Guide to Investing in Forex
The foreign exchange market is the most liquid financial market with a trading volume of trillions of dollars a day. This makes the forex market a popular ‘playground’ for banks, hedge funds, investment firms, and also retail investors.
Over the last few decades, it has become much easier for the ‘average Joe’ to participate in this immense market. With online forex trading platforms, basically any adult in the world can invest a few bucks in forex trading. Let’s take a look at spot forex trading and a few other ways to partake in the forex market.
Spot Forex Trading
The spot (cash) forex market is a decentralized, worldwide market where currency pairs are bought and sold. Trading is done electronically in an online network of central banks, banks, liquidity providers, commercial corporations, hedge funds, forex brokers, retail forex traders, and other participants. The spot forex market is open basically 24 hours a day, 5 days a week.
Currencies are traded in pairs, for example, the EUR/USD. Some brokers have over 50 different currency pairs to choose from. To enter a long position, a pair is bought and to enter a short position, it is sold. A long position makes money when the price of a pair rises and a short position makes money when it declines.
Retail forex traders access the spot forex market by simply opening a trading account with a reputable broker. After a trader has verified his personal details and made a deposit to his broker, he can use the broker’s trading platform to execute and manage his forex trades. This type of trading can be done without the need to phone or email the broker with order details.
Online forex trading can be done with a really small amount of capital. In many cases, this can be less than $100. The typical forex trading account is a margin account with which leveraged trading can be done. Leverage enables traders to control large forex trades with a limited amount of capital.
For example, with a trading account with 1:500 leverage, a 0.01 lot forex trade with a notional value of $1,000 *requires only $2 of margin to open. So, a trader with a $200 account can easily open trades of which the notional value is far more than his account balance.
*To simplify this example, the additional margin required to sustain a floating loss is not discussed.
The amount of leverage available to you depends on your broker and regulatory restriction of leverage. Traders residing in the European Union are restricted by ESMA (The European Securities and Markets Authority) to a maximum leverage of 1:30 while traders from other countries (excluding the U.S. and certain others) have access to much higher leverage.
For example, with the Pepperstone broker, you can choose between 1:1, 1:25, 1:50, 1:100, 1:200, 1:300, 1:400, and 1:500 leverage when you open a trading account. This applies to traders from certain countries outside of the U.S. and the European Union.
4 Ways to Tackle the Spot Forex Market
Execute your own trades manually
Online trading platforms have made manual forex trading incredibly convenient. Traders who like to do their own market analysis and pull the trigger themselves do not need to watch charts all day long. There are different types of orders to use, including stop loss, take profit, and pending orders with which you can enter trades when the market reaches a certain price. Trailing stop loss orders can also be used to automatically lock in gains as the market moves in your favour. You can also enter a trade with a market order which is executed immediately at the first available price. Besides these orders, there are other more advanced order types available at some brokers.
With online forex trading platforms, traders and investors have excellent trading tools and charting software at their disposal. Here are some examples:
- Demo forex trading accounts – Practice forex trading without risking your capital.
- Live price charts – Trades can be executed while you watch your charts. Different types of charts are available: candlestick, bar, line, and other types of charts.
- Technical indicators – For example, moving averages, oscillators, sentiment indicators, volume indicators, candlestick pattern recognition, etc.
- Newsfeed and economic calendars – Alerts you of important economic news and other market moving events.
- Drawing tool – To draw lines, channels, shapes, etc, on your charts.
- Price alerts – Alerts you when the price of a currency pair reaches a certain level.
- Email alerts – Receive emails when certain orders are triggered.
Traders who choose to execute their own trades need to learn how the forex market works and how to place and manage trades on a forex trading platform. Technical and fundamental analysis are commonly used to interpret current market conditions and to predict future price movements.
Forex brokers usually have good information to guide new traders in using their trading platforms and perform technical and fundamental analysis. Online sources can also be handy to help traders understand the different forex terms and concepts.
Different types of forex trading techniques include scalping, swing trading, carry trading, day trading, position trading, and different types of arbitrage trading. When comparing traders with investors, the latter are typically more likely to engage in long-term trading. Traders can also execute long-term trades but will usually not keep trades open for longer than a few months to a year.
Algorithmic Trading (With Robots)
Certain forex trading strategies can be automated by programming its execution logic into a computer algorithm or trading robot. Trading robots built for the popular MT4 forex trading platform are called EAs (expert advisors).
Algo trading can be done without any human intervention but some traders will frequently monitor the current market conditions and the performance of their algorithm(s).
Trading robots can analyse numerous currency pairs simultaneously and execute trades much faster than humans. Trading robots can also be a great way to eliminate human errors when it comes to trade execution and management. Of course, trading robots can monitor financial instruments continually, which is obviously a great advantage when compared to human beings’ capabilities and interruptions due to lifestyle requirements.
Modern trading technology makes it possible to automatically copy the real-time forex trades of other traders. This can be a great way to invest in the forex market because you can make money from forex even if you don’t have the experience, skill, or time to be a profitable trader.
Copy trading can often be done without paying commission directly to copied traders, although the brokers who facilitate copy trading will often be slightly more expensive in terms of trading costs (spreads, commissions, and rollover) in order to compensate copied traders for their services.
Some forex trading platforms are purpose designed for copy trading while others have incorporated copy trading mechanisms into their existing trading platform infrastructure. eToro and ZuluTrade are examples of brokers with platforms specifically designed for copy trading.
A good advantage of copy trading is that your capital remains in your own trading account. This means that you can combine your own trading with that of other traders. You also don’t need to transfer money to an individual or company who performs fund management for you.
You can also invest in the forex market by means of fund management firms. These firms usually have a team of professional traders who manage client accounts. In most cases, you will have to transfer your capital to the firm and pay a yearly management fee plus a certain commission on the profit they make.
More Ways to Invest in Forex
Besides spot forex trading, there are other ways to invest in the forex market as well. Some are really complicated while others are really basic. Let’s take a brief look…
Investing in Physical Currencies (Banknotes)
This is the most basic way to invest in currencies. On the one hand, this is the most efficient way to invest in currencies but on the other hand, it is the most inefficient.
Why is it the most efficient? Because if you get a good deal, you can exchange currencies for a better price than which is available in the spot market. You don’t need to pay the spread or any commission. In fact, you can earn some commission.
An why is it also the most inefficient? Because of the physical limitations and drawbacks of exchanging physical cash. Let’s say you have $25,000 and for some reason, you need to get rid of it quickly. Because you’re in a market with limited liquidity and counterparties, it may take quite some time to get a buyer or buyers for your dollars. You could probably exchange it at a bank but that’s not a very attractive option because of the transaction costs.
Other drawbacks of investing in physical cash are:
- The risk and potential expenses of storing and handling the cash.
- Dealing in different denominations of physical cash may be illegal in your country.
- No access to leverage.
- You cannot earn interest as with a carry trade.
Trading Vanilla Currency Options
This is probably one of the most complex instruments with which you can trade or invest in the forex market. A vanilla currency option gives you the right but not the obligation to buy or sell a certain currency pair at a predetermined strike price, at or before a certain time in the future.
Trading Currency Futures
Currency futures are traded on exchanges like the CME Group, which is the largest futures market place in the world. A currency future is a contract to exchange a certain amount of currency at a specific price on a specific date in the future.
Trading Currency ETFs (Exchange-Traded Funds)
ETFs are complex financial instruments that track the value of an individual underlying asset or a basket of underlying assets. ETFs offer investors a convenient way to invest in several underlying assets at once, with a single financial instrument. Currency ETFs are not as well-known and often traded as spot forex instruments.
Basic Forex Terminology
- Base currency – The currency you are getting rid of or spending is the base currency.
- Quote currency – Refers to the currency which you are purchasing.
- Exchange rate – Tells you just how much you will have to spend quote currency to be able to buy a base currency.
- Long position – This means that you intend to sell the quote currency and purchase the base currency.
- Short position – Means that you want to sell the base currency and buy the quote currency.
- Bid price – The price that the broker is willing to purchase the base currency in exchange to the quote currency.
- Ask price – Also called offer price, refers to the price that the broker is willing to sell the base currency for the quote currency.
- Spread – This refers to the difference in between the ask price and the bid price.