bretton Woods had failed. Rather than give a 1% margin, greater room for manoeuvre was introduced. Not long into this agreement, Europe made its first attempt at breaking free from the Dollar dominated system. In 1972 Europe formed the European Joint Float. Member nations included West Germany, France, Italy, the Netherlands, Belgium and Luxembourg. This agreement was very similar to Bretton Woods but with a larger band for rate fluctuation.
Just as their predecessors had failed, these agreements were flawed and subsequently fell apart. However, this time there was no new agreement to take its place. For the first time since WWII there was a (free float) system in place. The value of each currency is now governed completely by the laws of supply and demand. Large banks, private companies and individual speculators are all active participants in the Forex market.
The next major milestone was the establishment of European Monetary System which effectively came into force in 1979. The European Monetary System got off to something of a shaky start when Britain (one of the principle members of the European Community) decided not to join the system and Italy joined only under special arrangements. Britain did however later agree to participate to a limited degree by joining the exchange mechanism of the European Monetary System in 1990.
The final major development to affect the Forex market was the establishment of the Euro as a single currency for European Union member states in 1998 with eleven of the participating states replacing their national currency with the Euro.
*April 2016 Interbank Forex Market average daily volume from Bank for International Settlements.
When to trade Forex?
You can trade forex 24 hours a day, five days a week. The foreign exchange markets are worldwide and therefore follow a 24-hour global timetable.
The trading week for forex begins on Monday morning in Sydney, Australia and follows the sun westward as the world major capital markets open and close from Tokyo to London and finally closing on Friday evening in New York.
Unique benefits of a 24 hour market:
React to global trading opportunities whenever they arise
Trade when it is convenient for you
Take advantage of periods of higher volatility when markets overlap
Forex trading involves significant risk of loss and is not suitable for all investors.
Why trade Forex?
Forex is the most traded market in the world and when you understand the benefits of the market, it is easy to understand why.
24 Hour trading, 5 days a week
Unlike other markets, forex trading does not have to stop when the sun goes down. Since forex is traded all over the world, trading markets are open 24 hours a day, 5 days a week, so you can trade when it is convenient for you.
Trading opportunities in bull and bear markets
The forex market offers traders the unique advantage of trading opportunities in both rising and falling markets. And unlike other markets, there are no restrictions or additional costs for short selling.
Trade more with less
Forex is traded with a degree of leverage, allowing you to take a position in the market with a fraction of the capital you would usually need. As much as leverage may increase your gains, it can also increase your losses so it is important that you understand the risks of trading on margin.
With daily turnover reaching $5.1 trillion,* forex is the most liquid market in the world. This liquidity often results in more actionable prices and unlike other financial markets, traders can respond almost immediately to currency fluctuations, whenever they occur – 24 hours a day, 5 days a week.
Wide range of markets
Forex trading allows you to easily gain exposure to markets around the world. While most trading is done in the world major currencies, you also have access to emerging markets such as Mexican Peso (MXN) and Polish Zloty (PLN).
* April 2016 Interbank Forex Market average daily volume from Bank for International Settlements.
Forex Liquidity and Volatility
You will often hear it said that the forex market is the most liquid financial market in the world, and it is. But what does that mean for you and your trading?
What Is Liquidity?
Liquidity refers to how active a market is. It is determined by how many traders are actively trading and the total volume they are trading. One reason the foreign exchange market is so liquid is because it is tradable 24 hours a day during weekdays. It is also a very deep market, with nearly $6 trillion turnover each day. Although liquidity fluctuates as financial centres around the world open and close throughout the day, there are usually relatively high volumes of forex trading going on all the time.
What Is Volatility?
Volatility is the measure of how drastically a markets prices change. A markets liquidity has a big impact on how volatile the markets prices are. Lower liquidity usually results in a more volatile market and cause prices to change drastically; higher liquidity usually creates a less volatile market in which prices do not fluctuate as drastically.
Liquid markets such as forex tend to move in smaller increments because their high liquidity results in lower volatility. More traders trading at the same time usually results in the price making small movements up and down. However, drastic and sudden movements are also possible in the forex market. Since currencies are affected by so many political, economical, and social events, there are many occurrences that cause prices to become volatile. Traders should be mindful of current events and keep up on financial news in order to find potential profit and to better avoid potential loss.
Forex Gaps and Slippage
Gaps are sharp breaks in price with no trading occurring in between. Gaps can happen moving up or moving down. In the forex market, gaps primarily occur over the weekend because it is the only time the forex market closes. Gaps may also occur on very short timeframes such as a one-minute chart or immediately following a major news announcement.
Examples of when gappage can occur include:
When economic data is released – particularly if it contains data that the market is not expecting
As major news events are announced, particularly global and/or unexpected news When trading resumes after a weekend or holiday – especially if major news is announced in that period
Why are they important?
Gaps can give an idea of market sentiment. When a market gaps up, that means there were zero traders willing to sell at the levels of the gap. When a market gaps down, that means there were zero traders willing to buy at the levels of the gap. There are also important to be aware of because it is possible to gap past a stop order and get filled at worse price than your stop order.
Gaps sometimes result in corrective price action. In other words, after the gap occurs prices have a tendency to reverse and (fill) the gap.
So how do I use them?
If there is a gap, generally that is a signal to stay out of the market. Gaps can show strength in the direction of the gap or they can (close) by having prices move in the opposite direction of the gap to at least where the gap began. If there is a gap immediately before the entry of a trade, it may be wise to cancel the trade.
What Is Slippage?
Slippage is the difference between the expected price of a trade and the price at which the trade actually executes. Market gaps can cause slippage which may affect stop and limit orders – meaning they will be executed at a different price from that requested.
What are pips?
Currency prices typically move in such tiny increments that they are quoted in pips or percentage in point. In most cases, a pip refers to the fourth decimal point of a price that is equal to 1/100th of 1%.
The superscript number at the end of each price is the Fractional Pip, which is 1/10th of a pip. The fractional pip provides even more precise indication of price movements.
Calculating the value of a pip
The value of a pip varies based on the currency pairs that you are trading and depends on which currency is the base currency and which is the counter currency.
Which currencies can I trade?
Forex is the most widely traded market in the world, with more than $5.3 trillion* being bought and sold every single day. Traders will speculate on the future direction of currencies by taking either a long or short position, depending on whether you think the currency value will go up or down. Typically referred to as (The Majors), these seven currency pairs make up almost 80% of total daily trading volume*.
Euro/U.S. Dollar- EUR/USD
Great British Pound/US Dollar-GBP/USD
U.S. Dollar/Japanese Yen/USD/JPY
U.S. Dollar/Swiss Franc-USD/CHF
U.S. Dollar/Canadian Dollar-USD/CAD
Australian Dollar/U.S. Dollar-AUD/USD
New Zealand Dollar/U.S. Dollar-NZD/USD
Minor Currency Pairs
While the major currency pairs make up the majority of the market, you should not ignore the minors – also referred to as Cross Currency Pairs. The minor currency pairs account for all the other combination of major markets such as; EUR/GBP, EUR/CHF and GBP/JPY.
With so many options available, you are probably asking yourself – which currencies should I trade? A good rule of thumb for traders new to the market is to focus on one or two currency pairs.
Generally, traders will choose to trade the EUR/USD or USD/JPY because there is so much information and resources available about the underlying economies. Not surprisingly, these two pairs make up much of global daily volume.
*2013 BIS Triennial Central Bank Survey
Common Forex Mistakes
Trading forex can be a rewarding and exciting challenge, but it can also be discouraging if you are not careful. Whether you are new to forex trading or an experienced veteran, avoiding these trading mistakes can help keep your trades on the right track.
Not Doing Your Homework
Currency pairs are closely linked to national economies and are affected by many factors. They are also traded 24/5, meaning there is usually something going on that will move the markets.
Before entering a trade, make sure you do your homework. Not only should you be aware of upcoming events that could affect your trade, but you also need to forecast which way these events could swing the markets. Pay attention to what your technical indicators are telling you and how they compare to your fundamental event analysis.
Risking More than You Can Afford
One common mistake new traders make is misunderstanding how leverage works. Familiarize yourself with margin and leverage to help avoid accidentally putting more capital at risk than you had planned.
Many traders find it helpful to set a maximum percentage of their capital that they are willing to risk at one time, usually 1% to 3%. For example, if you have $50,000 of equity and are willing to risk 2% maximum, you would not tie up more than $1,000 at one time. It is important that you stick to that maximum once you set it.
Trading without a Net
You cannot watch the forex markets 24 hours a day. Stop and limit orders help you get in and out of the market at predetermined prices. This not only allows the trading platform to execute trades when you are not available, but it also makes you think through to the end of your trade and set exit strategies before you are actually in the trade and your emotions get the best of you. Placing contingent orders may not necessarily limit your risk for losses.
A loss never feels good. It can make you emotional and irrational, tempting you to make kneejerk follow-up trades that are outside your trading plan. No trader makes a great trade every time. Accept that losses are part of the reality of trading and stick to your plan. In the long run, your trading plan should compensate for that loss; if not, review your plan and adjust.
Trading from Scratch
Using your hard-earned capital to test a new trading plan is almost as risky as trading without a plan at all. Before you start trading real money, open a forex practice account and use virtual funds to try out trading plans and get a feel for the trading platform you are using. Although you will not be affected by your emotions the same way you will be when trading your own money, this is also a chance to see how you react to trades not going your way and learn from your mistakes without the risk.