The forex market is the largest and most liquid market, traded worldwide, with trillions of dollars exchanging hands daily. Several pros and cons are associated with trading the forex markets and the market’s liquidity. Transaction costs are generally low, reducing the expenses that need to be incorporated into your trading budget. The forex market also provides leverage, allowing you to increase your returns by enhancing the size of the position you take.
The forex market trades around the clock, 24 hours a day, six days a week. Most forex trading is transacted within the over-the-counter market instead of exchange only open for business during specific hours. The forex markets trade currency pairs, providing traders with many different products to trade. Since the over-the-counter market dominates the forex market, there can be periods when there is a lack of transparency.
Additionally, many factors will influence one currency or another providing a complex exchange rate determination scheme. Also, most of the available forex trading is self-directed. Forex and CFD brokers will offer self-guided teaching processes instead of professional licensed financial advisors such as those available when investors trade stocks.
What is Forex Trading?
Forex trading, or currency trading, is the simultaneous buying of one currency and selling of another. These two currencies make up what is known as a currency pair. Currencies are always traded in pairs; their relative value is the exchange rate.
Currency pairs are described using a six-letter, showing a base and counter currency. For example, EUR/USD is the Euro versus the U.S. dollar. The Euro is the base currency, and the dollar is the counter currency. The exchange rate tells you how much the counter currency is needed to buy one unit of the base currency. For example, if you look at the EUR/USD at 1.10, you will need 1.1 dollars to purchase one Euro. The goal of forex trading is to exchange one currency for another in the expectation that the exchange rate will change so that the currency you bought will increase in value compared to the one you sold.
How Do You Trade the Forex Market?
There are several ways to trade the forex markets. The most widely used is over-the-counter forex trading. Over-the-counter (OTC) trading is a type of securities transaction that occurs directly between two parties without the supervision of an exchange or other intermediary. OTC trading is done through dealer networks in over-the-counter, decentralized markets with no physical location. There are several types of OTC trades. Most require that you exchange one currency for another, where the digital exchange of the currency is recognized in your account. So if you are buying Euros and selling dollars, you need to accept the Euros in a Euro account and send dollars to a counterpart dollar account.
Another popular way to trade the forex market is through contracts for differences (CFDs). CFDs are derivatives that move in tandem with a forex pair and track the movements of hundreds of currency pairs. Instead of having to exchange one currency for another, all you are responsible for is the profit or loss in your account. CFDs are popular because your CFD broker will handle all of the operational aspects of moving currency from one account to another.
The futures market is the third most popular way to trade the forex market. A futures contract is an agreement between two parties to buy or sell an asset at a predetermined future date and price. Futures contracts are standardized contracts that are traded on a futures exchange. As opposed to OTC forex currency pairs, futures are regulated. For example, the Commodity Futures Trading Commission oversees futures trading in the United States.’
What Strategies Are Used to Trade Currencies?
The two most common types of analysis are fundamental analysis and technical analysis. Fundamental analysis is the study of macro events that will influence the direction of a currency pair. For example, the study of interest rates for each currency and trade flows. Technical analysis is the study of past price movements to help you determine the future value of a currency pair. This analysis includes charting, momentum, trend following, and mean-reversing trading strategies.
Pros of Forex Trading
The forex market is one of the most liquid and active markets, with trillions of dollars changing hands daily. The excellent liquidity allows traders can enter and exit positions at any time. You could be stuck waiting for specific hours to exit without this liquidity. While there is no official opening or close, forex trading occurs 24 hours a day in every time zone, starting in Australia and ending during the New York trading period. Excellent liquidity allows large traders to take big positions without worrying about moving the market.
The costs of trading the forex market are also beneficial. Generally, over-the-counter and CFD trading does not require a commission. Market makers offer a bid-offer spread, which lets you know where they are willing to purchase a currency pair (the bid) and where they are eager to sell a currency pair (the offer). Market makers make money by buying on the bid, selling on the offer, and capturing the spread between the two.
Forex trading offers high leverage levels, allowing traders to control significant positions with relatively little capital. Leverage exists in the OTC market, CFDs, and futures contracts. If you use leverage, you will need to open a margin account. A margin account is a brokerage account that allows an investor to increase the size of the assets using the securities they own for collateral. The investor must put up collateral to use the margin account, which creates leverage. Margin accounts are typically used to increase buying power. For example, if your broker tells you you have a margin of 20 to one, you can post $1 and control $20. Your broker is mainly concerned about having enough equity in your account to cover losses. Your broker will issue a margin call if your equity falls below a specific level. If you cannot add more capital and do not sell off your position or other positions, your broker will have the right to liquidate your position to cover your losses. Your broker will not take losses for you.
Since you will only require a small amount of capital to start forex trading, the barriers to entry are not elevated. Some brokers will let you open an account with minimal money.
The Cons of Trading Forex
Trading means that you are willing to take risks. If you plan to use leverage, then trading the forex markets can be a high-risk prospect. You can generate robust gains and also experience significant losses. You need to have a risk management process and stick with it.
The forex markets can also be very volatile. Several factors influence a currency. Changes to interest rates, political unrest, high inflation, and low growth can alter the trajectory of a currency pair. The exchange rate can be unpredictable and move quickly.
The forex market is largely unregulated. While futures contracts are regulated instruments, usually, OTC products are not. Therefore you have to go on the premise of buyer beware. It would help if you were on the lookout for fraudsters.
The currency markets are also more complex than other capital markets. You need to know which way you want to place a bet, which currency you are buying, and which you are selling. You also need to understand the exchange rate and what dynamics will influence each leg in a currency pair.
For example, the EUR/USD benefits the dollar as the currency pair declines when you are trading the USD/JPY, the dollar benefits as the currency pair rises. Some currencies are more liquid than others. The major currency pairs, which include the Euro, the Japanese Yen, the Swiss Franc, the Australian Dollar, the Canadian Dollar, and the British pound, are the most liquid.
The Bottom Line
The upshot is that trading the forex markets has several pros and cons. While the barriers to entry are low, and the amount of capital you need is also tiny, the risks of trading the forex markets are high. When you try to learn how to trade forex, few financial advisors are licensed that will provide you with expertise on making money over time. Most of the learning will come from a broker’s educational portal or your online trading. One of the pros of forex trading is that many brokers offer a demonstration account. This type of account allows you to practice trading without risking your capital. You can then go through the self-learning process using an account that will not show gains or losses that hit your bottom line. You also want to ensure that while studying how to trade forex, you learn the basics of risk management and incorporate these elements into your trading strategy.
