To trade Forex, open a trading account, analyze currency pairs, use technical and fundamental analysis, set a trading strategy, manage risk, and execute trades through a platform. Continuously educate yourself to make informed decisions.
By now, you've acquired knowledge about what the forex market is, its immense size, the various currency types traded in pairs, and their significance.
But how exactly do you go about trading forex?
Let's delve into the methods for individuals to participate in the world of forex trading.
The allure of forex has led traders to explore various methods of investing or speculating in currencies. Among the most popular financial instruments are retail forex, spot FX, currency futures, currency options, currency exchange-traded funds (ETFs), forex CFDs, and forex spread betting.
It's essential to clarify that we are focusing on the diverse avenues available to individual ("retail") traders for forex trading. Other financial instruments like FX swaps and forwards cater more to institutional traders and are not within the scope of this discussion.
With that clarification in mind, let's proceed to explore how you can become a participant in the world of forex trading.
Futures contracts involve agreements to buy or sell a particular asset at a predetermined price on a specified future date (hence, they are termed "futures"). In the context of forex, a currency future is a contract specifying the price at which a currency can be purchased or sold, along with a specific date for the exchange.
Currency futures were introduced by the Chicago Mercantile Exchange (CME) back in 1972, a period when bell-bottoms and platform boots were the fashion trends of the day. These futures contracts are highly standardized and are traded on a centralized exchange, ensuring a high level of transparency and regulation.
This centralized trading environment means that price and transaction information are readily accessible and transparent to participants.
So, as an individual trader, you have various avenues to embark on your journey into the world of forex trading, with currency futures being one of the options available to you.
An "option" represents a financial instrument that grants the buyer the right, but not the obligation, to purchase or sell an asset at a predetermined price on the option's expiration date. If a trader "sells" an option, it means they are committed to buying or selling an asset at a specific price when the option reaches its expiration date.
Similar to futures, options are also traded on exchanges, such as the Chicago Mercantile Exchange (CME), the International Securities Exchange (ISE), or the Philadelphia Stock Exchange (PHLX). However, one drawback when it comes to trading FX options is that market hours are limited for certain options, and liquidity is not as abundant as in the futures or spot market.
A currency ETF provides exposure to either a single currency or a basket of currencies. Currency ETFs offer everyday individuals an opportunity to participate in the forex market through a managed fund, eliminating the need for individual trade placements.
These ETFs can serve various purposes, including speculation in the forex market, portfolio diversification, or hedging against currency risks. Financial institutions establish and manage ETFs by purchasing and holding currencies within a fund. Subsequently, they offer shares of this fund to the public on an exchange, allowing individuals to purchase and trade these shares just like they would with stocks.
Similar to currency options, one limitation when trading currency ETFs is that the market is not open 24 hours a day. Additionally, ETFs are subject to trading commissions and other transaction costs.
The spot FX market operates as an "off-exchange" market, commonly referred to as an over-the-counter ("OTC") market. This off-exchange forex market is a sizable, continually expanding, and highly liquid financial market that remains active 24 hours a day. It doesn't adhere to the traditional concept of a market with a central trading location or an "exchange."
In the OTC market, a customer engages in direct trading with a counterparty. Unlike currency futures, ETFs, and, for the most part, currency options, which are transacted through centralized markets, spot FX transactions are essentially over-the-counter contracts, representing private agreements between two parties. A significant portion of this trading occurs via electronic trading networks or telephone communications.
The principal arena for FX trading is the "interdealer" market, where FX dealers engage in transactions among themselves. A dealer functions as a financial intermediary prepared to buy or sell currencies with its clients at any given moment. This market is often referred to as the "interbank" market, given the substantial presence of banks as FX dealers.
Access to the interdealer market is restricted to institutions that conduct large-volume trades and possess substantial net worth. This category includes banks, insurance companies, pension funds, major corporations, and other prominent financial institutions that utilize it to manage the risks associated with currency rate fluctuations.
Within the spot FX market, an institutional trader engages in the buying and selling of an agreement or contract designed for the physical exchange of one currency for another. A spot FX transaction is a bilateral agreement between two parties for the immediate exchange of one currency against another.
This agreement takes the form of a contract, signifying a legally binding commitment to buy or sell a specified amount of foreign currency at the prevailing "spot exchange rate" or the current exchange rate. So, for example, when you engage in a spot market trade for EUR/USD, you are essentially participating in a contract stipulating that you will receive a predetermined quantity of euros in exchange for U.S. dollars at an agreed-upon price, which is the current exchange rate.
There exists a secondary over-the-counter (OTC) market that offers an avenue for retail traders, often with more modest financial means, to participate in the forex market. Access to this market is facilitated by entities known as "forex trading providers."
Forex trading providers operate on your behalf within the primary OTC market. They seek out the most favorable available prices and then apply a "markup" before presenting these prices on their trading platforms. This process bears similarity to how a retail store purchases inventory from a wholesale market, adds a margin, and displays a final retail price to its customers.
While a spot forex contract typically necessitates the delivery of currency within two days, in practice, very few individuals take physical possession of any currency when engaging in forex trading. Instead, positions are typically "rolled" forward on the delivery date. This practice is particularly prevalent in the retail forex market.
It's important to remember that in forex trading, you are essentially trading a contract designed for the delivery of the underlying currency, rather than the currency itself. Moreover, these contracts are leveraged, which means you can control substantial sums of currency with only a relatively small initial margin.
Retail forex traders cannot "take or make delivery" of leveraged spot forex contracts. Attempting to deliver the full value of the contract in cash would be infeasible, given the limited funds available in your account. For instance, if you opened a short EUR/USD position and were required to deliver $100,000 worth of euros, it would be impossible to settle the contract with just $2,000 in your account. Consequently, you would either need to close the trade before its settlement date or "roll" it over.
To circumvent the logistical complexities of physical delivery, retail forex brokers automatically "roll over" client positions. This mechanism ensures that you won't be compelled to accept or deliver 100,000 euros, for example.
Retail forex transactions are terminated by entering into an equal but opposing transaction with your forex broker. For instance, if you initially bought British pounds with U.S. dollars, you would close the trade by selling British pounds for U.S. dollars. This process is also referred to as offsetting or liquidating a transaction.
If you have an open position at the close of the trading day, it will be automatically rolled over to the next value date to avoid physical currency delivery. Your retail forex broker will continually extend the duration of your spot contract until you decide to close it.
This practice of rolling over currency pairs is known as "Tomorrow-Next" or "Tom-Next," signifying "Tomorrow and the next day." When positions are rolled over, it can result in either interest being earned or paid by the trader. These charges are commonly referred to as swap fees or rollover fees. Your forex broker calculates and manages these fees, either debiting or crediting your account balance accordingly.
Retail forex trading is primarily speculative in nature. This means that traders are seeking to "speculate" or make educated predictions about and profit from the movements in exchange rates. They are not aiming to take physical possession of the currencies they purchase or deliver the currencies they sell.
Spread betting is a derivative product, meaning you don't take ownership of the underlying asset but instead speculate on whether its price will move up or down.
Forex spread betting allows you to speculate on the future price direction of a currency pair. The price of a currency pair used in spread betting is "derived" from the currency pair's price in the spot FX market.
Your profit or loss is determined by how much the market moves in your favor before you close your position and the amount of money you've bet per "point" of price movement.
Spread betting on forex is offered by "spread betting providers." However, it's important to note that spread betting is considered illegal in the United States. Despite being regulated by the Financial Services Authority (FSA) in the United Kingdom, the United States regards spread betting as internet gambling, which is currently prohibited.
A contract for difference ("CFD") is a financial derivative that tracks the market price of an underlying asset, allowing traders to speculate on whether the price will rise or fall.
The price of a CFD is "derived" from the underlying asset's price. A CFD is essentially a contract between a CFD provider and a trader, where one party agrees to pay the other the difference in the value of a security between the trade's opening and closing.
In simpler terms, a CFD represents a bet on whether a specific asset will increase or decrease in value. The CFD provider and the trader agree that the winner of the bet will pay the other party the difference between the asset's price when the trade was entered and its price when the trade is exited.
A forex CFD is an agreement ("contract") to exchange the difference in the price of a currency pair between the time you open and close your position.
The price of a currency pair's CFD is "derived" from the currency pair's price in the spot FX market. Trading forex CFDs allows you to take positions in both the long and short directions. If the price moves in your chosen direction, you profit; if it moves against you, you incur a loss.
In the European Union and the UK, regulators differentiate "rolling spot FX contracts" from traditional spot FX contracts. This differentiation is primarily due to the fact that with rolling spot FX contracts, there is no intention to ever take actual physical delivery or ownership of a currency. The sole purpose is to speculate on price movements in the underlying currency.
Trading rolling spot FX contracts, therefore, falls under the category of CFDs. In the United States, CFDs are illegal, so it's referred to as a "retail forex transaction."
Forex CFD trading is provided by "CFD providers." Outside of the United States, retail forex trading is commonly conducted using CFDs or spread bets.