Forex trading is volatile, fast-paced and risky, but some traders have found great success with it. Here’s what you need to know before getting into forex trading.
For those who find the stock market not quite thrilling or fast-paced enough, forex trading offers a hyper-speed alternative.
As the largest market in the world – larger than even the stock market – the forex market has reached daily trading volumes as high as US$6.6 trillion (S$9 trillion).
Given that the typical forex trade is completed in minutes, it’s not hard to imagine the fortunes that have been made (and lost) on the forex trading floor.
To be clear, forex trading is not to be taken lightly. But for the curious, here’s what you need to know about forex trading.
What is forex trading and how does it work?
Forex (or fx) is short for foreign exchange. It involves trading one currency for another. Like all trading activity, the motive in forex trading is to make profit.
Trading forex can produce profits because the value of currencies relative to each other is not fixed – they can move up or down depending on factors like demand, monetary policies and other geopolitical factors.
Rather than a centralised exchange, the forex market is a digital network made up of banks, brokers, institutions and traders. This digital nature of the forex market also means it’s easy to trade forex – you can do so simply with an online account.
The forex market is active 24/5, allowing you to make trades at your convenience.
Because the instrument being traded is currency, another characteristic of the forex market is its highly liquid nature.
How does forex trading work exactly?
In essence, in a forex trade, you are making a bet about the relative strength (or weakness) of one currency against another. If you bet correctly, you’ll make a gain; if not, then a loss.
Forex trades always involve selling one currency for another. As such, trades always take place around a pair of currencies, for example USD/EUR.
The first currency is known as the “base currency”, which is the currency you are buying. The second currency is known as the “quote currency”, and is the currency that you are selling.
If the price of the USD/EUR pair is, say, 1.3456, then 1 US Dollar is worth 1.3456 Euros.
If the US Dollar strengthens against the Euro, this means 1 US Dollar is worth more Euros. Which means the price of the pair would go up – say, 1.3476.
If the US Dollar weakens against the Euro, this means that 1 US Dollar would be worth less Euros. In this case, the price of the pair would go down – say 1.3406.
In other words:
|FX Pair: Currency A/Currency B|
|Currency A strengthens||Price of FX pair goes up|
|Currency A weakens||Price of FX pair goes down|
Let’s see how it all works with an example.
Trader Charlie thinks that the US Dollar will rise in value against the Euro (which means, the price of the USD/EUR pair will go up).
He thus takes a long position on the pair. Here are the possible outcomes for Charlie:
|FX Pair: USD/EUR||Pair price||Outcome (Long position)|
|USD strengthens||From 1.3456 to 1.3476 (Up)||Profit of 20 points|
|USD weakens||From 1.3456 to 1.3406 (Down)||Loss of 50 points|
However, if Charlie thought the US Dollar would instead weaken against the Euro (or, put another way, the Euro strengthens against the Dollar), he would instead take a short position on the pair.
Here are the possible outcomes in this case:
|FX Pair: USD/EUR||Pair price||Outcome (Short position)|
|USD strengthens||From 1.3456 to 1.3476 (Up)||Loss of 20 points|
|USD weakens||From 1.3456 to 1.3406 (Down)||Profit of 50 points|
(For a quick recap on short and long positions, read our Options Trading guide.)
Forex trading vs stock trading: What’s the difference?
|Forex trading||Stock trading|
|Making bets on prices of currencies in a pair||Buying and selling shares of a company|
|Highly volatile||Less volatile|
|Requires high amount of discipline and advanced knowledge for success||Can succeed with simple strategies|
|Common to trade on leverage, which can boost profits but also amplify losses||Need not use leverage to trade|
|Can trade with very little capital||May require substantial capital|
|Suitable only for selected traders||Suitable for most traders and investors|
Reasons to participate in forex trading
1: Forex trading is fast moving
Due to the highly volatile nature of currency prices, forex trades typically move very fast. Most traders will close their positions the moment they turn a profit, and are unlikely to hold on if their trade goes against them.
This means that fx trades are usually made and completed at a very fast rate, which may be appealing to certain types of traders.
2: Can start trading with little capital
You can start trading forex with as little as $100, which is attractive to those with little capital. In this sense, forex trading has a lower barrier to entry than stock trading, which requires a far higher sum of capital in order to buy top-rated stocks.
3: Trades may be made on high leverage
Trading on leverage isn’t limited to forex. However, leveraged trading is very common among forex traders, especially among those seeking to quickly amplify their profits.
Forex trades may be made on leverage as high as 50x. While this can generate a large amount of profit, losses are similarly multiplied, making leveraged forex trading a highly risky activity.
Potential pitfalls of forex trading
The volatility is not for the faint-hearted
Turn on your favourite currency conversion app and you’ll see the prices changing from minute-to-minute. That’s how volatile forex trading can be.
Currency prices change throughout the day. Now imagine you’ve opened a $10,000 position, waiting for the price to fall. However, it seems like the price is going against you, creeping upwards with every tick of the clock.
What would you do? Hold on to your position in the belief that the price will swing your way? Or close your position to prevent taking an even larger loss?
Btw, while there is technically no limit to how long you can hold your position, you may incur overnight fees and other charges as you do. So, you know, no stress!
Leveraged trades are common
Forex trading is a highly emotional game, and even those who pride themselves on having nerves of steel will find themselves sorely tested.
Part of the temptation stems from the common and widespread use of leverage, which basically means trading on borrowed money. Leverage allows you to boost the amount of money in your trade, even if your starting capital is a fraction of the amount.
With the larger sum, profits are boosted, allowing traders to quickly accumulate a large gain. However, the opposite is also true. Leverage will similarly amplify your losses, which means a bad trade can wipe out all your profits and capital, and even put you in debt.
Success takes work, and luck
Let’s be clear. Forex trading is simple on the surface, but if you want to be able to make the right calls, you’ll need to spend a lot of time and effort to study the underlying factors that affect currency prices.
This entails keeping up with current affairs, and having a thorough knowledge of history and economics. Being able to understand highly technical subjects like monetary policies and to predict socio-economic trends will also be helpful.
Calling it a complex task is an oversimplification.
And even then, there’s no way to know for sure if you’re making the right call. The outcome of your trade could turn on a whim, depending on which way Lady Luck decides to go.
How to start trading forex in Singapore
All forex trades have to be conducted over-the-counter, so the easiest way to trade forex is to do so with an online broker.
Popular brokers offer a wide selection of fx pairs, competitive trading fees, well-designed trading interface and convenient funding options.
Some good quality brokerages also offer beginner guides, news and educational material that can help increase your chances of success.