What is Forex Trading? The Fundamentals
Forex trading can sound intimidating if it is the first time you are looking at a currency exchange chart. There is a lot of jargon involved that you need to understand before placing a trade. Nevertheless, the truth is that anybody can have access to trade currencies and make a profit.
So, what is forex trading? It’s the discipline of exchanging international currencies, which are traded against one another in pairs. Transactions take place in the forex (also known as foreign exchange or FX) market.
When you travel abroad and swap currency for local use, you’re already participating in the global forex market. But did you know that the foreign currency market trades a daily volume of more than $5.1 trillion? Maybe you are wondering what concepts you need to learn to trade FX like a pro. We’ve got your back! By the end of this guide, you will have a better understanding of the forex basics and the ability to read forex charts.
Last Updated October 2020
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Forex trading basics
Let’s begin the introduction to forex by decoding the basics.
What is a forex pair?
In forex trading, prices are presented in currency pairs. One example is EUR/USD. The left currency (EUR or Euro) is known as the base currency, and the right currency (USD or US Dollars), the quoted currency. For example, a value of 1.0800 means that 1 Euro can be exchanged for 1.08 US Dollars.
There are different categories of forex pairs:
Major currency pairs
Majors are pairs that contain the USD on one side. They are the most liquid and frequently traded in the marketplace. These pairs include:
- EUR/USD: Euro vs. US Dollar
- USD/JPY: US Dollar vs. Japanese Yen
- GBP/USD: British Pound vs. US Dollar
- AUD/USD: Australian Dollar vs. US Dollar
- USD/CHF: US Dollar vs. Swiss Franc
- USD/CAD: US Dollar vs. Canadian Dollar
Crosses, or minors, are pairs that do not contain USD. The most active crosses known in the market involve the three different major currencies: EUR, JPY, and GBP.
Exotic currency pairs
Exotics are pairs made up of one major currency with another from an emerging market. Examples of emerging currencies include Brazil (BRL), Hong Kong (HKD), Singapore (SGD), and Mexico (MXN).
To keep things simple while getting started in forex, we suggest focusing your efforts on the majors and a couple of cross-currency pairs.
How to read forex charts
Now, let’s move on to deciphering graphic information. In trading, the market is represented visually through charts. A forex chart is simply one that depicts the exchange rate between two currencies over time.
There are three main types of charts:
- Bar chart
- Candle or Candlestick chart
- Line chart
The Bar Chart
Shows: Highs, lows, opening, closing prices
How to read: A vertical line presents the high and low prices over the time period. A small horizontal dash on the left of the vertical line shows the opening price, while one on the right represents the closing price.
This chart is also known as OHLC, which refers to the four major price points in a time period — the example below shows one day in the example below. These levels are:
- O – Open price
- H – High price
- L – Low price
- C – Close price
The Candle or Candlestick chart
This is the most commonly used chart type amongst all traders.
Shows: Highs, lows, opening, closing prices
How to read: A vertical body (candle) denotes the open and closing prices. It is pierced through with a vertical line (shadows) that indicates the highs and lows in the period.
Colors are very important here: A red or colored bar tells that a currency pair closed lower than the opening price. A green or transparent bar represents the opposite.
The Line Chart
Shows: Closing prices
How to read: A line connects a series of data points on the chart, all of which represent only the closing prices. This chart is mainly used to analyze day-to-day price changes.
It is important to clarify that you can select and analyze different timeframes in a chart. Each bar, candle, or point in a line chart can represent different time units:
|Minutes||1 Minute Chart (M1), 5 Minutes Chart (M5), 15 Minutes Chart (M15), and 30 Minutes Chart (30M).|
|Hours||1-hour chart (1H) or 4-hour chart (4H)|
|Daily||Daily chart or 1D|
|Weekly||Weekly Chart or W1|
|Monthly||Monthly Chart or Mn|
When is the forex market open?
Financial centers are comprised of banks, investment management firms, forex brokers, hedge funds, and investors. Therefore, forex pairs are traded 24 hours from Sunday 10:00 PM GMT to Friday at 10:00 PM GMT. The New York market starts trading right as the Australia market closes.
The 4 major sessions open in the below sequence:
- Australia (Australia and New Zealand): from 10:00 PM GMT to 7:00 AM GMT
- Tokyo (Asian markets): from 12:00 AM GMT to 9:00 AM GMT
- London (European markets): from 8:00 AM GMT to 5:00 PM GMT
- New York (Canada & USA): from 1:00 PM GMT to 10:00 PM GMT
This helps you get an idea of what type of schedule you can have when approaching a determined currency pair in the market. Most of the daily trading activity takes place between 1:00 PM and 5:00 PM when the London and New York sessions overlap.
What does a forex broker do?
Brokers are the “middle-men” between the individual traders and the actual FX market.
Brokers play the following functions.
- They provide traders with access to trading platforms.
- They offer leverage and settlement as trades are conducted.
- They keep the traders’ funds safe when there aren’t any active trades.
It is important to mention that brokers are governed by official entities so that traders work in regulated environments. You may have heard of the following regulators:
- Australia – Australian Securities and Investments Commission (ASIC)
- United States of America – Commodity and Futures Trading Commission (CFTC)
- United Kingdom – Financial Conduct Authority (FCA)
- New Zealand – Financial Service Provider (FCP)
Forex trading orders explained
Now that you’ve reviewed the essentials of forex trading, here are some things you need to know about before you place your first order.
When to place a Buy order:
You are expecting that the currency pair price will increase, so you place a buy order to obtain a profit from buying at a cheaper price and selling (or closing the order) at a higher price.
When to place a Sell order:
You are expecting that the currency pair price will decrease. Since it is a bit tricky to sell something that you don’t own, it is necessary to introduce the concept of short selling.
In short selling, a trader can sell the currency pair at a high price, then, if the price drops, they can buy or close the trade at a lower price. Basically you, as a trader, approach a broker who will borrow the base currency for you, which you can exchange at the ask price (more on this below) for a determined amount of the quoted currency. Then, if the price drops, you can exchange back, return what you borrowed from your broker and gain a profit.
Ask & Bid Prices
In forex trading, when getting quoted in a transaction, there are two prices you can get depending if you want to perform a buy trade or a sell trade, these are the ask price and the bid price.
- The bid price is how much a trader can sell a currency pair for
- The ask price is how much a dealer can buy the currency for
In other words, if you’re buying, you will be using the bid price. But if you wish to sell a currency, you will be using the ask price. Bear in mind that the ask price will always be higher than the bid price.
What is “the spread”?
Let’s talk about the term “the spread” in forex trading. The spread is the cost of participation in the market. It’s the difference between the ask price and the bid price. It is the amount that a trader will have to pay, and the amount the broker — the company that provides you access to the FX market — earns.
Pips, pipettes, and points
Price quotes are usually presented in a 4-digit system. Meaning, there are four digits after the decimal point. Although so, sometimes, a 5-digit system is used for precision. Pips and pipettes express the change in value between two currencies. A pip equals 10 pipettes. Let’s look at some examples below:
4-Digit System Example: 1.8766
The minimum change in the 4-digit system = 0.0001
0.0001 = 1 point / 1 pip
In the case of 1.8766, there are 6 pips.
5-digit System Example: 1.87658
Minimum Change 5-digit system = 0.00001
0.00001 = 1 point / 1 pipette
In the case of 1.87658, there are 58 pipettes.
Additional types of forex orders
Besides buying and selling, there are other types of orders you should consider when entering the market:
Take profit order
A take profit order occurs when a position closes once it hits a specific level of profit. Once the embedded condition is reached, the trade is closed at the current market value. Such orders are great as they can help the trader execute a transaction without having to keep a close watchful eye on the market.
These orders are more beneficial for short term traders and quick profits. It is, however, important to note that the take profit condition does not consider any losses. As a safety measure, stop losses should thus be set as well.
A stop-loss order is the other side of a take profit order. It’s a trade function offered by brokers to limit trade losses. A stop-loss level is usually set some pips away from the entry price. Just like the take profit order, the trader does not have to manually execute the transaction once the limit is reached. It helps traders to mitigate risks, allows fewer losses, and is especially useful in volatile markets.
Buy stop & sell stop orders
While the take profit and the stop-loss orders are useful for closing a trade, there are some conditions you can set to open the trade as well. Buy stops and sell stops are considered pending orders. They help the trader enter a market automatically only when the price reaches the set level. As the term suggests, a buy stop executes a non-manual buy while a sell stop creates a sell transaction. Both orders are executed at the next available market price after the set parameter.
Buy limit & sell limit orders
Buy limits and sell limits are considered pending orders too. They are usually beneficial when the trader anticipates an upward or downward movement trend despite recoils. Both of them allow the trader to specify the price in which he buys or sells rather than accepting the current market price. A buy limit will execute at the limit price or lower whereas a sell limit will execute the limit price or higher.
What are lot measurements?
Lots are a unit measurement of the trade volume you are buying or selling. Here’s what they represent:
- 1 lot = 100,000 units of the base currency
- 1 mini lot = 10,000 units of the base currency
- 1 micro lot = 1,000 units of the base currency
This is important because the more volume you want to trade, the tougher it gets to get that amount available as a trader. For example, let’s say you want to buy EURUSD, 1 lot is equal to 100,000 EUR. Assuming that the Ask is 1.24228. Then, to buy 1 lot you would need $124,288.
This is where the concept of leverage comes in:
Leverage is a financial tool where traders borrow capital from brokers and access the FX market. The broker presents the leverage in a ratio. For example, in 1:100, you are only required to have 1% of the total transaction, while your broker funds the remaining 99%. Leverage tends to have a negative connotation but can be very profitable when applied to the right market situation. It is also what makes forex trading so accessible to people.
What are margins and free margins?
Let’s revisit the example of the 1:100 leverage. The 1% amount put up by the trader is also known as the margin in forex trading. The forex margin can be seen as collateral, or the minimum sum of money you will need to open a new position. The amount is locked up during the duration of your trade. Your broker can also use the margin to cover potential losses depending on how the market goes. The other 99% funded by your broker is also known as the free margin. In other words, it is the amount that is unlocked and available for trading.
What is balance in a forex trade session?
The balance refers to the total amount at the start of a forex trade session. It is not influenced by any active open positions, rather it is the amount in the trader’s account when a trade position is closed.
What is equity in forex trading?
Equity in forex trading is simply the total or absolute value in the trader’s account. It consists of the free margin and the margin. Because the margin is usually locked, a drop in equity also means a drop in the free margin. This helps brokers and traders to identify when to pull out and close a position. A broker usually pulls a stop out when the free margin falls close to the safety net of the margin, so as to prevent a loss.
We’ve covered quite a bit in this introduction to forex trading. Ready to dive deeper into your knowledge of the subject? Check out the forex courses on Udemy.
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