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What Is Forex Trading? A Beginner’s Guide

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Table of Contents

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Table of Contents

How It Works

What Is Forex Trading?

How to Start Trading Forex

Types of Markets

Using the Forex Markets

Basic Forex Trading Strategies

Forex Terminology

Charts Used in Forex Trading

Pros and Cons of Trading Forex

FAQs

The Bottom Line

Guide to Forex Trading

Strategy & Education

What Is Forex Trading? A Beginner’s Guide

James Chen

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James Chen, CMT is an expert trader, investment adviser, and global market strategist.

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Updated January 19, 2024

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Gordon Scott

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Gordon Scott

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Gordon Scott has been an active investor and technical analyst or 20+ years. He is a Chartered Market Technician (CMT).

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Foreign exchange (Forex) trading is the process of buying one currency and selling another with the goal of making a profit from the trade. Forex (FX) is a portmanteau of the words foreign and exchange. According to a 2022 triennial report from the Bank for International Settlements (a global bank for national central banks), the daily global volume for forex trading reached $7.5 trillion in 2022.

Read on to learn about the forex markets, how they work, and how to start trading.

Key Takeaways

The foreign exchange (forex or FX) market is a global marketplace for exchanging national currencies.Because of the worldwide reach of trade, commerce, and finance, forex markets tend to be the world's largest and most liquid asset markets.Currencies trade against each other as exchange rate pairs. For example, EUR/USD is a currency pair for trading the euro against the U.S. dollar.Forex markets exist as spot (cash) and derivatives markets, offering forwards, futures, options, and currency swaps.Some market participants use forex to hedge against international currency and interest rate risk, speculate on geopolitical events, and diversify portfolios, among other reasons.

What Is the Forex Market?

The foreign exchange market is where currencies are traded. This international market's most unique aspect is that it lacks a central marketplace. Instead, currency trading is conducted electronically over the counter (OTC). This means that all transactions occur via computer networks among traders worldwide rather than on one centralized exchange.

The market is open 24 hours a day, five and a half days a week. Currencies are traded worldwide in the major financial centers of Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich—across almost every time zone. This means the forex market begins in Tokyo and Hong Kong when the U.S. trading day ends. The forex market can be highly active at any time, with price quotes changing constantly.

You’ll often see the terms FX, forex, foreign exchange market, and currency market. These terms are synonymous, and all refer to the forex market.

How Does the Forex Market Work?

The FX market is the only truly continuous and nonstop trading market in the world. In the past, the forex market was dominated by institutional firms and large banks, which acted on behalf of clients. But it has become more retail-oriented in recent years—traders and investors of all sizes participate in it.

Where Is It?

An interesting aspect of world forex markets is that no physical buildings function as trading venues. Instead, it is a series of connected trading terminals and computer networks. Market participants are institutions, investment banks, commercial banks, and retail investors from around the world.

Who Trades on It?

Currency trading was very difficult for individual investors until it made its way onto the internet. Most currency traders were large multinational corporations, hedge funds, or high-net-worth individuals (HNWIs) because forex trading required a lot of capital.

Commercial and investment banks still conduct most of the trading in forex markets on behalf of their clients. But there are also opportunities for professional and individual investors to trade one currency against another.

What Is Forex Trading?

Forex trading, or FX trading, involves buying and selling different currencies with the aim of making a profit. At its core, forex trading is about capturing the changing values of pairs of currencies. For example, if you think the Euro will increase in value against the U.S. Dollar, a speculator might buy Euros with Dollars. If the Euro's value rises on a relative basis (the EUR/USD rate), you can sell your Euros back for more Dollars than you initially spent, thus making a profit.

In addition to speculative trading, forex trading is also used for hedging purposes. Hedging in forex is used by individuals and businesses to protect themselves from adverse currency movements, known as currency risk. For example, a company doing business in another country might use forex trading to hedge against potential losses caused by fluctuations in the exchange rate abroad. By securing a favorable rate in advance through a forex transaction, they can reduce the risk of financial uncertainty and ensure more stable profits or costs in their domestic currency. This aspect of forex trading is crucial for international businesses seeking stability in their financial planning.

Forex trading features favorable aspects like high liquidity, meaning it's easy to buy and sell many currencies without a significant change in their value. Additionally, traders can use leverage, which allows them to control a large position with a relatively small amount of money. However, leverage can also amplify losses, making forex trading a field that requires knowledge, strategy, and an awareness of the risks involved.

Forex trading is also distinctly global, encompassing financial centers worldwide, which means that currency values are influenced by a variety of global events. Economic indicators such as interest rates, inflation, geopolitical stability, and economic growth can significantly impact currency prices. For instance, if a country's central bank raises its interest rates, its currency might strengthen due to the higher returns on investments denominated in that currency. Similarly, political uncertainty or a poor economic growth outlook can lead to a currency's depreciation. This global interconnectivity makes forex trading not just a financial activity but also a reflection of worldwide economic and political dynamics.

How to Start Trading Forex

Trading forex is similar to equity trading. Here are some steps to get yourself started on the forex trading journey.

Learn about forex: While it is not complicated, forex trading is an undertaking that requires specialized knowledge and a commitment to learning.

Set up a brokerage account: You will need a forex trading account at a brokerage to get started with forex trading.

Develop a trading strategy: While it is not always possible to predict and time market movement, having a trading strategy will help you set broad guidelines and a road map for trading.

Always be on top of your numbers: Once you begin trading, check your positions at the end of the day. Most trading software already provides a daily accounting of trades. Make sure that you do not have any pending positions to be filled and that you have sufficient cash in your account to make future trades.

Cultivate emotional equilibrium: Beginner forex trading is fraught with emotional roller coasters and unanswered questions. Discipline yourself to close out your positions when necessary.

Types of Markets

Forex is traded primarily via spot, forwards, and futures markets. The spot market is the largest of all three markets because it is the “underlying” asset on which forwards and futures markets are based. When people talk about the forex market, they are usually referring to the spot market.

The forwards and futures markets tend to be more popular with companies or financial firms that need to hedge their foreign exchange risks out to a specific future date.

Spot Market

The spot market is where currencies are bought and sold based on their trading price. That price is determined by supply and demand and is calculated based on several factors, such as:

Current interest ratesEconomic performanceGeopolitical sentimentPrice speculation

A finalized deal on the spot market is known as a spot deal. It is a bilateral transaction in which one party delivers an agreed-upon currency amount to the counterparty and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, it is settled in cash.

Although the spot market is commonly known as one that deals with transactions in the present (rather than in the future), these trades take two days to settle.

Forwards and Futures Markets

A forward contract is a private agreement between two parties to buy a currency at a future date and a predetermined price in the OTC markets. In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves.

A futures contract is a standardized agreement between two parties to take delivery of a currency at a future date and a predetermined price. Futures trade on exchanges and not OTC. In the futures market, futures contracts are bought and sold based on a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange (CME).

Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments that cannot be customized. The exchange acts as a counterparty to the trader, providing clearance and settlement services.

Unlike the spot, forwards, and futures markets, the options market does not trade actual currencies. Instead, it deals in contracts that represent claims to a certain currency type, a specific price per unit, and a future date for settlement.

Both types of contracts are binding and are typically settled for cash at the exchange in question upon expiry, although contracts can also be bought and sold before they expire. These markets can offer protection against risk when trading currencies.

In addition to forwards and futures, options contracts are traded on specific currency pairs. Forex options give holders the right, but not the obligation, to enter into a forex trade at a future date.

Using the Forex Markets

There are two distinct features of currencies as an asset class:

You can earn the interest rate differential between two currencies.

You can profit from changes in the exchange rate.

So, you can profit from the difference between two interest rates in two different economies by buying the currency with the higher interest rate and shorting the currency with the lower interest rate. For instance, before the 2008 financial crisis, shorting the Japanese yen (JPY) and buying British pounds (GBP) was common because the interest rate differential was substantial. This strategy is sometimes referred to as a carry trade.

Forex for Hedging

Companies doing business in foreign countries are at risk due to fluctuations in currency values when they buy or sell goods and services outside of their domestic market. Foreign exchange markets provide a way to hedge currency risk by fixing a rate at which the transaction will be completed. A trader can buy or sell currencies in the forward or swap markets in advance, which locks in an exchange rate.

Locking in the exchange rate helps them reduce losses or increase gains, depending on which currency in a pair is strengthened or weakened.

Forex for Speculation

Factors like interest rates, trade flows, tourism, economic strength, and geopolitical risk affect the supply and demand for currencies, creating daily volatility in the forex markets. This creates opportunities to profit from changes that may increase or reduce one currency’s value compared to another. A forecast that one currency will weaken is essentially the same as assuming that the other currency in the pair will strengthen.

So, a trader anticipating price movement could short or long one of the currencies in a pair and take advantage of the movement.

Basic Forex Trading Strategies

The most basic forms of forex trades are long and short trades, with the price changes reported as pips, points, and ticks. In a long trade, the trader is betting that the currency price will increase and that they can profit from it. A short trade consists of a bet that the currency pair’s price will decrease. Traders can also use trading strategies based on technical analysis, such as breakout and moving averages, to fine-tune their approach to trading.

Depending on the duration and numbers for trading, trading strategies can be categorized into four further types:

A scalp trade consists of cumulative positions held for seconds or minutes at most, and the profit amounts are restricted in terms of the number of pips.

Day trades are short-term trades in which positions are held and liquidated on the same day. The duration of a day trade can be hours or minutes.

In a swing trade, the trader holds the position for a period longer than a day, like days or weeks.

In a position trade, the trader holds the currency for a long period, lasting as long as months or even years.

Forex Terminology

The best way to get started on the forex journey is to learn its language. Here are a few terms to get you started:

Forex account: A forex account is used to make currency trades. Depending on the lot size, there can be three types of forex accounts:

Micro forex accounts: Accounts that allow you to trade up to $1,000 worth of currencies in one lot.

Mini forex accounts: Accounts that allow you to trade up to $10,000 worth of currencies in one lot.

Standard forex accounts: Accounts that allow you to trade up to $100,000 worth of currencies in one lot.

Ask: An ask (or offer) is the lowest price at which you are willing to buy a currency.

Bid: A bid is the price at which you are willing to sell a currency.

Contract for difference: A contract for difference (CFD) is a derivative that lets traders speculate on price movements for currencies without owning the underlying asset.

Leverage: Leverage is using borrowed capital to multiply returns. The forex market is characterized by high leverages, and traders often use it to boost their positions.

Remember that the trading limit for each lot includes margin money used for leverage. This means the broker can provide you with capital at a predetermined ratio. For example, they may put up $50 for every $1 you put up for trading, meaning you will only need to use $10 from your funds to trade $500 in currency.

Charts Used in Forex Trading

Three types of charts are used in forex trading. They are:

Line Charts

Line charts are used to identify big-picture trends for a currency. They are the most basic and common type of chart used by forex traders. They display the closing trading price for a currency for the periods specified by the user. The trend lines identified in a line chart can be used to devise trading strategies. For example, you can use the information in a trend line to identify breakouts or a change in trend for rising or declining prices.

While useful, a line chart is generally used as a starting point for further trading analysis.

Bar Charts

Like other instances in which they are used, bar charts provide more price information than line charts. Each bar chart represents one day of trading and contains the opening price, highest price, lowest price, and closing price (OHLC) for a trade. A dash on the left represents the day’s opening price, and a similar one on the right represents the closing price. Colors are sometimes used to indicate price movement, with green or white used for periods of rising prices and red or black for a period during which prices declined.

Bar charts for currency trading help traders identify whether it is a buyer’s or seller’s market.

Candlestick Charts

Japanese rice traders first used candlestick charts in the 18th century. They are visually more appealing and easier to read than the chart types described above. The upper portion of a candle is used for the opening price and highest price point of a currency, while the lower portion indicates the closing price and lowest price point. A down candle represents a period of declining prices and is shaded red or black, while an up candle is a period of increasing prices and is shaded green or white.

The formations and shapes in candlestick charts are used to identify market direction and movement. Some of the more common formations for candlestick charts are hanging man and shooting star.

Pros and Cons of Trading Forex

Pros

Largest in terms of daily trading volume in the world

Traded 24 hours a day, five and a half days a week

Starting capital can rapidly multiply

Generally follows the same rules as regular trading

More decentralized than traditional stock or bond markets

Cons

Leverage can make forex trades very volatile

Leverage in the range of 50:1 is common

Requires an understanding of economic fundamentals and indicators

Less regulation than other markets

No income generating instruments

Pros Explained

Forex markets are the largest in terms of daily trading volume globally and therefore offer the most liquidity. This makes it easy to enter and exit a position in any major currency within a fraction of a second for a small spread in most market conditions.

The forex market is traded 24 hours a day, five and a half days a week—starting each day in Australia and ending in New York. The broad time horizon and coverage offer traders opportunities to make profits or cover losses. The major forex market centers are Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich.

The available leverage in forex trading means that a trader's starting capital can rapidly multiply.

Forex trading generally follows the same rules as regular trading and requires much less initial capital; therefore, it is easier to start trading forex than stocks.

The forex market is more decentralized than traditional stock or bond markets. There is no centralized exchange that dominates currency trade operations, and the potential for manipulation—through insider information about a company or stock—is lower.

Cons Explained

Leveraged trading can make forex trades much more volatile than trading without leverage.

Banks, brokers, and dealers in the forex markets allow a high amount of leverage, meaning traders can control large positions with relatively little money.

Leverage in the range of 50:1 is common in forex, though even greater amounts of leverage are available from certain brokers. Nevertheless, leverage must be used cautiously because many inexperienced traders have suffered significant losses using more leverage than was necessary or prudent.

Trading currencies productively requires an understanding of economic fundamentals and indicators. A currency trader needs to have a big-picture understanding of the economies of the various countries and their interconnectedness to grasp the fundamentals that drive currency values.

The decentralized nature of forex markets means it is less regulated than other financial markets. The extent and nature of regulation in forex markets depend on the trading jurisdiction.

Forex markets lack instruments that provide regular income, such as regular dividend payments, which might make them attractive to investors not interested in exponential returns.

Are Forex Markets Volatile?

Forex markets are among the most liquid markets in the world. So, they can be less volatile than other markets, such as real estate. The volatility of a particular currency is a function of multiple factors, such as the politics and economics of its country. Therefore, events like economic instability in the form of a payment default or imbalance in trading relationships with another currency can result in significant volatility.

Are Forex Markets Regulated?

Forex trade regulation depends on the jurisdiction. Countries like the United States have sophisticated infrastructure and markets for forex trades. Forex trades are tightly regulated in the U.S. by the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC). However, due to the heavy use of leverage in forex trades, developing countries like India and China have restrictions on the firms and capital to be used in forex trading. Europe is the largest market for forex trades. The Financial Conduct Authority (FCA) monitors and regulates forex trades in the United Kingdom.

Which Currencies Can I Trade in?

Currencies with high liquidity have a ready market and exhibit smooth and predictable price action in response to external events. The U.S. dollar is the most traded currency in the world. It is paired up in six of the market's seven most liquid currency pairs. Currencies with low liquidity, however, cannot be traded in large lot sizes without significant market movement being associated with the price.

The Bottom Line

For traders—especially those with limited funds—day trading or swing trading in small amounts is easier in the forex market than in other markets. For those with longer-term horizons and more funds, long-term fundamentals-based trading or a carry trade can be profitable. A focus on understanding the macroeconomic fundamentals that drive currency values, as well as experience with technical analysis, may help new forex traders become more profitable.

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Bank for International Settlements. “OTC Foreign Exchange Turnover in April 2022,” Page 1.

Nasdaq. “Forex Market Overview.”

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Forex Trading Strategy & Education

Forex (FX): How Trading in the Foreign Exchange Market Works

1 of 24

What Is Forex Trading? A Beginner’s Guide

2 of 24

Getting Started in Forex

3 of 24

How Currency Trading Works

4 of 24

Best Forex Brokers

5 of 24

What Is a Currency Pair? Major, Minor, and Exotic Examples

6 of 24

What Are Pips in Forex Trading and What Is Their Value?

7 of 24

Why Interest Rates Matter for Forex Traders

8 of 24

The Major Central Banks

9 of 24

Forex Leverage: A Double-Edged Sword

10 of 24

Forex Basics: Setting Up an Account

11 of 24

Spot Exchange Rate: Definition, How They Work, and How to Trade

12 of 24

What a Currency Forward Is, How It Works, Example, Use in Hedging

13 of 24

What Are Currency Futures? How They Work in Trade and Investing

14 of 24

Foreign Currency (FX) Swap: Definition, How It Works, and Types

15 of 24

7 Currencies Worth More Than the U.S. Dollar

16 of 24

How to Create and Manage an Effective Forex Trading Strategy

17 of 24

9 Forex Trading Tips

18 of 24

Strategies for Part-Time Forex Traders

19 of 24

3 Simple Strategies for Euro Traders

20 of 24

Currency Carry Trades 101

21 of 24

Using Interest Rate Parity to Trade Forex

22 of 24

Harmonic Patterns in the Currency Markets

23 of 24

Forex Algorithmic Trading: Understanding the Basics

24 of 24

Forex Day Trading: 5 Mistakes to Avoid

Forex (FX): Definition, How to Trade Currencies, and Examples

How to Create and Manage an Effective Forex Trading Strategy

Tomorrow Next (Tom Next): Definition, Purpose, and Example

Benefits and Risks of Trading Forex With Bitcoin

Top 5 Forex Risks Traders Should Consider

Partner Links

Related Terms

Forex (FX): Definition, How to Trade Currencies, and Examples

Forex (FX) is the market for trading international currencies. The name is a portmanteau of the words foreign and exchange.

How to Create and Manage an Effective Forex Trading Strategy

A forex trading strategy is a set of analyses a trader uses to decide whether to buy or sell a currency pair. They're available online or you can create one of your own.

Tomorrow Next (Tom Next): Definition, Purpose, and Example

In currency transactions, tomorrow next is the purchase and sale of a currency made to avoid taking actual delivery of the currency.

Managed Forex Accounts: Meaning, Safety, FAQs

A managed forex account is a type of forex account in which a money manager trades the account on a client's behalf for a fee.

What Is a Cross Rate? Defintion and Examples of Major Cross Rates

A cross rate is a transaction in which any two currencies are exchanged for values that are expressed in a third currency. Most transactions are in major currency pairs.

The Interbank Market: What It Is and How It Works

The interbank market is a global network used by financial institutions to trade currencies among themselves. They use it to manage their interest rate risks.

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How to Become a Successful Forex Trader

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Table of Contents

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Table of Contents

Basic Framework

Medium-Term Forex Trading

Chart Creation and Makeup

Entry and Exit Points

Money Management and Risk

Examples

FAQs

The Bottom Line

Guide to Forex Trading

Strategy & Education

How to Become a Successful Forex Trader

Justin Kuepper

Updated February 12, 2024

Reviewed by

Gordon Scott

Reviewed by

Gordon Scott

Full Bio

Gordon Scott has been an active investor and technical analyst or 20+ years. He is a Chartered Market Technician (CMT).

Learn about our

Financial Review Board

Fact checked by

Marcus Reeves

Starting in the forex market often results in a life cycle that involves diving in head first, giving up, or taking a step back to do more research and open a demo account to practice. From there, new traders may feel more confident to open another live account, experience more success, break even, or turn a profit. That is why it's important to build a framework for trading in the forex markets, which we outline below.

Key Takeaways

New forex traders should often start by opening a demo account to get used to trading and using the tools involved in trading.Forex traders may be interested in short-, medium-, or long-term investing, depending on their interests, skills, time commitments, and risk tolerances.When considering a forex trading plan, master the platform from which you will execute your trades, setting the most useful indicators and other tools to your greatest advantage.Even with a perfect forex trading strategy, no system is foolproof so expect volatility in the market.

The Basic Forex Trading Framework

Forex trading is basically about catching the changing values of currency pairs. So if you think the value of the pound will increase against the U.S. dollar, you can buy them with dollars and make a profit by selling the pound when it rises. Forex trading is commonly used by speculative traders and as a hedging strategy.

The framework covered in this article focuses on one central concept: trading with the odds. To do this, we look at a variety of techniques in multiple timeframes to determine whether a given trade is worth taking. Keep in mind that this is not intended to represent a mechanical/automated trading system. Rather, it's meant to be a discretionary system.

You may choose to act on signals you observe or dismiss them. The key is finding situations where all (or most) of the technical signals point in the same direction. These high-probability trading situations will, in turn, generally be profitable.

Focus on Medium-Term Forex Trading

Why do we foxus on medium-term forex trading rather than long- or short-term strategies? To answer that question, let's take a look at the following comparison table:

Type of Trader

Definition

Good Points

Bad Points

Short-Term (Scalper)

A trader who looks to open and close a trade within minutes, often taking advantage of small price movements with a large amount of leverage

Quick realization of profits or losses due to the rapid-fire nature of this type of trading

Large capital and/or risk requirements due to the large amount of leverage needed to profit from such small movements, and spread costs are more significant

Medium-Term

A trader typically looking to hold positions for one or more days, often taking advantage of opportunistic technical situations

Lowest capital requirements of the three because leverage is necessary only to boost profits

Fewer opportunities because these types of trades are more difficult to find and execute

Long-Term

A trader looking to hold positions for months or years, often basing decisions on long-term fundamental factors

More reliable long-run profits because this depends on reliable fundamental factors

Large capital requirements to cover volatile movements against any open position

You'll notice that both short-term and long-term traders require a large amount of capital where the first type needs it to generate enough leverage, and the other to cover volatility.

Although these two types of traders exist in the marketplace, they are comprised of high-net-worth individuals (HMWIs), asset managers, or larger institutional investors. This is why retail traders are most likely to succeed using a medium-term strategy.

Daily trading in over-the-counter (OTC) trading in the forex markets reached $7.5 trillion in April 2022. That's a 14% increase from the $6.6 trillion recorded in 2019.

Forex Chart Creation and Markup

Selecting a Trading Program

We will be using a free program called MetaTrader to illustrate this trading strategy. However, many other similar programs can also be used that will yield the same results. There are two basic trading program requirements:

The ability to display three different timeframes simultaneously

The ability to plot technical indicators, such as moving averages (exponential and simple), relative strength index (RSI), stochastics, and moving average convergence divergence (MACD)

Setting up the Indicators

Now let's look at how to set up this strategy in your chosen trading program. We will also define a collection of technical indicators with rules associated with them. These technical indicators are used as a filter for your trades.

If you choose to use more indicators than shown here, you will create a more reliable system that will generate fewer trading opportunities. Conversely, if you select fewer indicators than shown here, you will create a less reliable system that will generate more trading opportunities. Here are the settings that we will use for this article:

Minute-by-minute candlestick chart

RSI (15)

Stochastics (15,3,3)

MACD (Default)

Hourly candlestick chart

EMA (100)

EMA (10)

EMA (5)

MACD (Default)

Daily candlestick chart

SMA (100)

Adding in Other Studies

Now you will want to incorporate the use of some of the more subjective criteria, such as the following:

Significant trendlines that you see in any of the timeframes

Fibonacci retracements, arcs or fans that you see in the hourly or daily charts

Support or resistance that you see in any of the timeframes

Pivot points calculated from the previous day to the hourly and minutely charts

Chart patterns that you see in any of the timeframes

In the end, your screen should look something like this:

Figure 1: A forex trading program screen.

Image by Sabrina Jiang © Investopedia 2021

Finding Forex Trading Entry and Exit Points

The key to finding entry points is to look for times all of the indicators points in the same direction. The signals of each timeframe should support the timing and direction of the trade. There are a few particular bullish and bearish entry points:

Bullish

Bullish candlestick engulfing or other formations

Trendline/channel breakouts upwards

Positive divergences in RSI, stochastics, and MACD

Moving average crossovers (shorter crossing over longer)

Strong, close support and weak, distant resistance

Bearish

Bearish candlestick engulfing or other formations

Trendline/channel breakouts downwards

Negative divergences in RSI, stochastics, and MACD

Moving average crossovers (shorter crossing under longer)

Strong, close resistance and weak, distant support

Placing the Trade

It is also a good idea to place exit points (both stop losses and take profits) before even placing the trade. These points should be placed at key levels and modified only if there is a change in the premise for your trade (oftentimes as a result of fundamentals coming into play). You can place these exit points at key levels, including:

Just before areas of strong support or resistanceAt key Fibonacci levels (retracements, fans, or arcs)Just inside of key trendlines or channels

Money Management and Risk in Forex Markets

Money management is key to success in any marketplace, but particularly in the volatile forex market. Many times fundamental factors can send currency rates swinging in one direction – only to have the rates whipsaw into another direction in mere minutes. So, it is important to limit your downside by always utilizing stop-loss points and trading only when your indicators point to good opportunities.

Here are a few specific ways in which you can limit risk:

Increase the number of indicators that you are using. This will result in a harsher filter through which your trades are screened. Note that this will result in fewer opportunities.

Place stop-loss points at the closest resistance levels. Note that this may result in forfeited gains.

Use trailing-stop losses to lock in profits and limit losses when your trade turns favorable. This may also result in forfeited gains.

Examples of Forex Trading

Let's take a look at a couple of examples of individual charts using a combination of indicators to locate specific entry and exit points. Again, make sure any trades that you intend to place are supported in all three timeframes.

Figure 2: A screen showing several indicators that point in the same direction.

Image by Sabrina Jiang © Investopedia 2021

In Figure 2, above, we can see that a multitude of indicators are pointing in the same direction. There is a bearish head-and-shoulders pattern, a MACD, Fibonacci resistance and bearish EMA crossover (five- and 10-day). We also see that Fibonacci support provides a nice exit point. This trade is good for 50 pips and takes place over less than two days.

Figure 3: A screen showing indicators pointing in a long direction.

Image by Sabrina Jiang © Investopedia 2021

In Figure 3, above, we can see many indicators that point to a long position. We have a bullish engulfing, Fibonacci support, and a 100-day SMA support. Again, we see a Fibonacci resistance level that provides an excellent exit point. This trade is good for almost 200 pips in only a few weeks. Note that we could break this trade into smaller trades on the hourly chart.

How Volatile Is the Forex Market?

Volatility in the forex market refers to changes in the value of currencies. The forex market tends to be very liquid, which means it is very active. As such, the market is characterized by multiple traders who actively trade large volumes each day. Higher liquidity tends to make the market less volatile. That's because more active traders in the market lead to smaller increases and decreases in price and volume. The market is also susceptible to different types of risk, which can increase volatility. They include geopolitical risk, exchange rate risk, and interest rate risk.

What Are the Risks Associated With Forex Trading?

The forex market involves trading currencies based on speculation and hedging. If a trader thinks the value of Currency 1 will rise against Currency 2, they will use Currency 2 to buy Currency 1. When the first currency's value increases, they can sell it to make a profit.This sounds simple enough, but there are risks involved. One of the main risks in forex trading is the change in exchange rates, which is constantly changing. Other risks include interest rate risk, geopolitical risk, and transaction risk.

How Much Experience Should I Have Before Trading Forex?

Foreign exchange trading can be fairly complicated, so it may not necessarily be a good place for beginners to start. Trading in the forex market involves a lot of speculation, which can lead to substantial losses if things don't go your way. Exchange rates can also impact the potential for profits because of how quickly they change.If you want to get your feet wet and try your hand at forex trading without risking capital, consider trying a forex trading simulator. You can practice forex trading and gain valuable experience without losing money.

The Bottom Line

Anyone can make money in the forex market, but it requires patience and following a well-defined strategy. Therefore, it's important to first approach forex trading through a careful, medium-term strategy so that you can avoid larger players and becoming a casualty of this market.

The comments, opinions, and analyses expressed on Investopedia are for informational purposes online. Read our warranty and liability disclaimer for more info.

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Inside Days: Definition, Trading Strategy, Examples, Vs. Outside

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How to Create and Manage an Effective Forex Trading Strategy

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Bearish Engulfing Pattern: Definition and Example of How To Use

A bearish engulfing pattern is a chart signal suggesting prices might drop. This can be important for investors wanting to know when an upward trend is ending.

Supertrend Indicator: What It Is, How It Works

The Supertrend Indicator is a popular technical analysis tool designed to assist traders in identifying market trends.

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Donchian channels are moving average indicators developed by Richard Donchian. They plot the highest high price and lowest low price of a security over a given period.

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A hanging man is a bearish candlestick pattern that forms at the end of an uptrend and warns of lower prices to come. The candle is formed by a long lower shadow coupled with a small real body.

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A Basic Guide To Forex Trading

Anna-Louise JacksonContributorAnna-Louise Jackson Anna-Louise JacksonContributorContributor Benjamin CurryeditorBen is the Retirement and Investing Editor for Forbes Advisor. With two decades of business and finance journalism experience, Ben has covered breaking market news, written on equity markets for Investopedia, and edited personal finance content for Bankrate and LendingTree.Fact CheckedBenjamin CurryBenjamin CurryeditorBen is the Retirement and Investing Editor for Forbes Advisor. With two decades of business and finance journalism experience, Ben has covered breaking market news, written on equity markets for Investopedia, and edited personal finance content for Bankrate and LendingTree.editorFact CheckedUpdated: Mar 17, 2023, 1:00am

Editorial Note: We earn a commission from partner links on Forbes Advisor. Commissions do not affect our editors' opinions or evaluations.

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Foreign exchange trading—also commonly called forex trading or FX—is the global market for exchanging foreign currencies. Forex is the largest market in the world, and the trades that happen in it affect everything from the price of clothing imported from China to the amount you pay for a margarita while vacationing in Mexico.

What Is Forex Trading?

At its simplest, forex trading is similar to the currency exchange you may do while traveling abroad: A trader buys one currency and sells another, and the exchange rate constantly fluctuates based on supply and demand.

Currencies are traded in the foreign exchange market, a global marketplace that’s open 24 hours a day Monday through Friday. All forex trading is conducted over the counter (OTC), meaning there’s no physical exchange (as there is for stocks) and a global network of banks and other financial institutions oversee the market (instead of a central exchange, like the New York Stock Exchange).

Featured Partner Offer1eToroWelcome Offer Deposit $100 and get a $10 bonus! (US Only)Trade in a variety of assets including stocks, ETFs and cryptocurrencies eToro offers trading tools to help both novices and experts 1eToroLearn More Via eToro's WebsiteA vast majority of trade activity in the forex market occurs between institutional traders, such as people who work for banks, fund managers and multinational corporations. These traders don’t necessarily intend to take physical possession of the currencies themselves; they may simply be speculating about or hedging against future exchange rate fluctuations.

A forex trader might buy U.S. dollars (and sell euros), for example, if she believes the dollar will strengthen in value and therefore be able to buy more euros in the future. Meanwhile, an American company with European operations could use the forex market as a hedge in the event the euro weakens, meaning the value of their income earned there falls.

How Currencies Are Traded

All currencies are assigned a three-letter code much like a stock’s ticker symbol. While there are more than 170 currencies worldwide, the U.S. dollar is involved in a vast majority of forex trading, so it’s especially helpful to know its code: USD. The second most popular currency in the forex market is the euro, the currency accepted in 19 countries in the European Union (code: EUR).

Other major currencies, in order of popularity, are: the Japanese yen (JPY), the British pound (GBP), the Australian dollar (AUD), the Canadian dollar (CAD), the Swiss franc (CHF) and the New Zealand dollar (NZD).

All forex trading is expressed as a combination of the two currencies being exchanged. The following seven currency pairs—what are known as the majors—account for about 75% of trading in the forex market:

EUR/USD

USD/JPY

GBP/USD

AUD/USD

USD/CAD

USD/CHF

NZD/USD

How Forex Trades Are Quoted

Each currency pair represents the current exchange rate for the two currencies. Here’s how to interpret that information, using EUR/USD—or the euro-to-dollar exchange rate—as an example:

The currency on the left (the euro) is the base currency.

The currency on the right (the U.S. dollar) is the quote currency.

The exchange rate represents how much of the quote currency is needed to buy 1 unit of the base currency. As a result, the base currency is always expressed as 1 unit while the quote currency varies based on the current market and how much is needed to buy 1 unit of the base currency.

If the EUR/USD exchange rate is 1.2, that means €1 will buy $1.20 (or, put another way, it will cost $1.20 to buy €1).

When the exchange rate rises, that means the base currency has risen in value relative to the quote currency (because €1 will buy more U.S. dollars) and conversely, if the exchange rate falls, that means the base currency has fallen in value.

A quick note: Currency pairs are usually presented with the base currency first and the quote currency second, though there’s historical convention for how some currency pairs are expressed. For example, USD to EUR conversions are listed as EUR/USD, but not USD/EUR.

Three Ways to Trade Forex

Most forex trades aren’t made for the purpose of exchanging currencies (as you might at a currency exchange while traveling) but rather to speculate about future price movements, much like you would with stock trading. Similar to stock traders, forex traders are attempting to buy currencies whose values they think will increase relative to other currencies or to get rid of currencies whose purchasing power they anticipate will decrease.

There are three different ways to trade forex, which will accommodate traders with varying goals:

The spot market. This is the primary forex market where those currency pairs are swapped and exchange rates are determined in real-time, based on supply and demand.

The forward market. Instead of executing a trade now, forex traders can also enter into a binding (private) contract with another trader and lock in an exchange rate for an agreed upon amount of currency on a future date.

The futures market. Similarly, traders can opt for a standardized contract to buy or sell a predetermined amount of a currency at a specific exchange rate at a date in the future. This is done on an exchange rather than privately, like the forwards market.

The forward and futures markets are primarily used by forex traders who want to speculate or hedge against future price changes in a currency. The exchange rates in these markets are based on what’s happening in the spot market, which is the largest of the forex markets and is where a majority of forex trades are executed.

Forex Terms to Know

Each market has its own language. These are words to know before engaging in forex trading:

Currency pair. All forex trades involve a currency pair. In addition to the majors, there also are less common trades (like exotics, which are currencies of developing countries).

Pip. Short for percentage in points, a pip refers to the smallest possible price change within a currency pair. Because forex prices are quoted out to at least four decimal places, a pip is equal to 0.0001.

Bid-ask spread. As with other assets (like stocks), exchange rates are determined by the maximum amount that buyers are willing to pay for a currency (the bid) and the minimum amount that sellers require to sell (the ask). The difference between these two amounts, and the value trades ultimately will get executed at, is the bid-ask spread.

Lot. Forex is traded by what’s known as a lot, or a standardized unit of currency. The typical lot size is 100,000 units of currency, though there are micro (1,000) and mini (10,000) lots available for trading, too.

Leverage. Because of those large lot sizes, some traders may not be willing to put up so much money to execute a trade. Leverage, another term for borrowing money, allows traders to participate in the forex market without the amount of money otherwise required.

Margin. Trading with leverage isn’t free, however. Traders must put down some money upfront as a deposit—or what’s known as margin.

What Moves the Forex Market

Like any other market, currency prices are set by the supply and demand of sellers and buyers. However, there are other macro forces at play in this market. Demand for particular currencies can also be influenced by interest rates, central bank policy, the pace of economic growth and the political environment in the country in question.

The forex market is open 24 hours a day, five days a week, which gives traders in this market the opportunity to react to news that might not affect the stock market until much later. Because so much of currency trading focuses on speculation or hedging, it’s important for traders to be up to speed on the dynamics that could cause sharp spikes in currencies.

Risks of Forex Trading

Because forex trading requires leverage and traders use margin, there are additional risks to forex trading than other types of assets. Currency prices are constantly fluctuating, but at very small amounts, which means traders need to execute large trades (using leverage) to make money.

This leverage is great if a trader makes a winning bet because it can magnify profits. However, it can also magnify losses, even exceeding the initial amount borrowed. In addition, if a currency falls too much in value, leverage users open themselves up to margin calls, which may force them to sell their securities purchased with borrowed funds at a loss. Outside of possible losses, transaction costs can also add up and possibly eat into what was a profitable trade.

On top of all that, you should keep in mind that those who trade foreign currencies are little fish swimming in a pond of skilled, professional traders—and the Securities and Exchange Commission warns about potential fraud or information that could be confusing to new traders.

Perhaps it’s a good thing then that forex trading isn’t so common among individual investors. In fact, retail trading (a.k.a. trading by non-professionals) accounts for just 5.5% of the entire global market, figures from DailyForex show, and some of the major online brokers don’t even offer forex trading.

What’s more, of the few retailer traders who engage in forex trading, most struggle to turn a profit with forex. CompareForexBrokers found that, on average, 71% of retail FX traders lost money. This makes forex trading a strategy often best left to the professionals.

Why Forex Trading Matters for Average Consumers

While the average investor probably shouldn’t dabble in the forex market, what happens there does affect all of us. The real-time activity in the spot market will impact the amount we pay for exports along with how much it costs to travel abroad.

If the value of the U.S. dollar strengthens relative to the euro, for example, it will be cheaper to travel abroad (your U.S. dollars can buy more euros) and buy imported goods (from cars to clothes). On the flip side, when the dollar weakens, it will be more expensive to travel abroad and import goods (but companies that export goods abroad will benefit).

If you’re planning to make a big purchase of an imported item, or you’re planning to travel outside the U.S., it’s good to keep an eye on the exchange rates that are set by the forex market.

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The forex (FX) market has many similarities to the equity markets. However, there are also some key differences. This article will show you those differences and help you get started in forex trading.

If you've decided to take a stab at forex trading, the good news is that access to the currency markets has never been easier. A wide range of online brokerage platforms offer everything from spot trading to futures and CFDs.

Key Takeaways

To settle on a forex broker, do your due diligence and make sure you choose one who can meet your trading needs now and over time.

Look for low spreads and fees from a provider in a well-regulated jurisdiction.

Compare the types of trading platforms, trading and analysis tools, access to leverage, and more.

Before trading, study basic forex strategies and learn how to analyze currency markets properly.

Consider starting with a demo account to try out and backtest your strategy before risking real money in the market.

Choose a Forex Broker

There are many forex brokers to choose from. Here are some things to look for in a forex broker:

Look for Lower Spreads

The spread, calculated in pips, is the difference between the price at which a currency can be purchased and the price at which it can be sold at any given point in time. Price changes are described in terms of pips, ticks, and points. A high spread indicates a big difference between the prices for buying and selling. A low spread indicates a narrow difference.

Forex brokers usually don't charge a commission. Instead, they make their money on the spread. So, look for a lower spread. When comparing forex brokers, you may find a large range of spreads.

Choose a Broker Who's Backed by Regulatory Agencies and a Reliable Institution

Unlike equity brokers, forex brokers are usually tied to large banks or lending institutions because of the large amounts of capital required (leverage that they need to provide).

Also, a forex broker should be registered as a Futures Commission Merchant (FCM) and regulated by the Commodity Futures Trading Commission (CFTC). You can check on this and other financial information and statistics at a forex brokerage website, the website of its parent company, or through BrokerCheck at the Financial Industry Regulatory Authority (FINRA) website.

Get the Tools You Need to Succeed

Forex brokers offer different trading platforms for use by their clients—just like brokers in other markets. These trading platforms usually feature real-time charts, technical analysis tools, real-time news and data, and even support for trading systems.

As part of your broker selection process, be sure to request free trials to test the different trading platforms. Brokers will also provide technical and fundamental information, economic calendars, and other extensive research.

Leverage Your Bets

Leverage is necessary in forex because the price deviations (the sources of profit) are merely fractions of a cent. Leverage, expressed as a ratio between total capital available to actual capital, is the amount of money a broker will lend you for trading. For example, a ratio of 100:1 means your broker would lend you $100 for every $1 of actual capital. Many brokerages offer a ratio of 250:1. So give leverage some thought. Bear in mind that while less leverage means lower risk of a margin call, it also means less bang for your buck.

If you have limited capital, consider a brokerage that offers high leverage through a margin account. If you have plenty of capital, any broker with a wide variety of leverage options should do. A variety of options lets you vary the amount of risk you are willing to take. For example, less leverage (and therefore less risk) may be preferable for highly volatile (exotic) currency pairs.

Choose a Broker With Appropriate Leverage, Tools, and Services for Your Capital

Many brokers offer two or more types of accounts. The smallest account is known as a mini account. It requires you to trade with a minimum of, say, $250 and offers a high amount of leverage (which you need in order to make money with this size of initial capital).

The standard account lets you use different degrees of leverage, but has an account minimum of $2,000. Premium accounts, which often require significantly higher amounts of capital, let you use different amounts of leverage and often offer additional tools and services.

Forex Broker Actions to Avoid

Sniping and Hunting

Sniping and hunting are the premature buying or selling of currency near preset points. They are inappropriate activities used to increase profits. The only way to determine the brokers that do this is to talk to fellow traders. There is no blacklist or organization that reports such activity.

Suspect Margin Rules

When you are trading with borrowed money, your forex broker has a say in how much risk you take. As such, your broker can buy or sell at their discretion, which can affect you negatively.

Let's say you have a margin account, and your position suffers a sudden drop before rebounding to all-time highs. Even if you have enough cash to cover the change in value, some brokers will liquidate your position on a margin call at the low. Their action can cost you a significant amount of capital.

Be sure to conduct thorough due diligence prior to selecting a broker. Once you've made your selection, signing up for a forex account is similar to getting an equity account.

The only major difference is that for forex accounts, you are required to sign a margin agreement. This agreement states that you will be trading with borrowed money and, as such, the brokerage has the right to intervene in your trades to protect its interests. That said, once you sign up and fund your account, you'll be ready to trade.

Define Your Method of Analysis

Technical analysis and fundamental analysis are two methods used by forex traders to help them determine when to enter and exit the forex market. Technical analysis is by far the more commonly used.

Fundamental Analysis

If you think it's difficult to value one company, try valuing a whole country. Fundamental analysis in the forex market is very complex. It's often used only to predict long-term trends. However, some traders do trade short term strictly on news releases. Fundamental indicators of currency values are released at different times. These include:

Non-farm Payrolls

Purchasing Managers' Index (PMI)

Consumer Price Index (CPI)

Retail Sales

Durable Goods

These reports are not the only economic announcements to watch. News coverage of, and press releases from, relevant government agency meetings can also move markets. For example, the Federal Reserve chair's comments on interest rates can cause market volatility.

These regular gatherings involve discussion of monetary policy, interest rates, inflation, and other issues that affect currency valuations.

Therefore, it's important that forex traders be aware of the various economic reports to Congress including those made by the Federal Open Market Committee (FOMC) and the Humphrey-Hawkins Report.

Reading the reports and examining the commentary can help forex fundamental analysts gain a better understanding of long-term market trends. Short-term traders may learn to profit from extraordinary events.

If you choose to use fundamental analysis, be sure to keep an economic calendar handy at all times so you know when these reports are released. Your trading platform or broker may also give you real-time access to the release of economic data.

Technical Analysis

Forex technical analysts analyze price trends, similar to their counterparts in the equity markets. The key difference between technical analysis in forex and in equities is timeframe. Forex markets are open 24 hours a day.

As a result, certain technical analysis tools that factor in time must be modified for the 24-hour period. Here are some of the most common forms of technical analysis used in forex:

The Elliott Waves

Fibonacci Studies

Parabolic SAR

Pivot points

Many technical analysts combine these studies to make more accurate predictions (e.g., the common practice of combining Fibonacci studies with Elliott Waves). Others create trading systems to repeatedly locate similar buying and selling conditions.

Develop Your Forex Trading Strategy

Most successful traders develop a strategy and perfect it over time. Some focus on one particular study or calculation, while others use broad spectrum analysis to determine their trades.

Experts suggest trying a combination of both fundamental and technical analysis in order to make long-term projections and determine short-term entry and exit points. That said, individual traders must decide what works best for them, often through trial and error.

Added Considerations

Open a demo account and paper trade until you can make a consistent profit. Many people jump into the forex market and quickly lose a lot of money due to taking on too much leverage. It is important to take your time and learn to trade properly before committing capital.

Trade without emotion. Avoid mental stop-loss points if you don't have the ability to execute them on time. Always set your stop-loss and take-profit points to execute automatically. Don't change them unless absolutely necessary.

The trend can be your friend. If you go against the trend, make sure you have a good reason. That's because you have a higher chance of success when trading with the general trend of the forex market.

What Is Forex Trading?

Forex trading is the exchange (or trading) of currencies on the foreign exchange market. Trading occurs in currency pairs such as the EUR/USD (the euro versus the U.S. dollar) and the USD/CAD (the U.S. dollar versus the Canadian dollar). The foreign exchange market is the most actively traded market in the world.

What Does the Spread Represent?

The spread is the difference between the price at which you can buy a currency pair and the price at which you can sell it. The spread is what's quoted for traders. More liquid markets (such as the EUR/USD) will have narrower spreads than less liquid markets. A spread is also one way that a forex broker makes money. The spread the trader pays the broker is more than the spread the broker will, in turn, pay when placing the trade.

What's a Forex Demo Account?

It's an account offered by some firms that let traders and investors test out their trading or investing skills in a no-pressure atmosphere without real money. A demo account lets you simulate real trades and test strategies without the fear of actual financial loss. You also have the chance to get used to the broker's trading platform technology. Beginning and experienced traders and investors use demo accounts.

The Bottom Line

The forex market is the largest financial market in the world with a daily volume of $6.6 trillion. Individuals have become increasingly interested in earning a living trading foreign exchange.

However, there's a lot to consider before you begin trading. You want to be sure that your broker meets certain regulatory and financial criteria. You need to find the right trading strategy for your objectives. Bear in mind that one way to learn to trade forex is with a demo account. Use one to practice trading until you're confident enough to use real funds.

Article Sources

editorial policy.

National Futures Association. "Futures Commission Merchant (FCM) Registration."

Commodity Futures Trading Commission. "Be Smart: Check Registration & Backgrounds Before You Trade."

U.S. Bureau of Labor Statistics. "Employment Situation Summary."

IHS Markit. "PMI by IHS Markit."

U.S. Bureau of Labor Statistics. "Consumer Price Index."

U.S. Census Bureau. "Advance Monthly Sales for Retail and Food Services," Pages 1-7.

U.S. Census Bureau. "Monthly Advanced Report on Durable Goods Manufacturers’ Shipments, Inventories and Orders," Pages 1-7.

Yahoo! Finance. "What's the Semiannual Humphrey-Hawkins Testimony?"

Bank for International Settlements. "Foreign Exchange Turnover in April 2019."

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Description

Part Of

Forex Trading Strategy & Education

Forex (FX): How Trading in the Foreign Exchange Market Works

1 of 24

What Is Forex Trading? A Beginner’s Guide

2 of 24

Getting Started in Forex

3 of 24

How Currency Trading Works

4 of 24

Best Forex Brokers

5 of 24

What Is a Currency Pair? Major, Minor, and Exotic Examples

6 of 24

What Are Pips in Forex Trading and What Is Their Value?

7 of 24

Why Interest Rates Matter for Forex Traders

8 of 24

The Major Central Banks

9 of 24

Forex Leverage: A Double-Edged Sword

10 of 24

Forex Basics: Setting Up an Account

11 of 24

Spot Exchange Rate: Definition, How They Work, and How to Trade

12 of 24

What a Currency Forward Is, How It Works, Example, Use in Hedging

13 of 24

What Are Currency Futures? How They Work in Trade and Investing

14 of 24

Foreign Currency (FX) Swap: Definition, How It Works, and Types

15 of 24

7 Currencies Worth More Than the U.S. Dollar

16 of 24

How to Create and Manage an Effective Forex Trading Strategy

17 of 24

9 Forex Trading Tips

18 of 24

Strategies for Part-Time Forex Traders

19 of 24

3 Simple Strategies for Euro Traders

20 of 24

Currency Carry Trades 101

21 of 24

Using Interest Rate Parity to Trade Forex

22 of 24

Harmonic Patterns in the Currency Markets

23 of 24

Forex Algorithmic Trading: Understanding the Basics

24 of 24

How to Create and Manage an Effective Forex Trading Strategy

How to Choose a Forex Broker: What You Need to Know

What Is Forex Trading? A Beginner’s Guide

Forex Trading With Bitcoin: How Does It Work?

Benefits and Risks of Trading Forex With Bitcoin

Managed Forex Accounts: Meaning, Safety, FAQs

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Related Terms

How to Create and Manage an Effective Forex Trading Strategy

A forex trading strategy is a set of analyses a trader uses to decide whether to buy or sell a currency pair. They're available online or you can create one of your own.

Managed Forex Accounts: Meaning, Safety, FAQs

A managed forex account is a type of forex account in which a money manager trades the account on a client's behalf for a fee.

Forex Account: What It Means and How It Works

Opening a forex account is the first step to becoming a forex trader.

Currency Trading Platform: Meaning, Example, Pros And Cons

A currency or forex trading platform is a type of trading platform used to help currency traders with forex trading analysis and trade execution.

Forex Spread Betting: What It Is, How It Works

Forex spread betting allows speculation on the movements of the selected currency without actually transacting in the foreign exchange market.

Forex (FX): Definition, How to Trade Currencies, and Examples

Forex (FX) is the market for trading international currencies. The name is a portmanteau of the words foreign and exchange.

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