Introduction to Forex Trading 

1.1 What is Forex Trading

Foreign exchange, or forex in short, refers to the exchanging of one currency for another for various purposes, such as for tourism, or cross-border business transactions.  

Due to the global nature of commerce and travel, forex markets rank among the world’s largest and most liquid markets. According to the Bank of International Settlements, global trading volume for forex in 2022 reached USD 7.5 trillion per day. ^[1] 

In comparison, global equity trading across stock markets worldwide was estimated to be just USD 41.35 trillion for the last three months of 2021. ^[2]  

This means that on the whole forex markets are much larger and offer more liquidity, which makes these markets inherently more resistant to manipulation. This is a key reason why some investors prefer to trade forex over stocks and shares.

1.2 Who Trades Forex  

Forex trading used to be dominated by banks, institutional investors like hedge funds, and the wealthy, due to the large amount of capital required. However, the introduction of online brokerages paved the way for individual investors to participate in forex trading. 

Retail investors trade forex for a number of reasons, besides the expectation of profit. Forex trading can also be used to hedge against currency risk, for portfolio diversification, or to speculate on geopolitical events such as elections.  

Hence, you’ll find a wide variety of different investors engaging in forex trading, such as  

• Traders who only have time to trade during the night 
• Investors who understand the interconnectedness of currency pairs 
• Individuals interested in macroeconomics and forex market

1.3 How Does Forex Trading work? 

The idea behind forex trading is simple. A trader buys one currency and sells it for another, attempting to make a profit from a favourable exchange rate. The exchange rate between a pair of currencies fluctuates in response to supply and demand.  

Let’s assume the exchange rate between USD and SGD is 1.34 (USD 1 = SGD 1.34). You go to a money changer and trade in USD 1,000 to receive SGD 1,340.  

Two weeks later, the exchange rate between USD and SGD dropped to 1.30. If you go back to the money changer to sell your stash of SGD for USD at this time, you will receive USD 1,030.77. This gives you a profit of USD 30.77. 

Note that this example ignores the money changer’s fee for providing the service – this is known as the spread, explained further below. 

In practice, forex trades are executed online without the need for physical currency notes to change hands.

Example: Forex trading in action 

Let’s assume you want to trade the forex pair USD/JPY, which has an exchange rate of 139.91. In other words, USD 1 will get you JPY 139.91. 

You assess that the Dollar is likely to strengthen against the Yen, hence you open a long trade on USD/JPY with USD 100,000. Let’s see how the change in the exchange rate at the time you close your trade affects your outcome.  

Scenario 1: USD/JPY 139.91 >>> 145.91 

In this case, the Dollar has grown in value against the Yen, proving your trading decision to be correct. Hence, your profit would be 100,000 x (145.91 – 139.91) = JPY 600,000.  

Converting from JPY to USD, your profit from the trade would be JPY 600,000/145.91 =  USD 4,112.12. 

Scenario 2: USD/JPY 139.91 >>> 129.91  

In this case the Dollar has fallen in value against the Yen, which means your trading decision was wrong. Your loss would be 100,000 x (139.11 – 129.91) = JPY 1,000,000. 

Converted back to USD, your loss on the trade would be JPY 1,000,000/129.91 = USD 7,697.63. 

However, if you had opted for a short position rather than a long one, you would have achieved a profit in the event of Scenario 2 (and correspondingly, incurred a loss in Scenario 1).1.4 Common Forex Jargon  

As forex trading comes with its distinctive terminology, it’s recommended to acquaint yourself with these terms before diving in. Here are some prevalent forex jargon phrases and their explanations. 

Bid-ask spread 

Referred to simply as “spread,” the bid-ask spread represents the disparity between the lowest price at which a seller is prepared to sell (ask) and the highest price a buyer is prepared to pay (bid). Monitoring the spread is crucial in forex trading because of its potential to influence your trading outcomes. 

Contract-for-Difference (CFD) 

In forex trading, CFDs are used to engage in trading based on the price movement of currencies without owning the underlying assets. 

Currency pair 

All forex trading is performed on currency pairs, which is expressed as “base/quote”. In USD/JPY the Dollar is the base currency, and the Yen, the quote currency. Thus, USD/JPY indicates that we are comparing the value of USD against JPY. Meanwhile EUR/USD indicates comparing the value of the Euro against the Dollar. 

Exchange rate 

The rate at which one currency can be exchanged for another. In forex trading, the exchange trade is always expressed as “base currency” for “quote currency”.  

Leverage 

Leverage provides traders with the means to amplify their trading capacity without requiring a substantial initial capital. This practice is prevalent in forex trading, primarily because of the conventional use of a lot size of 100,000 units per trade. 

Long position (buy) 

A trading position taken in expectation of increase in the value of an asset. In forex trading, you’d open a long position if you think the base currency would strengthen against the quote currency. 

Lot 

Traditionally, forex trades are executed in lots of 100,000 units of the base currency. Hence, in USD/AUD, one lot would be equivalent to USD 100,000, two lots would be USD 200,000, etc. However, micro lots (1,000 units ) and mini lots (10,000 units ) are also offered for trading by brokers. 

Pip 

A Percentage-in-Point, commonly known as a pip, denotes the smallest feasible price variation within a currency pair. As forex prices are quoted with at least four decimal places, a pip is equivalent to 0.0001. 

Short position (sell) 

A trading position taken in expectation of decrease in the value of an asset. In forex trading, you’d open a short position if you think the base currency would weaken against the quote currency. 

1.5 The Different Currency Pairs  

With approximately 180 currencies available in the forex markets, here’s a quick classification of these currencies and the reasons for the classifications.  

The Variety  

Out of the 180 currencies available, there are five currencies that dominates the rest. The reason behind this is that these five represent some of the largest global economies and are usually traded in high volumes.   

The USD (US Dollar), The EUR (Euro), The GBP (Great British Pound), The JPY (Japanese Yen), and The CAD (Canadian Dollar).  

The Types  

As mentioned in lesson 1.1, forex market trading involves the exchange of two currencies, forming what is commonly referred to as currency pairs. These pairs fall into three distinct categories: Major, Minor, and Exotic. 

Majors 

Major currency pairs are the preferred choice for many traders, encompassing the US dollar paired with other major currencies such as the euro, yen, or pound. Recognizable by names like EUR/USD, USD/JPY, and GBP/USD, these pairs present advantages like high liquidity, tight spreads, and low transaction costs.  

Examples of majors include: EUR/USD, USD/JPY, GBP/USD 

Minors 

Minor currency pairs, commonly referred to as cross pairs, provide an avenue to trade major currencies against each other without the US dollar. Notable examples include EUR/GBP, GBP/JPY, and CHF/JPY. While these pairs might feature wider spreads and heightened volatility, they also bring forth the opportunity for diversification, catering to traders seeking to broaden their investment portfolios. 

Examples of minors include: EUR/GBP, GBP/JPY,CHF/JPY 

Exotics 

For those seeking an adventurous approach, exotic currency pairs might pique your interest. Comprising less frequently traded currencies such as the Mexican peso, South African rand, or Turkish lira, these pairs are matched with major currencies like the US dollar or the euro. 

Examples of exotics include: EUR/CZK, EUR/SEK, EUR/TRY 

Unique Nicknames for Currency Pairs  

“Cable” is the nickname given to GBPUSD. With the advancement of communications during the mid-1800s, forex rates for GBPUSD were communicated using cables that ran across the Atlantic Ocean.  

The Euro (EUR/USD), being a much newer currency than the pound, gained the nickname “Fiber” as it was an upgrade from cables. The inspiration for the nickname came from the lightning-fast fibre optics which took over the usage of cables in exchanges.   

Finally, the “Loonie” represents USD/CAD. The loon, a common bird which is featured on the flip side of Canada’s dollar coin. The nickname Loonie was so popular that the Royal Canadian Mint trademarked the term back in 2006.   

Check out a more in-depth article regarding the different types of forex markets here.

Time’s up

Module Recap

• The forex markets are the largest and most liquid financial markets, with total trading volume that dwarfs the global stock market.  
• Forex trading is based on currency pairs, with the first currency known as the “base” and the second currency known as the “quote”. 
• You can trade major, minor or exotic currency pairs. 
• Leverage is commonly used in forex trading to facilitate larger trades without the need for a large capital.  
• You can take long or short positions in forex trading, allowing trading in all directions.  
• Another way to participate in forex trading is through Contracts-for-Difference (CFDs), which allow you to engage in trading based on the price movement of currency pairs without ownership of the underlying assets.

References 

1. Bank of International Settlements, Triennial Central Bank Survey, https://www.bis.org/statistics/rpfx22_fx_annex.pdf.
2. Statista, Value Of Global Equity Trading Worldwide From 1st Quarter 2017 To 4th Quarter 2021, https://www.statista.com/statistics/242745/volume-of-global-equity-trading/.