Retail forex trading: An introduction for active investors
If you’re looking to diversify your portfolio by trading international currencies, the retail foreign exchange (forex) market can provide an alternative assets route to accomplish this.
Forex is an exciting market. But it isn’t an easy one to learn or to trade. In a way, it’s still a specialist’s market. If you want to be one of the more successful speculators in this market, you have to know what you’re doing.
- The forex market offers an exciting but complex avenue for portfolio diversification.
- Forex trading differs significantly from stock trading in terms of valuation, payments, and trading hours.
- There are other ways to trade currencies, including ETFs and futures.
What is the foreign exchange market?
The foreign exchange market (also called forex or FX) refers to the over-the-counter (OTC) electronic networks where currencies are traded.
Contrary to how it might sound, there is no single venue or (physical or digital) marketplace for trading currencies. The “market” refers to the buying and selling that takes place through multiple payment or trading networks.
How can retail investors access the foreign exchange market?
You access the currency market using a trading platform that’s usually provided by or associated with a foreign exchange broker.
Here’s where investors often get confused. Banks are among the largest players in the forex world. So it would stand to reason that, if you trade forex, you’re trading on the “interbank” network. But that’s far from what’s actually happening.
Unless you’re trading upwards of a million currency units per trade (at least), your transactions are likely too small to be included on an interbank feed. Instead, you’ll probably be working with a liquidity platform (essentially a market maker) that’s providing the currency exchange quotes. The platform is typically the seller to your buy orders and the buyer of your sell orders.
How is retail forex trading different from trading stocks?
If you’re coming from the stock trading world, there are a few more adjustments that might be difficult at first. Here’s a short list:
Thinking in “pips.” Currency pairs move by “percentage in points,” more commonly known as pips. For most currencies, pips are measured using four decimal points, so 1 pip = 0.0001 (ten thousandths of a single currency unit).
Paying the spread. In forex, you often pay the difference between the bid and the ask, especially if you buy or sell using a market order. So if the bid price for a given currency is 1.0050 and the ask is 1.0052, the difference or “spread” is 0.0002, or 2 pips. In order to buy (or sell) into that market, you need to cross the bid/ask spread, so your indirect cost is 2 pips.
Calculating the value of a pip. If you’re trading, say, the value of the euro versus the U.S. dollar (EUR/USD), the monetary value of one pip will depend on at least two things: (1) Your domestic currency (whether it’s part of the currency pair you’re trading or not) and (2) your position size. If your home currency happens to be the base currency you’re trading, the conversion to pips is straightforward. But if your home currency is the Canadian dollar or the British pound, you’ll need to convert to your home currency in order to figure out your profit or loss from a EUR/USD trade. It’s a lot to unpack, so if you’re new to forex, it might be best to stick to currency pairs with your home currency as the numerator or denominator.
Position sizes come in different chunks. Some platforms allow lot sizes as small as 100 currency units, while others deal in minimum sizes of 1,000 or 10,000. The standard lot size in retail forex is 100,000 currency units. This is a big deal, because the amount of money that moves each pip can vary significantly depending on your lot size. Calculating the dollar-per-pip value of different lot sizes tends to throw off many a “noob” trader in forex.
Money never sleeps (except on weekends and some holidays). Currencies can move significantly during the European, American, and Pacific/Asian sessions within a 24-hour trading day, depending on the currency pair. Unlike the stock market, which has a closing period, forex trades 24 hours a day, five days a week (including some holidays). This means that if you hold a forex position past the current day, you may be pleasantly or rudely awakened to discover how your currency pair moved while you were asleep.
What happened to my balance? It’s a question that many new forex traders ask when encountering overnight forex rollovers for the first time. The rollover rate is the net interest return on currency pairs you hold after 5 p.m. ET. Remember that when you enter a forex trade, you’re borrowing one currency to buy another. If the interest rate on your “long” currency is higher than that of your borrowed currency, your account will be credited based on a positive net interest return. If the opposite is true and your net interest return is negative, you’ll have to pay the difference, and your account will be debited the amount you owe.
These examples just scratch the surface, but they’re among the primary differences that often catch new forex traders by surprise.
How can I approach trading the forex market?
Here’s some advice: Know your fundamental analysis and technical analysis.
The fundamental analysis part can be tough. Analyzing the fundamentals of a currency pair often involves studying the economic landscapes of two nations, not just one. That’s a lot of work, but if you’re looking to become a sophisticated currency trader, there’s no way around it.
The technical analysis part may be a bit more approachable, as technical chart patterns and indicators seem to be the same across all markets. In other words, classic chart patterns, candlestick patterns, and technical indicators and oscillators can apply to currency markets without significant modifications or adjustments.
What other ways can I trade currencies besides retail forex?
There are a handful of instruments you can trade to get exposure to foreign currencies. The most common, and perhaps the simplest, ways to go about it are through currency exchange-traded funds (ETFs) and currency futures contracts.
- Currency ETFs. There are several ETFs that track single currencies, currency indexes, and baskets of currencies. ETFs trade throughout the day—just like stocks—on stock exchanges, available through virtually all broker platforms, and profits and losses are settled at the end of each trading day.
- Currency futures. Futures contracts are highly leveraged instruments that represent a legal agreement to buy or sell a particular commodity or asset at a predetermined price at a specified time in the future. Mini and micro futures contracts are also available for most major currencies.
ETFs and futures also present their own unique risks, as every investment does. Get to know the mechanism of the instrument and the risks involved before trading.
The bottom line
Trading forex can bring a bit of culture shock; you have to adapt to unfamiliar customs and learn fragments of a new language. It can be exciting, but it’ll take time for you to get your bearings.
If you’re interested in trying your hand at forex, consider starting on a trading simulator (most of the top brokers and forex platforms offer them). A simulator lets you buy and sell—and track profits and losses—on prices as they exist in the real world, but with fake money. Learn the logistics, price dynamics, chart patterns, and even your emotions, before you speculate with real dollars, pounds, euros, or yen.