Introduction to Forex Trading

Forex trading is all the rage, for good reason: it is possible for the average person to make a tremendous amount of money. This is largely because Forex trading offers an incredible amount of leverage, as much as 400:1.

Let’s take a look at Forex trading for the complete beginner and see if this is a viable wealth vehicle for you.

What is Forex?

Forex (FOReign EXchange) is the foreign currency market. It is actually the largest financial market in the world. The turnover is over $2.5 trillion per day, that’s more than 100x the Nasdaq turnover rate!

So with Forex trading, you’re not investing in companies, like with the stock market. Instead, you’re purchasing another country’s currency in the anticipation that it will increase in value relative to another.

The Advantages of Forex Trading

There are many advantages to investing in the Foreign Exchange, including:

  1. High Liquidity. You’re simply trading cash for cash at the current exchange rate. Cash is about as liquid as an investment can be.

  2. Easy Access. The foreign exchange market is open 24 hours a day, 7 days a week. This can be an incredible advantage. In the stock market, if something happens after the close of the trading, you can’t act upon it until the next trading day. By then the market will adjust for the news.

    • The foreign exchange market is always open, and if you’re quick enough, you can beat any market adjustments you see coming with investments that will benefit you.

  3. Two-Way Market. Currencies are always traded in pairs. You always sell one currency to buy the other.

    • For example, you may sell US dollars to purchase Euros. This is the position you would take if you believed the value of the euro will rise against the value of the US dollar (this is considered to be “selling short”).

    • If you believed the value of Euros will fall relative to the US dollar, you would sell Euros and buy dollars (”selling long”).

    • So there is the opportunity to make money from both the rise and fall of a currency. In the first case, if the Euro rises or the dollar falls, you would make money.

  4. Leverage. Forex accounts have anywhere from 50:1 to 400:1 leverage. This means you could control $100,000 with as little as $250. Wow!

Forex Terms and Definitions

Market Order: This is simply the execution of your decision to purchase a currency. You have made an order to purchase a currency at the current exchange rates.

Entry Order:  While a market order is made at the current exchange rate, an entry order is only executed if the exchange rate reaches a value that you have specified.

Stop-Loss Order: This is a mechanism to limit your losses (or gains). You can specify that your position will be liquidated once your losses (or gains) have reached a certain threshold. For example, you could specify that you want to sell once you’ve lost $1,500.

Bid: This is the price at which you can buy.

Ask: This is the price at which you can sell.

Pip: This is the last decimal of the exchange rate. This is true for all currencies, except the Yen, which is the second to last decimal.

Margin: This is the minimum amount you need to purchase, as trades come in sets called lots. For example, the margin of one lot of a currency pair might be $200. This is the amount of money you are actually risking.

Lot: A lot is 100,000 units of the first currency.  So a USD/GBP lot would be worth $100,000. The reverse pairing would be worth 100,000 GPB.

Currency Pairs and Trading Principles

Whenever you look at the quotes on the Forex market, you will see the items listed as pairs, such as USD/EUR. This would indicate the exchange rate for selling US dollars and buying Euros.

So the USD/GBP exchange rate might be 0.6409, meaning that for every US dollar you would get 0.6409 British pounds. The opposite pairing would be 1.5603

The first currency quoted is referred to as the ‘base currency’; the second currency is considered to be the ‘quote currency’. You may also hear this referred to as the ‘foreign’ or ‘counter’ currency.

Pips and Spreads

A pip is the smallest amount by which the price quote can change. If the USD/GPB bid is quoted at 0.6409 and it changes to 0.6411, the price is said to have moved up ‘2 pips’.

Just as with the stock market, there is a spread; the spread is where the brokers make their money. That is why the bid (the price you can buy at) and the ask (the price you can sell at) are never the same.

So, if the USD/GPB price is 0.6409, the bid price might be 0.6411, and the ask price might be 0.6407. The broker would keep the 0.02, whether you buy or sell.

Note that a 2 or 3-pip spread is very common on the major currencies.

Trading Accounts

Just as you need a brokerage account to trade stocks, you will need a brokerage account to trade in currencies. There is no shortage of Forex brokerage houses available.

There are 3 basic types of accounts for those that wish to trade without professional guidance:

  1. Standard Account. This account allows you to trade in full-size lots – 100,000 units. You will typically need $10,000 or more in your account to be able to open this type of account, though it is frequently recommended that the trader have at least $100,000. Standard accounts are only recommended for experienced traders.

  2. Mini Account. The trade sizes are 1/10 of a standard lot or 10,000 units. These are recommended for accounts of $10,000 – $100,000.

  3. Micro Account. Micro accounts are 1/100 of a standard account, or 1,000 units. These are recommended for accounts of $1,000 – $10,000.

The real difference in these accounts is the amount of leverage the trader has. In the standard accounts, the leverage is either 50:1 or 100:1. In the mini/micro accounts, the leverage is frequently 200:1 or even 400:1.

This means that to purchase 1 lot with USD as the base currency (100,000 units) in a standard account would be $2,000. With a micro account, it could be $500.

While leverage is great, it can also destroy your account quickly. The margin calls come much more quickly at higher leverage, since your account loses money much more quickly. While the profits are much greater, the risk is much greater as well.

Practice Accounts

Many brokerages provide practice accounts that allow you to make trades without actually risking any money or making any. It’s a great way to learn Forex trading, but does have one potential downfall.

When you’re trading with a practice account, it’s easy to develop a tendency to take a lot more risk than you would if you were using real money. This can be especially bad if you do extremely well with your practice account, as you might then be too bold when you move on to a real account.

Emotion also comes into play much less with practice accounts; after all, you’re not really risking anything.

Even so, it’s still wise to use a practice account for a while until you understand the basics well enough before risking any real money. It will do you the most good if you take the account seriously – as if it is real money – and use it to work on real-life strategies as you learn the ins and outs of Forex trading.

Forex trading offers a lot of opportunities, even to those with relatively small amounts of money. Real success comes from discipline and understanding the factors that can make currency values rise and fall.

Now that you have a basic understanding of how Forex trading works, you can develop your skills in this area by researching currency behavior and utilizing a practice account.

 It will take some time and effort to become comfortable in your skills, but once you learn some profitable techniques, the world of currency exchange can be your playground.

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