Forex Trading 101: 5 Fundamental Currency Trading Concepts
Disclaimer: This article has been produced using publicly available content for educational purposes only and does not constitute trading advice or a solicitation to buy or sell any financial instrument.
Learning to trade on the Forex market is incredibly exciting and can have significant pay offs. Of course, this means that it comes with a lot of risk. This best way to manage your risk and be successful is to learn the fundamentals and never stop learning after that. In this article we will explain what we believe to be the fundamentals of Forex trading but this guide is limited and you should do your own research to deepen your understanding. We will cover:
- Which Major Currencies Are Traded?
- Which Factors Most Heavily Influence Exchange Rates?
- How Can Leverage Can Work With You and Against You?
- How to Understand Interest Rates?
- Manage Your Risk
Which major currencies are traded?
A key difference between the Forex market and the stock market is the number of options you can buy from. The stock market has thousands of stocks that you can actively monitor and trade. Assuming you do your research and pick the right stocks, there are thousands of good stocks to buy and your hope is that the company’s growth outperforms the average market growth. In total, there are only 180 currencies in the world that can be traded. However, generally speaking, the currencies that are most heavily traded are known as ‘The Majors’. The Majors are the 8 currencies with the highest trade volume. These are:
- United States Dollar
- Euro (The currency of countries in the Eurozone, most notably Germany, France, Italy, and Spain)
- Japanese Yen
- British Pound
- Swiss Franc
- Canadian Dollar
- Australian Dollar
- New Zealand Dollar
These currencies are in the countries that have the most sophisticated financial systems in the world and have reliable economic data released daily. By sticking to these currencies, you are playing in the safest part of the Forex market and are best able to make accurate prediction swings.
Which Factors Most Heavily Influence Exchange Rates?
Though there are many economic factors that influence exchange rates the most important to follow is interest rates. We’ll dive into understanding interest rates a little deeper later in this article. Interest rates of a country are set by that country's central bank, with higher interest signalling that a country is experiencing higher economic growth.
Other important factors to consider when you are trading in the Forex market are economic growth (in terms of GDP among other indicators), unemployment, and the balance of trade between countries (the difference between imports and exports). If you are trading currencies it is important to follow general world news about The Majors because the value of currencies is heavily impacted by good or bad economic reporting coming out of countries. Say a country massively outperforms the expected economic growth for a quarter then the value of their currency will likely increase against others.
Finally, always remember that currency is traded in pairs (eg. USD/EUR is the Euro against the US Dollar). Currency is always valued in relation to other currencies, so the value of any currency is only ever in relation to other currencies. This can be a little tricky to get your head around so we would recommend spending some time saying out loud what difference currency pair rates actually mean.
How Can Leverage Can Work With You and Against You?
Forex is known as a market where lots of people trade with large amounts of leverage. Leverage is when you essentially borrow money from your broker to increase profits. The amount of leverage depends on the regulatory authority but can commonly be 1-100 and as high as 1-400. Though this opens a great opportunity for making bigger profits than your personal capital might have otherwise enabled, the opportunity to lose a lot of money quickly is also increased. Consequently, it is crucial to truly understand how leverage works and the risk associated with it before you make leveraged trades. There are plenty of horror stories where people have lost all their money in a short period of time because they are over leveraged.
How to Understand Interest Rates?
Understanding interest rates is imperative to making good Forex trades. Fundamentally, the direction of interest rate of a currency points you in the direction of where that currency is heading. If interest rates are rising, then it is a sign that the country is growing fast and the central bank wants to reign it in. This can get a little complicated to understand when you think about currency’s being traded in pairs. Yield and return are two key concepts to understand that are driven by interest rates.
Every currency has an interest rate set by the central bank that determines the yield you will gain from that currency. For example, say that the Euro has an interest rate of 5% then the Euro has a yield of 5. However, because currencies are traded in pairs you don’t earn all 5% of that yield. Your actual return will be the difference in interest rates between the two currencies in the pair you are holding. Furthering our example, let's say you are trading the Euro/British Pound pair (EUR/GBP) and the GDP has an interest rate of 2%. You will be earning 5% on the Euro but you will be paying the 2% interest rate for holding against the Pound. This means that your net return will be the 3% difference between the two currencies. Of course, you will also make gains if the Euro becomes more valuable in relation to the pound, which could be likely in this example given the Euro has a higher interest rate.
Manage Your Risk
All trading comes with significant risks and the Forex market is no different. It is important to figure out ways to manage and limit the amount of risk you are exposed to. Most online brokers have automatic stops in place to ensure that you don’t ever end up in a situation where you owe them more money than you’ve got in your account but you don’t want to end up in a situation where you lose all your money in the account. First of all, particularly when you are learning Forex trading, never put in more money than you can afford to lose. This way you won’t financially cripple yourself by making a beginner mistake.
It’s also important to know your limits and manage your emotions. You should set a lost limit for every trade you make to ensure that your downside is limited. It’s also important to manage your emotions because it can be easy to make poor decisions when you’ve just lost or gained a lot of money. Finally, learn about the different tools and strategies that you can employ to actively mitigate the risk of any position. Develop your own principles of Forex trading that can be proven quantitatively and stick with them in the long run. Of course, you modify these principles, but only do so if you have reasonable justification.