Forex trading is the process of exchanging currencies in an effort to earn a profit. The FX market is the largest market in the world based on transaction volume. It is also the most liquid and fast paced market known to investors.
As a beginner, forex trading can be daunting. By the end of this guide, you will understand how forex trading works, the benefits and drawbacks, and how to open a forex trading account.
What is forex trading?
Forex is short for foreign exchange. The foreign exchange market, also known as the FX market, is the world’s most traded market. It has a turnover of approximately $5.1 trillion per day. To put this into perspective, the US stock market trades roughly $257 billion per day.
Forex trading occurs when currencies are traded in the foreign exchange market. The forex market is open 24 hours a day, 5 days a week. There is no centralized marketplace for forex. Rather, currencies are traded in whatever market is open at the time.
The forex market is known for being:
- Fast paced:
Currencies are traded 24 hours a day, 5 days a week. When the market closes in one country, it opens in another – so prices are changing constantly. - Extremely big:
The forex market dwarfs the stock market in terms of the sheer value of trades being made. Figures change constantly, but the forex market typically sees trillions of dollars of trades being made every day. - Decentralized:
There isn’t a centralized forex marketplace where you are able to make trades. Instead, buyers and sellers make direct over-the-counter deals with each other wherever foreign currency can be exchanged. - High liquidity:
Liquidity refers to how easily an investment – in this case currency – can be bought and sold without its value being affected and how easily it may be exchanged for other assets. Currency is the asset with the highest liquidity.
How does forex trading work?
All forex trades involve simultaneously buying one type of currency and selling another. These are known as currency pairs. Think of each currency pair as a different individual product which is bought and sold. The first currency listed is known as the base currency, while the second is the quote currency.
Example: CAD/USD = 0.75
- The Canadian dollar (CAD) is the base currency and the US dollar (USD) is the quote currency.
When you buy a currency pair, you are buying the base currency and implicitly selling the quote currency. The opposite applies when selling a currency pair, where you are selling the base currency and implicitly buying the quote currency.
- If you buy this currency pair, you are buying CAD at a rate of $0.75 CAD per $1 USD.
- If the Canadian dollar goes up in value relative to the American dollar between the time when you buy and sell this currency pair, you will have made a net profit.
The bid is the buying price. It refers to how much of the quote currency you need to buy one of the base currency. The ask is the selling price and it refers to how much of the base currency you will need to sell to get one of the quote currency.
- The bid would be 0.75 because you need $0.75 in CAD to buy one full US dollar.
- The ask would be 1.33 because you need to sell $1.33 in Canadian to get one US dollar.
Just because you’re in Canada, it doesn’t mean you can only trade Canadian dollars – you might buy a currency pair of euros and Japanese yen (EUR/JPY = 114.41). The key to actually making money with forex trading is to have an understanding of how currency values are likely to change. If you aren’t following shifts in both the euro and the Japanese yen, then that particular trade may not be a good idea.
Pros and cons of forex trading
Pros:
- Liquid investment. The forex market is the largest in the world in terms of daily trading volume. Because of this, the assets held in the market are the most liquid. Entering and exiting the market is very easy.
- Market is almost always open. The forex market is open 5 days a week, 24 hours a day. Each day starts in Australia and ends in New York. Major centres include Sydney, Tokyo, Hong Kong, Singapore, New York, London, Paris and Frankfurt.
- Legal in Canada. In some parts of the world, forex trading is illegal. You might be wondering, is forex trading legal in Canada? Yes, it is legal in Canada, but there are rules and regulations you must understand and follow.
Cons:
- High leverage. Banks, brokers and dealers allow a high amount of leverage in the forex market. For this reason, traders can control a large portion of the market without investing much money of their own. Too much leverage can result in a trader becoming suddenly insolvent.
- Knowledge and understanding. In order to successfully trade currencies, traders require knowledge of economics – more specifically, an understanding of international economics and how countries function together.
- Small profit margins. The profit margins per transaction are small. Normally, you need to invest a large sum of money to make a sizable profit in the forex market.
- High risk. Forex trading is subject to a lot of regulations, you need a deep understanding of world economics and a big investment. There is a lot of risk involved with forex trading, especially for beginners.
What should I watch out for?
Before you start trading forex, research and understand the risks involved with this sort of trading.
- Even though you’ll put down only a small percentage of the value of your trade up front, you are ultimately responsible for the entire amount of your trade.
- Forex rates are volatile and can quickly move against you, possibly resulting in a significant loss of money.
- Markets are open 24 hours a day, which can result in devoting plenty of time to tracking open positions.
- Predicting currency markets is difficult, and a wide range of factors affect currency pairs.
- Even a stop-loss order — a hedging tool designed to minimize your losses — offers only limited protection against the risks involved.
How do I make money off forex trading?
Remember, the actual asset you are buying and selling is currency pairs. Your profits depend entirely on how the value of those 2 currencies change relative to each other.
The margins on forex transactions can be quite small, for example, a smart trade might net you a profit of 1 cent on every dollar. This means that traditionally, you could only make real money on the forex market if you could afford to invest huge sums. However, now everyone can stand to make reasonable returns thanks to the widespread use of leverage, also known as buying on margin.
Buying on margin is a relatively safe way of financing your trading with the effect of magnifying your profits and losses. Buying on margin involves having a broker put up some of the money for an investment and you putting up the rest. This money combined lets you make bigger investments for potentially bigger profits, but poor investments mean the losses are bigger too.
Example: You have $2,500 to invest in a currency pair
You’re feeling good about the odds of making a profit on a particular currency exchange, so you decide to leverage your potential earnings by getting an additional $2,500 from your broker. Now you have $5,000 total to invest.
- If your forex investment goes up in value and is now worth 10% more, a $2,500 investment (without leverage) would net you $250 profit. A $5,000 investment (with leverage) would get you a $500 profit.
- If the forex investment goes down in value then your losses are also magnified. If your margin account drops below a certain value then your broker may require you to put more funds into it or close it and extract the remaining funds to cover their losses.
Predicting currency movements
The key to making smart trades is to understand the market. With forex, that means understanding the international currency market and foreign exchange rates. It’s important to keep up with the news and keep an eye out for factors that may affect currency values, like strong economic growth, natural disasters or political strife.
Want to learn more about how to make smart trades? Read up on some strategies that may help.
How to get started?
To start forex trading, you’ll need a forex trading account. Using an account, you can access features like margin accounts, leverage and a wealth of research and market analysis tools. For practical purposes the only viable forex trading accounts for individuals are based online. This is because only electronic mediums can keep up with the pace of forex trading.
How to open a forex trading account:
- Once you choose a platform, you can sign up for forex account online. This usually takes about 5-10 minutes.
- You will need to provide your name, SIN, date of birth, address, contact details, residence information and proof of identification.
- Some providers may require you to provide different levels of personal financial information.
- Depending on the platform, you may also be required to provide your employment status and previous trading experience.
How to choose a forex trading platform?
There are a variety of options available, each with different benefits. Compare them by asking the following questions:
- What are their brokerage fees?
- What types of trades can I do with them? Only forex or shares too?
- Do they offer helpful information and advice?
- How easily can I link my trading account with my bank account?
More questions?
Do you keep running into terms you don’t know? Try keeping our glossary handy.
Do you have a specific question you still need answered? Look for it in the forex FAQ.
Frequently asked questions
Disclaimer: This information should not be interpreted as an endorsement of futures, stocks, ETFs, CFDs, options or any specific provider, service or offering. It should not be relied upon as investment advice or construed as providing recommendations of any kind. Futures, stocks, ETFs and options trading involves substantial risk of loss and therefore are not appropriate for all investors. Trading CFDs and forex on leverage comes with a higher risk of losing money rapidly. Past performance is not an indication of future results. Consider your own circumstances, and obtain your own advice, before making any trades. Read the Product Disclosure Statement (PDS) and Target Market Determination (TMD) for the product on the provider's website.
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What are forex options?
A foreign exchange option offers flexibility and could insulate you from poor exchange rates.