What Is Forex ?
"Forex " stands for Foreign Exchange; it's also known as FX. In a Forex trade, you buy one currency while simultaneously selling another.
Currencies trade in pairs, like the Euro-US Dollar (EUR/USD) or US Dollar / Japanese Yen (USD/JPY).
Forex trading is used to speculate on the relative strength of one currency against another. The foreign exchange market is an over-the-counter market, which means that it is a decentralized market with no central exchange.
Who trades currencies, and why?
Daily turnover in the world's currencies comes from two sources:
Foreign trade (5%). Companies buy and sell products in foreign countries, plus convert profits from foreign sales into domestic currency.
Speculation for profit (95%).
Most traders focus on the biggest, most liquid currency pairs, known as "The Majors". These include US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar. In fact, more than 85% of daily Forex trading happens in the major currency pairs.
The world's most traded market, open 24 hours a day
With average daily turnover of US$3.2 trillion, Forex is the most traded market in the world.
To put it very simply, currency trading is a way to profit from the rise and fall in the values of the different currencies of the world. One currency is constantly changing in value in comparison to another. So you can make money by exchanging a falling currency for a rising one.
In practice, you will work with a pair of currencies, which might be the US dollar and the euro, known as the EUR/USD pair. You will watch how the price of this pair changes according to which of the two currencies is perceived to be strengthening and which one is weakening. Then you buy or sell the pair to profit from the change.
Anybody can get into foreign exchange trading these days. Once, it was true, that it was almost exclusively the province of the international banks and financial institutions, and Forex traders worked out of Wall Street and the other major financial centres of the world.
This has all changed now with the rise of the internet. Almost all trading is done online, so it can be done from anywhere. You don't have to be on a trading floor in a major city. Traders can work from their offices or from home. Individuals can set up as traders too, controlling their own account through their broker's software platform via the internet.
High Liquidity
One definition of the liquidity of a commodity is that it is a measure of how easily it can be converted to cash without affecting the value. Currencies are already cash so currency is more liquid than any other commodity.
Currency pairs
There are around 150 currencies in the world. Most countries, however small, have their own currency, although many European countries use the euro and some countries use the US dollar. However, some of the minor currencies are pegged against the dollar, so that cuts down the number that you could trade.
Most traders would not get involved in 90% of the world currencies which are considered to be minor currencies not stable or liquid enough for serious trading. Certainly in the beginning it is wise for a new trader to stick to the major currencies.
Opinion on what constitutes a major currency may vary a little bit but generally there are 7 currencies considered major. These are the US dollar (USD), euro (EUR), Japanese yen (JPY), British pound (GBP), Swiss franc (CHF), Canadian dollar (CAD) and Australian dollar (AUD). These in combination give 6 major FX pairs involving the US dollar:
EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, AUD/USD.
Of course it is possible also to trade cross pairs, that is pairs of the major currencies that do not involve the US dollar. However, the 6 major pairs account for 90% of the funds traded on the Forex markets. The most traded pair is EUR/USD.
EUR/USD is probably the best pair for Forex trading, especially for a beginner. Why? There are three main reasons.
First, there is very high liquidity in this market. This means that you will not have trouble getting matched and stops are likely to kick in at the right level which makes it more forgiving of errors.
Second, the popularity of the pair means that the spread (your cost) is smaller than for many other pairs.
Third, there is plenty of information about these currencies so you are likely to be able to keep on top of significant financial reports and events easily.
When you are starting out it is best to stick with one pair. Although it may seem that you will have more trading opportunities if you try to apply your system to several different pairs, in fact this quickly becomes confusing and stressful, and that is when mistakes are made. So unless you are using a robot which may be set up for another currency pair, most sources recommend taking EUR/USD and avoid trading any other FX pairs for the first few months at least.
Huge Leverage
Leverage is the ability to control a large amount of something with a much smaller amount. In trading, this refers to trading on margin, where you invest a small amount of money in your broker account and use it to control much larger sums. In effect, your broker loans you the larger amount, although they may or may not actually put the money into the market depending on their business model.
In Forex trading you can commonly command 100 times leverage and sometimes 200 times your investment. This is much more than you would be offered with stock trading and reflects the liquidity of the market and the brokers' ability to apply stops. This is what gives Forex trading its unmatched ability to make big profits from small investment funds.
Contract Size
Understanding contract sizes (lots) is a necessary precursor to understanding the need for high leverage in the Forex market. Each standard lot traded in the Forex market is a $100,000 contract. In other words, when trading one lot in a standard account, a trader is essentially placing a $100,000 trade in the market. Without leverage, most investors would not be able to afford such a transaction. Leverage of (100-1) would allow a trader to place the same one lot ($100,000) trade with the post of $1,000 in margin. $100,000 divided by 100 equals $1,000, thus (100-1) leverage means that $1,000 of margin is able to control a $100,000 position.
Many retail Forex traders today begin their trading in a Mini account. Because standard contracts in the Forex market are rather large, even with (100-1) leverage, $1,000 of margin per contract traded is still a bit expensive for some investors. For this reason most retail brokers offer the option of a mini account. Lot size 0,5 or 0,2 etc.