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With heightened volatility in the financial markets seen in recent months, it’s easy to understand why both new and experienced traders are hoping to profit from more trading opportunities in the market.
When it comes to trading, there are many asset classes that traders can use. One of the most popular instruments is foreign exchange trading, better known as forex trading or FX trading. Forex trading is done in pairs such as the EUR/USD, AUD/USD and USD/JPY, which involves the exchange of one currency for the other, with the aim to make profits through a change in the exchange rates.
However, before you dip your toes into forex trading, it’s important to understand the basics of how it works, and why it’s quite different to long-term investing.
# 1 A Zero-Sum Game
Unlike investing in stocks, bonds or properties, forex trading is a zero-sum game. What this means is that if a trader makes a profitable trade, there is someone else on the opposite side of the trade in the forex market who makes the corresponding loss.
While it’s a zero-sum game, it’s equally important to remember that the majority of people who participate in the forex market are not looking to make a profit from the exchange.
Businesses and people have to use the forex market all the time. If we travel to the United States, we will need to exchange our Singapore Dollar for US Dollar (USD). Singapore companies that purchase products from the United States may need to pay in USD. Thus, for these exchanges, these people looking to convert their funds into another currency are not actually looking to profit from the trade.
# 2 Trading Only On The Currencies Of The Pair
Unlike stocks, bonds or property investments where it’s important to understand the long-term potential of the investments, the holding period of your trades are typically much shorter, within weeks, days or even hours, in the forex market.
Think of a forex trade as two sides of a coin – you are on one of the sides.
For example, if you trade the EUR/USD and you are longing (i.e. buying) the EURO, this means you expect the EURO to perform well relative to the USD.
If the EUR/USD is currently 1.08391, and you long EUR (i.e. you buy EURO with USD), you will pay USD 1.0831 for 1 Euro. If the EUR/USD goes up to 1.10391, this means your EURO is now worth 1.10391, or 0.02 more. Thus, you are in a profitable position on your trade.
Remember that one currency only appreciates relative to the other currency it is being quoted in. So, if the EURO depreciates against every other foreign currency but appreciates against the USD, then your EUR/USD trade will still be profitable. Similarly, even if the EURO strengthens against most other currencies, but depreciates against the USD, you will make a loss on your trade.
# 3 Don’t Usually Own The Underlying Assets
When you are trading forex, you rarely own the underlying assets. For example, if you long the EUR/USD for 10,000 EURO, you don’t own 10,000 EURO, nor did you pay the equivalent value of 10,000 EURO in USD for your trade position.
Instead, what is happening is that the forex broker that you use is electronically recording down the trade position. Any profits or losses from this trade will be attributed to you.
So, while you own the profits from the trade and are responsible for any losses, you never actually own the underlying currencies that you trade.
# 4 Capturing Profits From Volatility
Volatility is necessary to make trading profits. Think of it this way: if the EUR/USD is at 1.10, and always stay that way, then there is no reason to trade the currency pair since prices never change.
In reality, prices do not remain the same in the short-term, even if they may be relatively stable in the long-term. It’s this volatility in prices that allows traders to make profits.
As a forex trader, you are using this short-term volatility to generate profits. However, bear in mind that the higher the volatility, the higher your potential returns and risks are. So you have to practice adequate risk management in your trades.
# 5 Using Leverage
Some people feel that forex trading is risky. By itself, this isn’t true. Unlike stocks, most currency pairs don’t move by much most of the time. Even during market crashes, currency pairs are usually unaffected since their movements, if any, is always relative to one another.
What makes forex trading both risky and potentially rewarding is with the use of leverage.
Leverage refers to the use of borrowed capital to increase a trader’s position. By using leverage, traders are hoping to earn a higher return as compared to what they can make by just using their capital in hand.
For example, if I only have $1,000, making a 2% gain in the markets will translate to only $20 in profit. However, by taking a 10X leverage position, my profits will be $200, or a 20% gain on my original capital.
However, leverage can be a double-edged sword. By using leverage, you are not only increasing the potential returns on your trades, but also the risk. If the trade moves against you, your losses will be magnified.
In Singapore, the Monetary Authority of Singapore (MAS) requires most retail traders to maintain a minimum margin of 5% for all forex trades. For example, to maintain a forex trading position of $20,000, a trader needs to have a minimum capital of $1,000. Do note that traders can use a Contract for Difference CFD to trade Forex as well, which lets you speculate the price movements of FX by going long or short.
While anyone can start trading forex with just a small initial capital, generating consistent profits from your trades is not easy and requires practice, constant analysis and refinement to your strategies, and robust risk management techniques. Without any of these, your aspirations to become a profitable forex trader is likely to be short-lived.
DollarsAndSense publishes an influencer series interviewing many prominent traders in Singapore who share both their successes and failures. We believe that while it’s important to inspire those who wish to trade, it’s equally important to also share setbacks so that aspiring traders are aware of the challenges.
If you are keen to start forex trading, you can open an account with IG. Regulated by the Monetary Authority of Singapore (MAS), IG is one of the world’s largest forex broker and the No.1 CFD provider.
Besides allowing you to trade, IG also provides a suite of services such as its IG Academy. The IG Academy allows traders to learn and to stay up-to-date with the market through its online courses, webinars and events. Besides forex trading, there are also other products such as shares, indices, commodities and also knock-outs that you can trade on IG.
For those who are new to trading, it’s advisable to start with a demo account first. A demo account allows you to get familiar with trading without having to put up any actual money first. IG allows you to practice your trade with $200,000 of virtual funds. With the demo account, you can also gain access to all the exclusive educational content from IG and also join the IG trading community.
IG provides an execution-only service. The information in this article is for informational and educational purposes only and does not constitute (and should not be construed as containing) any form of financial or investment advice or an investment recommendation or an offer of or solicitation to invest or transact in any financial instrument. Nor does the information take into account the investment objective, financial situation or particular need of any person. Where in doubt, you should seek advice from an independent financial adviser regarding the suitability of your investment, under a separate arrangement, as you deem fit.
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 the information. All forms of investment carry risks. Trading in leveraged products such as CFDs carry risks and may not be suitable for everyone. Losses can exceed deposits.
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