How to trade forex is a science, rather than an art form. This beginners guide on how to trade forex will introduce you to the forex markets and explain how retail investors gain access to this fast-moving and high stakes investment activity.
Warning: Trading forex remains a high-risk investment activity, and is not a simple alternative to buying shares or investing in property. Trading forex is considered high risk due to the leverage implicit in the stake offered by brokers. When trading with leverage, investment losses can actually exceed your original investment amount.
In general, trading forex is not recommended for beginners. FX trades should only be placed by:
- Sophisticated investors
- Individuals with a relevant professional background
- Enthusiasts who are satisfied that they have gained enough knowledge through investing courses such as Forex trading A-Z, offered on the Udemy education platform.
It goes without saying that you should only invest with money you can afford to lose. This guide is a piece of financial journalism and does not replace advice from a financial adviser.
How to trade forex – a beginners guide
An introduction to the foreign exchange market
The forex market is on many bases, the world largest financial market. Each day, more foreign currency is traded than stocks are traded on the worlds stock markets. The approximate total volume is in excess of $3 trillion per day.
What’s remarkable about this volume is that it easily exceeds the world’s total economic activity, or GDP, which is approaching $90 trillion. This means that a higher value of currencies change hands on a daily basis than real goods and services do in the real economy.
There are three main reasons behind the vast scale of the forex market:
The wholesale interbank market
Foreign currencies can be passed between multiple parties, including banks, dealers and clients, in connection with a single underlying transaction. If a business wishes to buy £1m of Euros, the Euros that arrive in their account may have passed through multiple hands before they appear on their statement. Indeed the vast majority of forex transactions are between banks themselves, in the perpetual back-and-forth movements of currencies between institutions to ensure each can meet their short term needs.
Central bank intervention
Some central banks transact on a large-scale to protect the value of their currencies. This is known as ‘pegging’ the value of a currency. It is done by accepting surplus sell orders or fulfilling surplus buy orders in order to maintain a balance of supply and demand at the target price. China is sitting on an estimated $3 trillion in foreign currency reserves, part of which will have arisen from transactions of this nature.
Leveraged speculation
Compared to the stock markets, the daily change in currency pairs is quite subtle. It is rare for a currency to gain or lose more than 1% of value in a single day.
Therefore, speculators tend to multiply the size of their bets to allow them to capture a reasonable profit from relatively small movements.
An investor with £1,000 might use it to buy shares worth £1,000. However, with the right forex broker account, a speculator could use £1,000 in capital to buy £20,000 of foreign currency. This is known as leverage, and I will cover this in more detail below.
Why do people use the forex market?
There are many different reasons for people to use the forex market in some form.
Businesses looking to hedge against forex risk from their operations.
For example, imagine a British company imports its goods from Europe and pays in Euros. The cost of these purchases will constantly fluctuate in GBP terms, each time the Euro rate moves. They could enter into an agreement with another party to fix a certain FX rate for dates in the future, which will provide them with certainty over the GBP cost of those purchases.
Tourists
Tourists travelling abroad. Travellers will exchange their domestic currency for the currency of their holiday destination at the spot rate using a retail forex bureau de change.
Large corporations borrowing in a foreign currency.
Companies do this occasionally to take advantage of lower interest rates available in overseas bond markets. Bonds issued in a different currency to the company are known as ‘Eurobonds’.
This fundraising will necessitate them to swap the proceeds for their own currency before they can actually use the money.
Forex traders wishing to profit from a movement in a currency pair
Forex traders, whether individuals or trading on account for an investment bank or hedge fund, will enter into FX deals to allow them to take advantage of a rise or fall in the value of a currency.
Which countries do the most forex trading?
The Bank for International Settlements (BIS) reported in 2019 that just five countries; the United Kingdom, the United States, Hong Kong, Singapore and Japan – initiated approximately 80% of all forex trades.
This data relates to the dealers and sales desks which work as the machinery of the forex market. The underlying clients and currency demand will have actually come from a much wider pool of countries. Ultimately, every economy needs easy access to foreign currencies to enable global trade – even North Korea.
How to begin trading forex – getting started
So how does a beginner actually trade forex? Can you use your stockbroker? Is it as simple as buying the currency you expect to appreciate?
Let’s look at these fundamental questions first before we discuss the financial instruments and trading strategies that investors use to trade.
The quick answer is that ordinary stockbrokers, fund supermarkets or share dealing accounts do not offer a full suite of forex trading tools.
Often, these platforms cater to buy-to-hold investors who are looking for a low-cost way to manage a long term portfolio, rather than day trading or forex trading.
Trading forex with your stockbroker account
However, it is still possible to trade forex with a stockbroker account.
Full-service stockbrokers such as Interactive Investor, Barclays and HSBC allow you to execute foreign exchange transactions. This is primarily to allow UK investors to buy shares denominated in a foreign currency (such stocks traded on the New York Stock Exchange, which are priced in USD).
The facility is also useful to convert foreign dividends back into GBP to allow them to be reinvested elsewhere.
But you could also speculate on the value of a foreign currency using this forex service.
If you believe that the value of the US Dollar will rise against Pound Sterling, then you could convert £1,000 into $1,200 US Dollars.
If you were correct, then at a later date, you could convert those US Dollars back into Pound Sterling, at an advantageous rate, resulting in £1,060 returning to your account. The £60 difference is your profit on the trade.
This is a simple example of utilising the spot market for forex.
In other words, you are buying and selling real currency at the live market price.
The advantages of trading in this manner are:
- This uses no leverage. You’re invested with your own cash, therefore it’s easy to monitor and manage your risk.
- The price quoted to you by your broker is easy to compare to other online FX services. So you can check that you’re being offered a competitive rate before entering into the trade.
The drawbacks are:
- Commissions or forex rates offered by a stockbroker may not be the best on the market. There are two reasons why I suggest this:
- A stockbroker may not process the same volumes as an FX firm, so won’t achieve economies of scale.
- Forex transactions are a secondary service of a stockbroker and simply don’t need to be priced competitively to attract investment clients to the firm.
- Stock brokers have not designed their platforms to be used as a forex speculation tool. Therefore these FX trades will be reported with ‘treasury’ or ‘account transactions’ rather than being considered as part of your active investment portfolio. You will need to manually calculate your gain or loss on live FX positions as your account view will not keep track of the cost of your initial trade.
Forex trading with a retail Forex broker
If you’re a UK investor, before you invest, be sure to check that any broker you are considering investing with is regulated and authorised to provide forex trading services by the Financial Conduct Authority. Their register of firms is here.
Also, check out our guide on spotting investment scams, which could help you avoid loss as forex scams are one of the most common forms of investment scams online.
As you are learning about forex trading, you will hear about the following financial instruments:
- FX Forwards
- FX Futures
- FX Swaps
These represent different types of trades that a professional forex trader may enter into with a bank or dealer.
They differ in how they work, when they expire, and whether the trade value needs to be physically settled.
They’re interesting to learn about from an academic standpoint, but I will not cover them in this beginners guide to forex trading because they are irrelevant to a retail investor. These are only traded through professional platforms.
If you search online for “forex broker” or “forex trading”, you will be presented with brokers who offer services to retail investors.
I will now explain the two main forms that they take:
- Spread betting & CFDs – Available
- Binary options – Now banned in the UK
Forex trading via spread betting & CFDs
Spread betting, or contracts for difference offer an alternative way to gain exposure to short term movements in foreign currency pairs.
Investors use spread betting as a quick and convenient way to profit from rises or falls in the prices of many financial instruments. Foreign currency pairs are one of the most popular instruments traded on these platforms.
For any currency pair, a spread betting firm will quote a bid/offer spread (a buy and a sell price).
For example, GBP/USD: 1.2901 (Bid) / 1.2909 (Offer)
For your purposes, the broker is offering to buy from you at 1.2901 and sell to you for 1.2909. The difference between the two is the ‘bid-offer spread’ and will naturally lead to a profit margin for the dealer over time.
If you believe this rate will increase, you can buy at 1.2909. If you believe the rate will fall, you can sell at 1.2901.
You control the size of a spread bet by choosing how much you want to stake on each point movement – which is the smallest decimal point visible. The difference between 1.2901 and 1.2909 is 8 points or 8 pips.
Forex spread betting example
Let’s imagine that we’re bullish on the value of Pound Sterling, therefore we expect the GBP/USD rate to rise. We stake £1 per point on an increase, and ‘buy’ at 1.2909.
20 minutes later, the market rate has increased. The firm now quotes you the following:
GBP/USD: 1.2916 (Bid) / 1.2923 (Offer)
To close out our position transaction, we need to complete the opposite trade by selling. We will receive the bid price this time, which is 1.2916.
We bought at 1.2909 and sold at 1.2916 therefore we made a profit of 7 pips, or £7.
You will notice that the fact we must buy at the higher price and sell at the lower price means we lose out by the width of the bid-offer spread each time we open and close a transaction.
This is why spread betting firms compete on how ‘tight’ (or narrow) their bid-offer spreads are. In theory the tighter the spread, the lower the transaction costs for the forex trader.
Forex spread betting providers
The larger spread betting platforms which cater to UK investors include IG, CMC Markets, City Index and FXCM.
In the UK, spread betting carries the advantage of being a tax-free method of investing. Any net proceeds from spread betting are not considered as taxable income. Rather, they’re treated like winnings from a casino.
Forex spread betting risk
Spread betting investors often take very high risks when placing spread bets, due to the implicit leverage in the bets.
Leverage in action
When we staked “£1 per point” in the GBP/USD trade above. How much of our own capital did we actually put at risk?
We can work this out by calculating our loss if the price fell from 1.2909 to zero? This would have been 12,909 points lost, or £12,909. Therefore in principle, our bet represented a £12,909 trade for Pound Sterling versus the US Dollar. This is the amount we would need to physically invest for a movement of £0.0001 to result in a £1 gain or loss.
Because a single point is such a minuscule price movement, investors can be completely unaware that a small sounding bet of ‘£10 per point’ could represent a £100k+ trade.
When you enter a trade, spread betting firms only require you to hold a relatively small cash balance in your account compared to the maximum liability should your trade go against you. This fraction is often 5% but can be even lower.
In our example, we might have only needed to have 5% * £12,909 = £646 in our account to take this position.
Risks of leverage
The risk of taking large positions against a small cash deposit is that it doesn’t take a large adverse price movement to wipe out our cash amount.
In our example, Pound Sterling would only need to fall by 646 points to wipe out our £646 minimum deposit. In terms of price, that would look like a fall from 1.2909 to 1.2263.
Movements of this nature over longer terms are hardly rare occurrences. This means that when trading with high leverage, it’s not a matter of ‘if’ we’ll be wiped out, but just a matter of when.
You can enjoy a whole string of lucky or skilful trading gains, but you only need to lose big once to be taken to zero if you continue to leverage your account to the max.
Not many investors listen to these sensible warnings, which is why all UK regulated spread betting & CFD firms will include a health warning on the front page of their website, explaining what percentage of their clients lose money. This percentage is typically over 70%.
It takes self-restraint and discipline to trade using low leverage (or zero leverage) on a spread betting platform, but it’ll go a long way to reducing account volatility.
The potential for unlimited losses
Spread betting could lead to potentially unlimited losses where the investor bets downward and the price of the instrument skyrockets. There is no limit on how high a price can rise, and therefore an investor on the losing side of this trade could lose significantly more than they deposited.
Protections can be put in place, such as automatic ‘stop-losses’ which close out your trade as soon as your account value hits zero. Indeed, spread betting firms in the UK have been required by the regulator to ensure that this does happen, but it would be reckless to rely completely on these regulations.
The best way to directly manage your risk is to exercise control over the size of the bet in the first place. Moreover, some investors trade currencies through a broker such as Vantage FX. Read a full review of vantage FX here, this is not an endorsement but an example.
Forex trading via binary options
Retailer investors in the UK used to be able to gain exposure to forex through binary options.
Binary options are a simple bet on the directionality of an instrument. A currency pair binary option will offer the investor two options:
- Bet on the currency appreciating
- Bet on the currency depreciating
At any given moment, the odds of an up or down movement are balanced – like the outcome of a coin flip. However, binary option providers would build a profit margin into the payouts offered, much like how bookmakers calculate the payouts on football matches.
This would mean that if you correctly predicted up, you might receive a payout of 1.9 x your stake, in contrast to the “fair” odds of a similar risk bet being 2.0.
Binary options are effectively gambling through a bookmaker who specialises in financial markets. As a result, the vast majority of clients lose money.
This led the FCA to ban the sale of these services to UK investors in April 2019.
The FCA warns that any firms offering such services now are probably unauthorised and might be an investment scam.
The UK authorities aren’t alone in their dislike of gambling entertainment being packaged as an ‘investment opportunity. This warning from the US Securities and Exchange Commission adds concerns that:
“Much of the binary options market operates through Internet-based trading platforms that are not necessarily complying with applicable U.s. regulatory requirements and may be engaging in illegal activity.”
The SEC encourages US investors to use the broker check tool maintained by US regulator FINRA to check the status of any broker.
What is the expected return from forex trading?
The expected return for all participants from the forex market is 0%.
By this, I mean that the combined sum of returns experienced by everyone who traded in the market each year will be precisely nil.
There are still winners, and losers, but these will be equal to each other, and I’ll explain why.
When investing in the stock market or buying property, it is possible for most participants to experience a neutral or positive return.
In a year where stock markets rise overall – anyone who bought or holds shares will enjoy a gain. Anyone who sold their shares will have received cash, which will be worth the same value.
Thus overall, there are few losers in this scenario, and all participants have either maintained or increased their buying power.
I’ll contrast this with forex trading. When a currency strengthens, it does so at the expense of the opposing currency pair. The holder of the strengthening currency sees a gain, whereas the individual on the other side of the trade will see an equal and opposite loss.
It isn’t theoretically possible for all currencies to strengthen at one, because strength is only measured relative to another currency getting weaker.
This is known as a zero sum game. This is why pension funds, and institutional investors do not generally ‘invest in the forex market’, as they would see higher expected returns from investing in wealth-producing assets such as corporate bonds.
It’s true that many hedge funds and private investors successfully trade forex and win more often than they lose, but it’s difficult for an institution to pick the winning traders in advance.