Forex

Beginners guide to forex or currency trading

If you’ve ever had to change your money to travel abroad, you’ll understand the basics of currency trading. The amount that you receive in exchange for your pound will depend on when you exchange it because the value of the pound changes over time. However, making money by trading currencies is very different to just exchanging your money for a holiday.

What is currency trading?

Forex or foreign exchange trading involves changing money from one currency into another. It can be used as a form or investment rather than just for tourism or commerce between countries. Changing the currency of your money can affect it’s value. Forex trading takes advantage of this in order to try to make a profit.

Forex trading has become the largest financial market in the world, with trillions of dollars being traded every day. The huge number of transactions means that trading costs can be kept low and many brokerage firms don’t charge commissions on these trades. Forex trades can also be made at any time as there is no central marketplace so there is no set end to the trading day.

How forex trading works

You will need to open an account with a Forex broker in order to trade in currencies. The broker will make the trades on your behalf. Some brokers can also manage your money for you, but usually they will only make trades when instructed by you. You will need to pay a transaction fee for every trade that you make through the broker.

In order to make a trade, you will need to choose a currency pair that you are interested in exchanging, such as GBP/USD. You can then get a Forex quote for this pair. The quote will show you the current bid price and ask price from your broker.

You will need to decide how you think the exchange rate between the two currencies is likely to change. If you think that the US dollar is going to get stronger relative to the pound, you will want to exchange your pounds for dollars.

You will then need to wait to see what happens. If you were right and the dollar does increase in value, the exchange rate will change. Your dollars will now be worth more in pounds than you used to buy them in your initial trade. By changing the dollars back into pounds, you can make a profit.

However, you could also change your dollars into another currency, such as euros. Any currency can be traded for any other currency.

The broker may also enable you to choose when you want your trade to be made:

• Market order: the trade is made immediately at the current market rate.
• Limit order: the trade is made when the price to buy or sell reaches a specific value.
• Stop order: when you choose to buy for more than the current market price or sell for less than the current market price in order to get a quick trade and minimise your losses.

Differences between forex and stock trading

The procedure for forex trading is very similar to buying and selling stocks, but there are some key differences. One obvious difference is that there are far fewer currencies than there are stocks you can trade in. While this might seem to make investing in forex simpler as there will be fewer choices to compare, predicting the changes in currency values is extremely difficult. Many more factors affect the value of a country’s economy than are influencing a company’s share prices.

Another important difference is that forex trading involves currency pairs. You are always exchanging money from one currency to another rather than buying a share. For example, if you are buying the currency pair USD/EUR you are selling USD while buying EUR at the same time. Your US dollars are being exchanged for euros. If the value of the currency pair is 0.8, you will get 0.8 euros for every dollar. When you are ready, you will usually exchange the money into your home currency and transfer it out of the trading account.

The price for the currency pair reflects their relative values rather than the price for buying or selling a share. If the USD/EUR falls, it means that you will get fewer euros for each US dollar that you exchange. The dollar is getting weaker and the euro is getting stronger, relative to one another. This could be due to economic trouble in the USA bringing down the dollar or an economic boost in the EU raising the value of its currency. If the USD/EUR rises then the opposite is true.

Terms you need to know

• Currency pair: any two currencies that you are interested in trading between.
• Base currency: the currency you want to sell or change from, named first in the currency pair.
• Quote currency: the currency that you want to buy or change your money into, named second in the currency pair.
• Exchange rate: how much you have to pay in your base currency to receive a certain amount of the quote currency.
• Pips: the units used to measure the change in value between two currencies. One pip is the smallest possible price change for the currency pair, which is usually 0.0001. Multiplying the change in pips for the currency you’ve bought by the exchange rate reveals the change in value.
• Bid price: the amount for which you can sell the currency to the broker.
• Ask price: the amount for which you can buy the currency from the broker.
• Spread: the difference between the bid price and ask price.
• Long position: when you want to buy the base currency and sell the quote currency.
• Short position: when you want to buy the quote currency and sell the base currency.

What factors affect currency movements?

The goal of forex trading is usually to convert money into a currency that is expected to become stronger. It can then be used to buy back more of the original currency. Although this sounds simple, it can be very difficult to predict how the values of currencies will change. Various approaches are used to try to do this. Many investors focus on the basic economic figures for each country, such as the GDP. Some traders perform detailed technical analyses, looking at historical changes in currency values and related numbers. Others have a more subjective approach, trying to grasp the general mood of the market.

However you choose to make your trading decisions, it is clear that the values of currencies can change quickly and that they are affected by a wide range of different factors, including:

• Economic growth: a country with a growing economy will have a stronger currency than one with a weak economy. Other economic factors such as employment and inflation will also have an influence.
• Trade: if a country is exporting a lot of goods, it’s currency will tend to be worth more. A country that has to import a lot will usually have a weaker currency.
• Politics: elections, changes in regulations, economic interventions, monetary policy, trade agreements and other political actions can influence currency values. If the changes are likely to boost trade or the economy, it could raise the value of the currency.
• War, natural disasters and instability: Anything that disrupts trade, the economy, or the stability of the government is likely to reduce the value of a currency.
• Forex trading: traders can influence the relative values of currencies. If many traders are trying to buy a particular currency, its value will go up. If many are trying to sell, the value will go down.

Trading Strategies

Forex trading can be very fast paced as many investors choose to take advantage of the rapid fluctuations in currency values. Trading is also possible over 24 hours as currencies are always being exchanged across different time zones. However, there are several different strategies you can use to trade in forex.

• Speculation: investors buy and sell currencies rapidly as their values tend to change quickly. Traders hope that the currency they buy will grow stronger or that the one they sell will grow weaker.
• Assets: investors hold a currency for longer in order to gain from the difference in the interest rates for the two currencies or from slower changes in the exchange rate.
• Futures or forward markets: allow currencies to be traded at a specific rate on a set date in the future. Businesses sometimes use this form of forex trading to protect themselves against currency fluctuations when buying or selling abroad.
• Leverage: when a broker allows you to invest more than the amount you have put into your trading account. It can allow you to make bigger trades with higher potential returns, but there is a risk you could end up owing your broker money. Both gains and losses will be magnified.
• Diversification: investors may use forex to spread or hedge the risk while also putting money in stocks, bonds or other investments. For example, if your stocks are based in the UK and you’re worried that they could be affected by a weakening pound, you could short sell the pound against another currency to offset this.