If you are interested in the subject of investing, you would have likely have heard about Foreign Exchange (Forex) Trading by now. You may even know a few people around you who trade Forex full-time as a career.
Forex Trading refers to the buying and selling of currency pairs with the aim of generating profits. The objective is simple; make profits by trading on the constant fluctuation of major currency pairs.
Before you start trading Forex, here are some important things that you first need to know.
#1 When You Trade Forex, You Don’t Actually Own Physical Currencies
While some people liken Forex trading to going to a traditional moneychanger to buy foreign currencies, it’s quite different.
The biggest difference when it comes to Forex trading is that you never really own the physical currencies that you trade. Of course, if you go to a moneychanger, you’ll have to give the person some of your money in one currency to receive money in another currency.
For example, if you decide to long the EUR/USD (that means you are buying the Euro (EUR) with expectations that it will perform well against the US Dollar (USD)), you don’t actually own any USD, nor did you have to sell any USD to buy the EUR.
Instead, what’s happening is that the Forex broker you use electronically records your order, and attributes any profits or losses on the trade to you, based on how the currency rates fluctuate.
If the rates move in your favour, you will make profits. If the rates move against you, you will incur losses. And it you want to stop trading, you simply get out of the position. You never really own the physical currencies that you trade.
#2 Know The Bid-Ask Spread You Are Facing
The bid-ask spread is an important component of Forex trading.
You will immediately realise just how competitive Forex spreads are compared to the spread we are used to seeing on the board at traditional money changers. While most money changers earn a spread of about $0.01 or $0.02 for every dollar traded, Forex spread can be as low as $0.00006.
The spread that you face is important because it ultimately affects the profitability of your trades. Traders start each trade at a slight loss due to the spread they incur. Hence, the lower the spread is, the easier it is to breakeven and to subsequently make profits on their trades.
Major brokers like IG are able to offer competitive spreads to its customers due to the volume of transactions that they handle each day. The table below shows the minimum and average spreads that traders can expect from IG across major currency pairs.
Note: Minimum & Average Spread is quoted in pips. 1 pip = 0.0001
#3 You Are Capturing Profits From Volatility
If you are new to trading, it’s easy to be confused by the differences between investing and trading. Here’s one way to think about it.
When you invest, you are buying into an asset that you believe will appreciate in value over the long-term. When you trade Forex, your aim is to make profits based on exchange rate fluctuations in the short-term. Even though some exchange rates may not deviate much in the long-term, you can still make profits if you are able to capture the short-term price volatility successfully.
#4 Be Very Familiar With Currency Pairs That You Are Trading
Just like there are many stocks you can choose from, there are likewise multiple currency pairs that you can trade on. Popular pairs include EUR/USD, USD/JPY & EUR/GBP.
Always remember that different currency pairs exhibit different types of behavior. A trading strategy that works well for one currency pair may not be suitable for another.
Another area that new traders tend to overlook is major macroeconomic policies that may affect currencies. These include announcements relating to interest rates, fiscal spending and policy updates. These announcements can have a major implication on short-term exchange rate volatility or even introduce shocks. So ensure you know when these announcements will be delivered and be prepared for them in advance. If in doubt, stay out of trades during these periods of extreme uncertainties.
#5 You Are Using Leverage, A Double-Edged Sword
Contrary to popular beliefs, the trading of foreign currencies, by itself, isn’t really “risky”. Most major currency pairs hardly ever fluctuate 2% to 3% over short period of time.
What makes Forex trading riskier is that leverage is employed. It’s common to find leverage of about 50:1 for Forex trading. This means that with a sum of just $1,000, a trader can take up a position of up to $50,000.
In this example, a 1% movement in the currency would mean your position is now standing at either $50,500 or $49,500. This translates to a 50% profit or 50% loss on your $1,000 capital. This highlights that while a 1% movement in currency prices may not seem significant, leveraging up to 50:1 could result in a 50% gain or loss on capital.
During volatile periods, when currency pairs can take wild swings, it’s possible for traders to incur losses that exceed their initial capital outlay. This makes Forex trading dangerous if traders are unable to adequately manage the risks they are exposed to.
Try A Demo Account Before You Get Started
Many people are enticed by Forex trading because of the possibility of being able to make profits with only a small capital outlay. At the same time however, we shouldn’t just focus on the profits we hope to make, while ignoring other important aspects of Forex trading.
If you are new to Forex trading, it’s highly recommended that you first try out your strategies with a demo account first. IG allows you to practise your trading with $100,000 in virtual funds, giving you the opportunity to become familiar and confident with trading before you decide on whether you should put in actual money into your trades.
This article was sponsored by IG, the world’s No.1 CFD provider (by revenue excluding FX, 2016). All views, opinions and recommendations expressed in the article are the independent opinion of DollarsAndSense.sg and do not in any way reflect the views, opinions, endorsements or recommendations, of IG Asia Pte Ltd (Co. Reg. No. 20051002K) (“IG”). Information is for educational purposes only and does not constitute any form of investment advice nor an offer or solicitation to invest in any financial instrument. No responsibility is accepted by IG for any loss or damage arising in any way (including due to negligence) from anyone acting or refraining from acting as a result of this information or material.