The forex (FX) market has many similarities to the equity markets; however, there are some key differences. This article will show you those differences and help you get started in forex trading.
Choosing a Forex Broker
There are many forex brokers to choose from, just as in any other market. Here are some things to look for:
- Low Spreads. The spread, calculated in "pips," is the difference between the price at which a currency can be purchased and the price at which it can be sold at any given point in time. Forex brokers don't charge a commission, so this difference is how they make money. In comparing brokers, you will find that the difference in spreads in forex is as great as the difference in commissions in the stock arena. Key takeaway: Lower spreads save you money!
- Quality Institution. Unlike equity brokers, forex brokers are usually tied to large banks or lending institutions because of the large amounts of capital required (leverage they need to provide). Also, forex brokers should be registered with the Futures Commission Merchant (FCM) and regulated by the Commodity Futures Trading Commission (CFTC). You can find this and other financial information and statistics about a forex brokerage on its website, the website of its parent company or through the Financial Industry Regulatory Authority's BrokerCheck website. Key takeaway: Make sure your broker is backed by regulatory agencies and a reliable institution!
- Extensive Tools and Research. Forex brokers offer many different trading platforms for their clients – just like brokers in other markets. These trading platforms often feature real-time charts, technical analysis tools, real-time news and data and even support for trading systems. Before committing to any broker, be sure to request free trials to test different trading platforms. Brokers usually also provide technical and fundamental information, economic calendars and other research. Key takeaway: Find a broker who will provide the tools to succeed!
- Wide Range of Leverage Options. Leverage is necessary in forex because the price deviations (the sources of profit) are merely fractions of a cent. Leverage, expressed as a ratio between total capital available to actual capital, is the amount of money a broker will lend you for trading. For example, a ratio of 100:1 means your broker would lend you $100 for every $1 of actual capital. Many brokerages offer as much as 250:1. Remember, lower leverage means lower risk of a margin call, but also lower bang for your buck (and vice-versa). Key takeaway: If you have limited capital, make sure your broker offers high leverage. If capital is not a problem, any broker with a wide variety of leverage options should do. A variety of options lets you vary the amount of risk you are willing to take. For example, less leverage (and therefore less risk) may be preferable for highly volatile (exotic) currency pairs.
- Account Types. Many brokers offer two or more types of accounts. The smallest account is known as a mini account and requires you to trade with a minimum of, say, $250, offering a high amount of leverage (which you need in order to make money with this size of initial capital). The standard account lets you trade at a variety of different leverages, but it requires a minimum of $2,000. Finally, premium accounts, which often require significantly higher amounts of capital, let you use different amounts of leverage and often offer additional tools and services. Key takeaway: Make sure your broker uses the proper leverage, tools, and services relative to your amount of capital.
Broker Actions to Avoid in Forex Trading
- Sniping or Hunting. Sniping and hunting – defined as prematurely buying or selling near preset points – are inappropriate acts committed by brokers to increase profits. Unfortunately, the only way to determine the brokers that do this and those that do not is to talk to fellow traders. There is no blacklist or organization that reports such activity. Key takeaway: Be sure to conduct thorough due diligence prior to selecting a broker.
- Strict Margin Rules. When you are trading with borrowed money, your broker has a say in how much risk you take. As such, your broker can buy or sell at their discretion, which can be a bad thing for you. Let's say you have a margin account, and your position takes a dive before rebounding to all-time highs. Even if you have enough cash to cover, some brokers will liquidate your position on a margin call at that low. This action on their part can cost you a significant amount of capital. Key takeaway: Again, this underscores the importance of conducting a fair amount of due diligence prior to hiring a broker.
Signing up for a forex account is similar to getting an equity account. The only major difference is that for forex accounts, you are required to sign a margin agreement. This agreement states that you are trading with borrowed money, and, as such, the brokerage has the right to intervene in your trades to protect its interests. That said, once you sign up and fund your account, you'll be ready to trade.
Defining a Basic Forex Trading Strategy
Technical analysis and fundamental analysis are two of the oft-used strategies in the forex market. Technical analysis is by far the most common strategy used by individual forex traders, which we'll explain in further detail below.
If you think it's difficult to value one company, try valuing a whole country! Fundamental analysis in the forex market is very complex, and is often used only to predict long-term trends; however, some traders do trade short term strictly on news releases. There are many fundamental indicators of currency values released at many different times such as:
These reports are not the only fundamental factors to watch. There are also several meetings where quotes and commentary can affect markets just as much as any report. These meetings are often called to discuss interest rates, inflation, and other issues that affect currency valuations. Even changes in wording when addressing certain issues – the Federal Reserve chairman's comments on interest rates, for example – can cause market volatility. Therefore, two important meetings for forex traders to watch are the Federal Open Market Committee and Humphrey Hawkins Hearings.
Simply reading the reports and examining the commentary can help forex fundamental analysts gain a better understanding of long-term market trends and allow short-term traders to profit from extraordinary events. If you choose to follow a fundamental strategy, be sure to keep an economic calendar handy at all times so you know when these reports are released. Your broker may also provide real-time access to this type of information.
Technical analysts of the forex analyze price trends, similar to their counterparts in the equity markets. The only key difference between technical analysis in forex and technical analysis in equities is the timeframe, as forex markets are open 24 hours a day. As a result, some forms of technical analysis that factor in time must be modified to factor in the 24-hour forex market. These are some of the most common forms of technical analysis used in forex:
Many technical analysts combine these studies to make more accurate predictions. (i.e., the common practice of combining the Fibonacci studies with Elliott Waves.) Others create trading systems to repeatedly locate similar buying and selling conditions.
Finding Your Forex Trading Strategy
Most successful traders develop a strategy and perfect it over time. Some focus on one particular study or calculation, while others use broad spectrum analysis to determine their trades. Most experts suggest trying a combination of both fundamental and technical analysis in order to make long-term projections and determine entry and exit points. That said, it is the individual trader who needs to decide what works best for him or her (most often through trial and error) in the end.
Forex Trading Considerations to Remember
- Open a demo account and paper trade until you can make a consistent profit. Many people jump into the forex market and quickly lose a lot of money due to taking on too much leverage. It is important to take your time and learn to trade properly before committing capital.
- Trade without emotion. Don't keep "mental" stop-loss points if you don't have the ability to execute them on time. Always set your stop-loss and take-profit points to execute automatically, and don't change them unless absolutely necessary.
- The trend can be your friend. If you go against the trend, make sure you have a good reason. That's because you have a higher chance of success in trading with the trend because the forex market tends to move in that direction than the other.
The Bottom Line
The forex market is the largest market in the world, and individuals are becoming increasingly interested in plying their trade in FX. However, there are multiple considerations to take into account before you begin trading, such as being sure your broker meets certain criteria and understanding a trading strategy that works best for you. One way to learn to trade forex is to open up a demo account and try it out.