The foreign exchange market, also known as the forex (FX) or currency market, is the largest and most liquid market in the world. It represents the exchange of one nation’s currency for another, and is used for everything from travelers exchanging currencies to global financing. With over $7.5 trillion in currencies traded daily, the FX market impacts consumers in a global market, affecting the price of imported and exported goods. To put this in perspective, the five-day Average Daily Trading Volume (ADTV) for US stock and options traded daily is less than $300 billion. While the forex market is huge, 75% of FX trading is conducted in the seven major currency pairs, six of which include the U.S. dollar (USD), with participants including governments, large international banks, regional banks, corporations, and individuals.
Foreign exchange trading continues 24 hours a day, with only the trading centers changing throughout the day. We’ll look at how the forex market works and what you need to know to trade in the financial world’s biggest and busiest arena.
How to Trade Forex
Trading foreign exchange markets involves buying or selling one currency in exchange for another. The goal of trading is to profit from the changes in exchange rates between the two currencies. To trade forex, you will need to open a trading account with a broker that provides access to the FX market. After opening an account, you will need to deposit funds to use for trading.
Once you have funds in your account, you can start trading by placing buy or sell orders for currency pairs. These orders can be placed through the broker’s trading platform, which provides access to real-time pricing information and charts. To be successful in trading forex, you will need to develop a trading strategy that takes into account factors such as market conditions, news events, and chart analysis. Trades are sized in lots, with the standard lot representing 100,000 of the base currency (first of the pair). If you put a buy order in for USD/CAD, for example, you are betting on the U.S. dollar appreciating against the Canadian dollar, and this is considered a long position. If you put in a sell order for USD/CAD, you are betting on the Canadian dollar appreciating against the U.S. dollar, and it is a short position.
Foreign exchange traders typically utilize technical analysis for their trading, and many also use fundamental analysis to gauge the relative strength of global economies. It is also important to manage your risk by using stop-loss orders and proper position sizing. Before placing a trade, you want to know your entry level as well as your exit points for taking profits or minimizing losses. Trading forex can be challenging, but with the right knowledge and discipline, it can be a rewarding and profitable experience.
Steps Required to Trade Forex
Getting started trading forex is relatively straightforward. While there are some differences in opening a traditional stock trading account vs. a FX brokerage account, the overall steps are largely the same.
Step 1: Research and select a broker. The first step is to find out which brokers will offer you a foreign exchange trading account. If your existing broker supports FX trading and you have an approved margin agreement, you can skip ahead and begin trading. If not, you’ll want to look at FX brokers and compare them in terms of platform capabilities, regulatory compliance, fees, margin rates, and customer support. Investopedia does a regular roundup of forex-focused brokers to consider, and there are also large, traditional brokers worth considering. Once you’ve identified a broker that fits your needs, opening a forex trading account is a fast and easy process.
Step 2: Open a forex trading account. To open an account, you need to provide personal information, including name, address, and tax ID number, and some financial background information. You will also have to answer some questions about your finances and investment goals as part of “know your client” compliance.
When you open a FX trading account, it will include the execution of a margin agreement, because currency trading includes leverage. An options agreement will be required to trade currency options, which can be accomplished through either over-the-counter (OTC) options offered by some of the forex brokers or exchange-traded options on currency futures.
Step 3: Verify your identity. Your broker will confirm your identity through your passport, license, or national ID. A copy of a utility bill or bank statement will also assist with verifying your address. The broker requests the financial and tax information to comply with U.S. government laws and Commodity Futures Trading Commission (CFTC) rules.
Once your account and margin agreements have been approved, you need to fund the account to start trading. It should be noted, however, that some of the leading online forex companies do not offer accounts to U.S. customers.
Step 4: Fund your forex account. Once your account has been approved, you need to fund it in order to begin trading. Some forex platforms allow you to begin trading with as little as $100, which at the 2% margin (or 50:1 leverage) available for some markets, allows for a position of $5,000. Funding is typically accomplished by ACH bank transfer, wire transfer, debit card (after verification), or check.
Step 5: Research currencies and identify trading opportunities. Once the account is open and funded, forex traders typically choose the currency pairs they want to trade, then utilize technical analysis to determine their timing points and price levels for trade entry and exit. Like all markets, but especially leveraged markets like foreign exchange, trade size and trade management are very important to achieve the preservation of capital on losing trades and growth of capital on profitable ones.
The overall financial condition of a country, including interest rates, plays into the value of a nation’s currency, so there is a place for fundamental analysis in currency trading. News and fundamental data releases can also have a large impact on currency values. Beyond fundamental considerations, however, technical analysis is a critical part of currency trading because of the often fast moving currency markets. Many traders focus exclusively on technical analysis to capitalize on the price action of the forex market, using common technical techniques such as trend lines, channels, breakouts, patterns, and support and resistance levels to identify trading opportunities in the foreign exchange markets.
Step 6: Size up your first forex trade. Before making their first FX trade, every trader needs to understand how much capital they have, as well as the specific leverage available to them for their chosen currency pair. Since leverage in forex trading can be as high as 50:1, it is critical to understand how much capital you will have at risk on any trade. The 1% rule for how much capital to risk on an individual trade is a good rule of thumb for new forex traders. This means you should only risk 1% or your total account value on a particular trade. Other traders may choose to use a 2% or even 5% rule for the amount of capital they will allocate to any particular trade.
The amount you are willing to risk along with how far you are willing to let the market move against your position before taking a loss sets the parameters of the trade. You should also set a take profit point if you intend to systemize your trading, but with the downside risk contained, you always have the option of letting winning positions run. Once the trade parameters have been determined, you are ready to enter the order through your broker’s trading platform.
Step 7: Monitor and manage your position. Once the position has been established, the trader should have a clear understanding of their position and, through their research prior to trading, have clear exit points for either taking profits or taking a loss on their trade. Many traders will use a one-cancels-the-other (OCO) so that they will automatically take their profit or loss should either of these levels be reached, and cancel the remaining order.
Compare The Best Forex Brokers
| Company | Fees | Account Minimum |
|---|---|---|
| IG | Spread cost; Overnight financing costs; Inactivity fees | $250 |
| XTB | Spread cost; Commissions; Overnight financing costs; Inactivity fees | $0 |
| Plus500 | Spread cost; Overnight financing costs; Inactivity fees; Currency conversion; Guaranteed stop order | Varies with instrument |
What You Need to Open a Forex Account
To open a forex account with a broker, you simply need to provide you personal information and fund the account.
Personal Information
- Account information: Brokers often prompt you to create an account as the first step of onboarding. This generally involves providing an email, creating a password, and verifying the account.
- Personal information: You will need to provide your full name, date of birth, and contact details including mailing address, email (if not already provided), and phone number.
- ID verification: You will need to provide a copy of government-issued ID, such as a driver’s license or passport, to verify your identity.
- Proof of address: You will need a bill or a bank statement that shows your name and address to confirm residency.
- Know your client information: You will be asked about your occupation, income, and investment information along with other questions to assess your financial situation, trading experience, and risk tolerance.
- Financial information: Your bank account details may be requested for setting up funding via bank transfers.
Minimum Deposits
The minimum deposits for forex trading accounts can be quite low and may not even apply at all. Due to the role of leverage in forex trading, however, it is a good idea to have enough risk capital in the account to actually engage in meaningful trading. Even if you can open an account with a $0 minimum, trading with smaller account balances is difficult and can severely limit the range of price action you can handle on any one position. Although there is no hard and fast rule, a balance of $2,500 in risk capital is a good starting point for developing your FX trading skills.
Understand the Basics
In currency trading, the first currency listed is the base currency, and the second currency is the quote currency. For example:
USD/JPY 134.82
The USD/JPY currency pair is made up of the U.S. dollar as the base currency and the Japanese yen as the quote currency. The base currency is always one unit of currency, in this case, $1, and the quote currency is the figure that changes. In this example, $1 USD can buy 134.82 Japanese yen. Throughout the day, this value will fluctuate up and down based on trading activity.
Transacting in the most common currency pairs is typically very easy because these markets are very liquid, and have very narrow bid/offer spreads. Another important forex trading term is a pip, which is the smallest increment a market trades in. This is typically 0.0001, although it is 0.01 for USD/JPY. Spreads in FX are now so narrow that many of the currency pairs trade in tenths of a pip (out to a fifth decimal place; or a third for USD/JPY).
In EUR/USD (euro/U.S. dollar) trading, the euro is the base currency, and the quoted rate represents the dollars that each euro buys. Beyond these specialized terms, the foreign exchange market trades like other markets, where there are bids and offers for buying and selling that creates price action in the market. Like other markets, you also have access to trading orders, such as limit and stop loss orders, for entering, managing, and exiting positions.
In addition to outright trading of currencies, some forex brokers offer contracts for difference (CFD) for currencies and some commodities. These contracts allow traders to use significant leverage, up to 400:1, for trading currencies where there is no transfer of assets. Instead, they only settle the difference in value. That said, there are additional risks with contracts for differences that investors need to consider.
U.S. investors do not have the ability to trade CFDs. The Securities and Exchange Commission (SEC) and the CFTC prohibit U.S. citizens from trading these assets as they do not pass through regulated exchanges.
Options for Trading Forex
There are multiple options for trading foreign exchange. They include trading directly with a bank or financial services provider, trading currency futures listed on exchanges through a commodity trading account, and opening an account with a foreign exchange broker that essentially provides individual traders with access to the interbank market through its own platform.
Know the Risks
LIke any trading market, FX trading involves risk. Forex trading can be volatile, as markets can adjust very quickly to new information and news. While this is similar to many other markets, the market participants in forex also include central banks. With the largest banks making up a large share of the market, prices can fluctuate greatly during the day. Simply put, retail forex traders are small fish in a large ocean. While this volatility and price action appeals to many traders, the price swings involved also add to the risk of getting stopped out of positions and experiencing slippage on price fills.
Moreover, leverage in currency trading is significantly greater than stocks, with some brokers offering up to 50:1 leverage on more liquid currency pairs. This is significantly greater leverage than the 2:1 leverage offered to stock traders that establish short positions. Leverage presents greater profitability to traders, but that opportunity also involves commensurate risk on losses. The supercharging effect of leverage makes trade selection, size, and position management very important for controlling risks. It should also be noted that less active currency pairs may have even more extreme moves due to having less liquidity.
Types of Forex Markets
The types of foreign exchange trading include spot, forward, and futures.
Spot Forex Market
Spot foreign exchange is the outright exchange of one currency for another at the time of the trade for a specific exchange rate. Spot FX trades typically settle with the actual exchange of currencies at the rate traded two days after the trade. There are some exceptions to the spot plus two-day settlement, most notably USD/CAD (US dollar vs. Canadian dollar) which settles one day after the trade date. When people are talking about the FX market, they are usually talking about the spot currency market.
Forward Forex Market
Forward foreign exchange represents a contract between two parties to exchange a set amount of one currency for a set amount of another currency on a specific date in the future. The difference in this future FX rate from the current spot rate is a function of interest rate differentials. While the specifics of forward forex trading are not standardized, the market provides users with the flexibility to hedge specific risk amounts over specific days. An example would be locking in the forward foreign exchange rate for a company that needs to meet a payroll for a specific amount on a specific date.
Counterparties trying to set a fair currency rate for the future will use the current spot exchange rate, then adjust it based on interest rate differentials for the time period of the transaction. This adjustment is made to compensate the participant with exposure to the currency that has the lower interest rate.
Futures Forex Market
There are also exchange traded futures contracts, which are similar to forward foreign exchange, but have fixed contract terms and trade on regulated futures exchanges. Currency futures contracts in the US are based on one currency, and the contract is cash settled in US dollars. While these markets are standardized, they do not allow users to hedge specific date risks or amounts, all of which is possible in the forward forex market.
Factors to Consider When Opening a Forex Account
There are a number of factors to consider when opening a foreign exchange account. Factors to consider include the commissions and fees charged, minimum investment amounts for both funding the account and position size, and the number of currency pairs available to trade. Other considerations include the research tools and trading platform, whether demo accounts are available for practice, and the quality of the broker’s customer service.
Fees: Brokerage fees for foreign exchange trading are generally very reasonable. There are two primary payment methods. One is to pay brokerage on trades, which usually work as a rate on the notional amount traded and are tiered lower for higher trading volumes. The other primary method is no brokerage fee, but wider bid/offer spreads that price the brokers’ fees into the trading price. Whether you prefer to pay your fees as basis points on the trade size or through pricing spreads will likely depend on how actively you are trading and the average trade size.
Account minimums: Account minimums for foreign exchange brokerage are generally very low. Accounts can typically be opened without any money, and funding requirements can be as low as $100. As mentioned previously, however, you will want more than $100 in the account to really begin trading.
Number and quality of supported markets: Some brokers support up to 200 currency pairs, but there is a great difference in liquidity in the various markets. The top seven most actively traded currency pairs represent 75% of all FX trading, and these markets are very active. Once you get beyond these currency pairs, there is a wide difference in liquidity. Traders can access less actively traded pairs by creating positions using the U.S. dollar as the pivot. As most currencies have a U.S. dollar pair, you can take up offsetting positions to create a synthetic currency pair. There would be an available market for this much less active currency pair, but the spreads would be wider and there would not be nearly as much liquidity in this market.
Research tools: Research tools, such as the quality of technical analysis and fundamental news, are also important factors for a foreign exchange trader. How fast these tools populate data becomes very important for trading fast-moving currency markets. Equally important, whether these tools integrate smoothly into the trading platform can make a difference in the trading experience. Some of the best interfaces allow for smooth indicator overlays and trading directly from charts. Some traders may want to be able to integrate their current charting or third-party analytical tools into their chosen platform for currency trading, so that is another potential consideration.
Demo account: Demo accounts are a great way to become familiar with trading a particular market on a broker’s platform. Traders new to forex trading would be smart to choose a broker with demo trading so they can learn how to place orders and manage positions effectively without having to commit capital first. Demo accounts allow users to become comfortable with the platform and its various tools prior to trading for their own account.
Customer service: While many forex traders are comfortable using the trading platform of their chosen FX broker, newer customers may want to consider the quality of customer service offered by their broker. Some are quicker to answer the phone, and others less so. Brokers may also have automated assistance and chat functionality to assist customers.
FAQs
Is Trading Forex Difficult?
Trading in the foreign exchange markets is not necessarily more difficult to trade than other markets. As with all markets, forex has its pros and cons, but the basic market structure is the same. A trader buys or sells a particular amount of a chosen asset and then manages risk through stops and profit-taking levels. The forex market, similar to futures markets, has a tendency to move quickly and can be volatile. It also involves using margin leverage where a trader only needs to post a small percentage of the full value of their positions. This can lead to either large gains or losses, and sometimes both in the same trading session. The fast moves in forex, coupled with the high leverage of retail currency trading, means it is critical for traders to manage their risk appropriately. As mentioned, this is done through taking appropriately sized positions and employing disciplined risk management techniques with stop-losses.
How Much Money Do You Need to Start Trading?
While some forex trading platforms will let you start trading with as little as $100, this is a very small amount considering the risks involved with trading the highly leveraged foreign exchange markets. Here again, there are pros and cons to trading in this highly leveraged market.
While a disciplined trader will keep their risk consistent regardless of their capital level, trading with a smaller stake means that getting a bad fill on a stop loss when a fast-moving market shoots through your stop level could result in an outsize loss of capital. There is very little room for error with a small amount of capital. Realistically, capital of at least $2,500 should be used, and even this is a relatively small amount. Trading accounts to be used in fast-moving markets, like foreign exchange, should account for some margin of error and the unexpected.
Can You Cash Out Your Forex Account?
A trader can always cash out of their forex account. All they have to do is liquidate their trading position, wait for settlement, and transfer the funds out of the account.
Who Trades Forex?
Forex trading involves all the usual suspects, like retail traders, large investment banks, regional banks, private wealth management firms, corporations, and so on. Unlike other financial markets, however, governments are also active participants in the foreign exchange markets. Other primary FX market participants include the large international banks that make up the inter-bank market. The interbank market for foreign exchange is available to the other market participants through direct transactions with banks or through other market brokers. Some of these market brokers include platforms making foreign exchange trading available to individual traders.
Can You Lose Money Trading Forex?
As with every type of investing, the risk of losing money is the price you pay for the opportunity to make more money. While forex markets are now easily traded, most new to FX trading lose money because, like futures markets, forex combines leverage with fast moving price action. Risk management is critical in forex markets, and that means properly sizing your positions and using the market order tools to stem losses quickly. Forex traders who don’t master these basics do not stay forex traders for very long.
