Introduction to Forex Trading

1.1 What is Forex Trading

Foreign exchange, or forex in short, refers to the exchanging of one currency for another for various purposes, such as for tourism, or cross-border business transactions. 

Due to the global nature of commerce and travel, forex markets rank among the world’s largest and most liquid markets. According to the Bank of International Settlements, global trading volume for forex in 2022 reached USD 7.5 trillion per day. [1] 

In comparison, global equity trading across stock markets worldwide was estimated to be just USD 41.35 trillion for the last three months of 2021. [2] 

This means that on the whole forex markets are much larger and offer more liquidity, which makes these markets inherently more resistant to manipulation. This is a key reason why some investors prefer to trade forex over stocks and shares. 

1.2 Who Trades Forex 

Forex trading used to be dominated by banks, institutional investors like hedge funds, and the wealthy, due to the large amount of capital required. However, the introduction of online brokerages paved the way for individual investors to participate in forex trading.

Retail investors trade forex for a number of reasons, besides the expectation of profit. Forex trading can also be used to hedge against currency risk, for portfolio diversification, or to speculate on geopolitical events such as elections. 

Hence, you’ll find a wide variety of different investors engaging in forex trading, such as 

• Those who want to generate passive income
• Traders who only have time to trade during the night
• Investors who understand the interconnectedness of currency pairs
• Individuals interested in macroeconomics and forex, and who are eager to develop and test their own theories

1.3 How Does Forex Trading work?

The idea behind forex trading is simple. A trader buys one currency and sells it for another, attempting to make a profit from a favourable exchange rate. The exchange rate between a pair of currencies fluctuates in response to supply and demand. 

Illustration: Profiting at the money changer 

Let’s assume the exchange rate between USD and SGD is 1.34 (USD 1 = SGD 1.34). You go to a money changer and trade in USD 1,000 to receive SGD 1,340. 

Two weeks later, the exchange rate between USD and SGD dropped to 1.30. If you go back to the money changer to sell your stash of SGD for USD at this time, you will receive USD 1,030.77. This gives you a profit of USD 30.77.

Note that this example ignores the money changer’s fee for providing the service – this is known as the spread, explained further below.

In practice, forex trades are executed online without the need for physical currency notes to change hands.

Example: Forex trading in action

Let’s assume you want to trade the forex pair USD/JPY, which has an exchange rate of 139.91. In other words, USD 1 will get you JPY 139.91.

You assess that the Dollar is likely to strengthen against the Yen, hence you open a long trade on USD/JPY with USD 100,000. Let’s see how the change in the exchange rate at the time you close your trade affects your outcome. 

Scenario 1: USD/JPY 139.91 >>> 145.91

In this case, the Dollar has grown in value against the Yen, proving your guess to be correct. Hence, your profit would be 100,000 x (145.91 – 139.91) = JPY 600,000. 

Converting from JPY to USD, your profit from the trade would be JPY 600,000/145.91 =  USD 4,112.12.

Scenario 2: USD/JPY 139.91 >>> 129.91 

In this case the Dollar has fallen in value against the Yen, which means your guess was wrong. Your loss would be 100,000 x (139.11 – 129.91) = JPY 1,000,000.

Converted back to USD, your loss on the trade would be JPY 1,000,000/129.91 = USD 7,697.63.

However, if instead of opening a long position, you took a short position, you would be in profit should Scenario 2 happen (and conversely, take a loss in Scenario 1).

1.4 Common Forex Jargon 

Since forex trading has its own unique terms, it’s advisable to familiarise yourself before jumping in. Here are some common forex jargon, and what they mean. 

• Bid-ask spread

Or simply “spread” for short, the bid-ask spread is the difference between the minimum amount a seller is willing to sell at (ask) and the maximum price a buyer is willing to pay (bid). It’s important to pay attention to the spread when trading forex due to its ability to impact your results. 

• Contract-for-Difference (CFD)

In forex trading, CFDs are used to speculate on the price movement of currencies without owning the underlying assets.

• Currency pair

All forex trading is performed on currency pairs, which is expressed as “base/quote”. In USD/JPY the Dollar is the base currency, and the Yen, the quote currency. Thus, USD/JPY indicates that we are comparing the value of USD against JPY. Meanwhile EUR/USD indicates comparing the value of the Euro against the Dollar.

• Exchange rate

The rate at which one currency can be exchanged for another. In forex trading, the exchange trade is always expressed as “base currency” for “quote currency”. 

• Leverage

Leverage is a way for traders to amplify their trading power without having to put up a large amount of starting capital. It is common in forex trading, due to the traditionally used lot of 100,000 units per trade.

• Long position

A trading position taken in expectation of increase in the value of an asset. In forex trading, you’d open a long position if you think the base currency would strengthen against the quote currency.

• Lot

Traditionally, forex trades are executed in lots of 100,000 units of the base currency. Hence, in USD/AUD, one lot would be equivalent to USD 100,000, two lots would be USD 200,000, etc. However, micro lots (1,000 units ) and mini lots (10,000 units ) are also offered for trading by brokers.

• Pip

Percentage-in-points, referring to the smallest possible price change within a currency pair. Because forex prices are quoted out to at least four decimal places, a pip is equal to 0.0001

• Short position 

A trading position taken in expectation of decrease in the value of an asset. In forex trading, you’d open a short position if you think the base currency would weaken against the quote currency.

1.5 The Different Currency Pairs 

With approximately 180 currencies available in the forex markets, here’s a quick classification of these currencies and the reasons for the classifications. 

The Variety 

Out of the 180 currencies available, there are six currencies that dominates the rest. The reason behind this is that these six represent some of the largest global economies and are usually traded in high volumes.  

The USD (US Dollar), The EUR (Euro), The GBP (Great British Pound), The JPY (Japanese Yen), and The CAD (Canadian Dollar). 

The Types 

As mentioned in lesson 1.1, the trading of the forex market is done of two currencies, also known as current pairs. Currency pairs can be categorised in three classifications: Major, Minor, and Exotic.  

• Majors

Major currency pairs are the go-to for many traders, consisting of the US dollar and another major currency like the euro, yen, or pound. With names like EUR/USD, USD/JPY, and GBP/USD, these pairs offer high liquidity, tight spreads, and low transaction costs. 

Examples of majors include: EUR/USD, USD/JPY, GBP/USD

• Minors

However, for those who want to spice things up, minor currency pairs, also known as cross pairs, offer a way to trade major currencies against each other without the US dollar. Think EUR/GBP, GBP/JPY, and CHF/JPY. These pairs may have wider spreads and increased volatility, but they also offer diversification potential for traders looking to expand their portfolios. 

Examples of minors include: EUR/GBP, GBP/JPY,CHF/JPY

• Exotics

If you’re really looking for adventure, exotic currency pairs might be right up your alley. Made up of less common currencies like the Mexican peso, South African rand, or Turkish lira, these pairs are paired with major currencies like the US dollar or the euro.  

Examples of exotics include: EUR/CZK, EUR/SEK, EUR/TRY

Unique Nicknames for Currency Pairs 

“Cable” is the nickname given to GBPUSD. With the advancement of communications during the mid-1800s, forex rates for GBPUSD were communicated using cables that ran across the Atlantic Ocean. 

The Euro (EUR/USD), being a much newer currency than the pound, gained the nickname “Fiber” as it was an upgrade from cables. The inspiration for the nickname came from the lightning-fast fibre optics which took over the usage of cables in exchanges.  

Finally, the “Loonie” represents USD/CAD. The loon, a common bird which is featured on the flip side of Canada’s dollar coin. The nickname Loonie was so popular that the Royal Canadian Mint trademarked the term back in 2006.  

CTA: Check out a more in-depth article regarding the different types of forex markets here.  

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