How To Trade In Forex For Beginners
Are you considering investing in Forex Trading? If you are, there are at least five things you should know prior to jumping right in. Foreign exchange trading has multiple nuances that are different that investing in stock trading. In this article, I go through what the forex market is, five of the basic terms and reasons why it might be a good addition to your portfolio.
What Is Forex Trading?
Foreign exchange trading is also called Forex or FX. If you have had a chance to travel to a foreign country you’ve probably already started investing in forex trading. It happens when you come across the various kiosks where you can buy dollars of the local currency. There is usually a fee associated with this. In addition, it’s a tangible exchange of one monetary vehicle for another. This is a form of Forex trading, but for this article I will reference the concept of actively trading various foreign currency at one time versus physical dollar exchange.
The Forex market is the largest in the world but not often used in the general sense of investing by most investors. Usually, this is because currency trading is considered riskier than stock trading. The FX market is very active and involves somewhat complex trading strategies. For this reason, most financial advisors would not recommend this type of trading to be suitable for retirement planning. It is my goal to introduce you to the world of Forex trading only. Your individual investment goals may vary, so I would not recommend or discourage forex trading.
That being said, Investing in Forex trading can be very lucrative. In a general sense, Forex trading is betting on one currency going up against others. If you buy US dollars against Euros, you are expecting the US dollar to appreciate against the Euro. The quoting process also looks a little different, which we will go through in the next section on Quoting.
Know The Basics
When I first started forex trading, I discovered five things that were very important, if you want to have any idea what you are doing in currency trading. Those were; understanding the quote, the various lot sizes, leverage and capital requirements and the time factor associated.
Quoting
I put quoting first, because ultimately, you have to understand what you are looking at in order to trade it. When trading stock, you see a quote of 55.05 / 55.07. This means a bid of 55.05 and an ask of 55.07. The quoting of forex is similar; however, you may see this type of quote in forex: EUR/USD 1.20037 / 57. If we break down this quote further, we understand the bid to mean the price at which we sell the investment and the ask is the price we pay to buy the investment. So, in the terms of currency quoting, the base currency, the EUR (Euro) is always on the left and the counter currency is always on the right. The 1.20037 is in US dollars. So, if we were selling EUR, we would get 1.20037 per US dollar we were trading.
Bid and Ask Further Defined
Now if we decide to buy US dollars, this is where the 57 comes into play. Since the base currency is at 1.20037, the ask is expressed as 57. This means that to buy EUR, we would need to pay 1.20057 US dollars per EUR. Therefore, maybe an easier representation of the quote is Bid: 1.20037 Ask: 1.20057 in US dollars for EUR. The spread is .00020. Every quote in Forex is expressed in a pair. You are always buying or selling the base currency (the one on the left).
The purpose of the bid price being lower than the ask price, when investing in forex trading, is for the market makers or brokers to make money off of the spread. They buy your dollars at the bid price they sell your dollars to other investors at the ask price, profiting off of the difference. Did I mention Forex trading was a little more complex than stock trading? Although, the bid and ask concept is the same in stock trading.
PIP
In the previous paragraph about the bid and the ask, we saw that the spread was .00020 or 20 PIPs on a standard lot. This can be translated into 20 dollars of movement when holding a standard lot of currency units. A pip is simply a unit of measurement based upon the lot size you hold. A standard lot is 100,000 units.
Don’t worry, most individual investors trade in smaller lots. In fact, most investors trade in mini and micro lots. It would not be a very good strategy for an individual investor to start with standard lot trading.
Lot Sizes
Another interesting nuance that should be called out are the various lot sizes in Forex trading. Mostly in stock trading we consider a lot of 100 shares and you buy in terms of lots, so 5, 10 or 15 lots would be 500, 1000 or 1500 shares, respectively. In Forex, they have three lot sizes; micro lot (1,000 units), mini lot (10,000 units) and standard lot (100,000 units). The typical lot size for most individual investors is a micro lot or mini lot. To understand the pip movement on a micro lot, just move the decimal place 2 to the left. On our previous example, the spread would then be .20 PIPs or 20 cents.
Capital Requirement and Leverage
In order to start investing in Forex trading, reason would stand that you need to deposit some money. A benefit of Forex Trading is that the minimums to entry are very low. If you started with 100 dollars buying micro lots, remember that when buying micro lots, PIPs are equal to 10 cents. (Move the decimal place…yes that’s right) So, when you are placing any stop loss on your trade, and you want to manage your downside risk by a move of two percent, tow percent of 100 is two dollars. So you would set your stop loss at 20 PIPs (Two dollars in this scenario). As with other investments, the potential for higher gains depends on the amount you are willing to invest
Leverage in Forex Trading is a huge factor. In a stock trading account, you may use leverage depending on what you are buying, we call that going on margin. In a Forex account, you can use leverage on most everything. Plus, the requirement may be a low as 50 to 1. Meaning that with for every 1 dollar invested it purchases 50 units of currency. Using leverage is a highly risky strategy and should only be optimized with a seasoned trader.
Disclaimer: I receive affiliate compensation for some of the links in this post at NO cost to you. However, these are the best tools I have used and tested that I believe are most effective for launching and running an online business. You can read our full affiliate disclosure in our privacy policy. Also, I am not a licensed advisor, any information within this article is purely my opinion and not an endorsement of an investing strategy.
Reasons To Start Trading Forex
There are multiple reasons someone would consider investing in the Forex market. I have mentioned several above, but three of the most important in my opinion are: Diversification, Time and Liquidity.
Diversification
When using Forex trading as an additional tool in your investing bag, it spreads your risk overall. If you are solely in the stock market, you will miss out on several factors that affect the company or companies you are trading. Foreign exchange is hugely important with many of the US companies. Foreign exchange affects the value of the goods or services exchanged overseas. Trading in the Forex market is a good way to become diversified in international investment. Also, as a hedge, Forex can be very useful, especially when trying to work against inflation.
Time Factor
This is one that I personally feel as equally passionate about as diversification. Since the currency markets are worldwide, the Forex exchange never sleeps during the week. If you are an early riser like me, maybe you want to get your trades in for Forex at 4 or 5am, a good 4 plus hours before the US stock market opens. The only time the Forex market is closed is Saturday and Sunday.
Liquidity
One of the various ways to test a viable investing scenario is to confirm liquidity. If you remember in my post on ‘Penny Stocks’ we discussed how important liquidity was in that market, well Forex trading is highly liquid and trades constantly. This is a huge advantage if you want to get in to a trade quickly or get out of a trade quickly. Since this market is international and you aren’t focused on the sentiment of a company, more so the sentiment of a country, it is the largest market in the world.
My Final Take
If all this scares you and you are more comfortable investing in the stock market because that is what you know, don’t worry, there are alternatives. There are mutual funds and ETFs that offer exposure to the currency markets. Work with your brokerage firm to understand any particular advantages or disadvantages they offer.
That being said, Investing in Forex Trading is an excellent option for many of the reasons listed above. One thing to consider prior to jumping into Forex trading is that most brokerage firms allow a demo account and this should be utilized prior to investing your own money. Get a feel for how things work in the Forex market and then start using your own money. I still firmly believe that this should be only one of the ways to make money.
Remember millionaires and billionaires have multiple streams of income. If you are going to start trading Forex, manage your risks affectively. Make sure you work with a reputable broker, understand using leverage and learn about the economy for the currency you are trading. Forex can be an exciting and profitable addition to your portfolio. I wish you all the luck. Happy Trading.
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