The forex market is larger, more active and more lucrative than the stock market, with a daily trading volume of around $6 trillion. Sounds like an exciting opportunity, right?
However, because it’s generally considered more complex and risky, forex trading is not ideal for the uninformed trader.
We cover the terminology, strategies and trading tips needed to improve your understanding of what forex trading entails and the pitfalls to avoid.
What Is Forex?
Forex is a term used to describe the ‘foreign currency exchange’ market, abbreviated to FX.
The FX market determines the rate of exchange between fiat currencies — the real cash issued by governments around the globe as legal tender.
The forex market is characterised by its:
- Massive size and liquidity because currency is always in-demand. That means you can quickly and easily buy and sell currencies. High liquidity also means that even trades of a significant size are less likely to influence market prices.
- Decentralised structure. It’s a decentralised over-the-counter (OTC) market coordinated through a network of central/international banks, commercial banks and other financial institutions and forex brokers.
- 24-hour availability, 5 days a week due to international timezones and the fact there’s no central marketplace that opens or closes. In Australia, you can trade from Monday 8 am to Saturday 8 am (AEST).
What Is Forex Trading?
Forex trading involves what’s known as currency pairs, which are simply the two currencies being exchanged on forex markets.
Although it’s an OTC market, individual forex traders in Australia would typically trade forex through a broker or a forex trading platform (i.e., you don’t need to hold or transact the actual fiat currencies).
Predicting changes in the difference in value between the two currencies on the forex market is how a trader makes a profit or loss on the position they open with a broker.
Forex traders look to profit from currency pairs through both long and short positions:
- With a long position, your aim is to buy at a low exchange rate before selling when the rate of exchange between the currency pair increases due to the base currency becoming stronger.
- You can also short-sell a currency pair in search of profits if you believe that a currency will weaken relative to its paired currency.
(Related: What Is Slippage In Trading?)
Forex Currency Pairs Explained.
On the forex market, currencies are represented by a three-letter code, such as AUD for the Australian dollar.
In a currency pair, the base currency you’re buying is listed first, followed by the ‘quote’ currency—which is the currency it will be exchanged for.
Commonly traded currency pairs on Australian trading platforms include:
Currency pairs are categorised in the following ways:
- Major currency pairs include two currencies from countries with high volumes of international transactions, one of which will always be the US dollar (USD). Because the majors represent the world’s largest economies, they provide more trading opportunities due to higher liquidity and market volatility.
- Minor/cross currency pairs are used to describe a pairing that includes major currencies, but where neither currency is the US dollar.
- Exotic currency pairs include one major currency and a currency from an emerging market that’s not as widely traded (e.g., the Turkish Lira or the Singapore dollar).
Which Ways Can You Trade Forex?
Forex trading can include:
- Spot trading, where two currencies are directly exchanged at current market rates and settled ‘on the spot.’
- Forwards, swaps, futures and options contracts, where you buy and sell currencies at a current price for settlement at a future date, which is typically used to hedge against falls in the exchange rate.
Traditional forex trades involve the literal purchase and exchange of a certain amount of one currency for another.
However, most retail investors will use OTC derivatives, such as contracts for difference (CFDs) offered by online stockbrokers to execute forex trades in Australia.
What Are Forex Contracts For Difference (CFDs)?
In a CFD transaction, the trader and the broker agree to exchange the difference in the currency pair’s value between the contract’s opening and closing.
CFDs have risen in use among Australian traders because they:
- Simplify forex trading by allowing you to speculate on the price movements of currency pairs without owning or having to deliver the underlying currency.
- Enable both long and short positions on the currency pair, so you can potentially profit from rising and falling prices.
- Let you trade on margin, which means you can open more substantial leveraged positions with a smaller amount of upfront funds in your account. Leverage magnifies both your potential profits and losses. If your account drops below the required margin, you’ll receive a ‘margin call’ from your broker to deposit more funds if you want to keep a trade open—which can further exacerbate the size of your losses.
- Are offered by many popular online brokers, giving you access to a wide range of trading tools and platforms.
(Related: What Is Leverage In Trading?)
Factors To Understand Before Trading Forex.
Here’s where beginner forex traders typically get unstuck.
1. Margin And Leverage.
Trading CFDs lets you use leverage to increase the size of your position.
For example, a leverage ratio of 30:1 would allow for a trade valued at $30,000 with just $1,000 in funds from your account.
Forex brokers require that you have a minimum amount of money available in your account to cover open positions that use leverage, known as margin.
The amount or percentage of margin required varies by broker or forex trading platform, depending on the size of a trade.
The fee charged by forex brokers is typically referred to as the “spread,” which is the difference between the buying and selling price they offer for a currency pair
Forex brokers may describe spreads in terms of their pip value (e.g., if the spread is 0.8 and the value per pip for a specific currency pair is $10, the cost is $8).
Pip is an abbreviation for ‘points in percentage’ and describes the smallest increment size of the change in an exchange rate’s value.
For example, if the EUR/USD pair moves from 1.2500 to 1.2501, that is a one-pip move.How many pips/points the exchange rate moves determines the size of your profit or loss.
The standardised unit of measure for a certain amount of currency.
In forex trading, lot sizes typically range from micro-lots (0.01 lots) to standard lots (100,000 units of the base currency).
5. Interest And Other Fees.
Overnight interest fees are typically charged when you hold a position open overnight (beyond the trading day’s close), which generally ranges from 1-3% per year.
If you want to open a trade in anything other than Australian dollars, your forex broker will charge a currency conversion fee.
Some forex brokers may charge other fees such as commissions, account maintenance, or withdrawal fees. These fees may be a flat rate or a percentage of the transaction value.
Laws About Forex Trading In Australia.
Is forex trading legal?
Yes, it’s legal to trade forex in Australia, but the financial watchdog ASIC has placed limits on the amount of leverage that regulated forex brokers operating in Australia can offer on CFDs.
The rules are designed to protect consumers from significant losses — because ASIC’s research found most retail traders who use CFDs lose money. The leverage limits for trading forex CFDs are:
- 30:1 for major currency pairs; and
- 20:1 for minor currency pairs.
Example Of A Forex Trade.
Let’s say you’re an Australian forex trader who believes the euro will appreciate against the Australian dollar in the short term.
At the time of trading, the exchange rate is 1.5600, meaning you can buy one euro for 1.5600 AUD.
Using 1:10 leverage, you spend $1000 to open a position valued at $10,000 AUD, which allows you to buy 6,410 euros.
Over the next few days, the exchange rate for EUR/AUD rises to 1.5800, reflecting the strengthening of the euro against the AUD.
You decide to close your position, effectively ‘selling’ your euros for Australian dollars, and thereby realising a profit.
How To Start Trading Forex In Australia.
Individuals new to forex trading can easily get started by using a regulated forex broker or share trading app. Follow these steps.
1. Choose A Forex Broker.
If you don’t already have a forex trading account with a broker that offers forex or CFDs, select a licensed forex provider, create an account and add funds.
You’ll need to deposit enough money to meet your broker’s minimum margin requirements for the size of forex trades you have in mind.
Remember that trading success is never guaranteed, so only add an amount of money you’re prepared to lose.
2. Establish A Trading Strategy.
Make sure you understand how forex works and the risks associated with the trading products you’re using.
Read the product disclosure statements provided by brokers.
Develop a clear plan for how you’ll spot good trading opportunities, what kind of trades you’ll make, how much you’ll spend, and how you’ll determine when to open and close your positions.
You’ll be targeted with ads that sell trading robots and software that promises to automate FX trading, thus enabling you to passively earn profits from forex markets. The old adage ‘if it sounds too good to be true, it probably is’ applies here —use caution. The Australian Government’s MoneySmart site suggests that before you use a service like this, check they are licensed through ASIC Connect’s Professional Registers.
3. Test Your Trading Strategy.
If you’re unsure about the strength of your approach to forex trading, use practice / demo account features offered by your forex trading platform to do a few test runs.
Use a demo account to:
- Familiarise yourself with the platform’s research tools.
- Practice placing trades, different types of market orders and closing positions.
- Test and refine your trading strategies before you commit real cash.
4. Place Your Trades And Review Regularly.
Once you’re ready, we recommend you:
- Place one trade at a time to reduce the complexity of monitoring multiple currency pairs.
- Open a reasonably small position that risks just 1-2% of your account’s capital.
- Use market orders to manage your risks, such as stop-loss, limit and take-profit orders.
Even if you’re using stop or limit orders, it’s worthwhile paying attention to major news announcements so you can adjust trades on-the-go.
In addition to monitoring your open position/s, it pays to take time to review closed trades to learn why you achieved a profit or made a loss.
Pros And Cons Of Trading Forex Currency Pairs.
In past decades, companies were the major users of FX to hedge currency risks related to expanding their business operations in overseas markets and also to ensure they had foreign currency to pay globally-distributed employees.
Once seen as merely a functional necessity for the exchange of cash, forex is now viewed as an investment asset class in its own right — with most serious traders dabbling in forex trading to some extent.
Top benefits of forex trading include:
- You can increase the number, frequency and variety of your trades. Forex trading offers a huge range of currency pairs and lets you trade outside of regular market hours. It has low barriers to entry if you use margin trading, and offers comparatively low fees compared to other financial markets.
- You can use leverage to maximise your capital and increase profits. Of course, leverage is a double-edged sword where your losses are also amplified based on the inflated position size.
The main cons of trading currency pairs are:
- Risk of excessive losses due to highly leveraged trades that can be liquidated quickly based on even small market movements.
- Inherent unpredictability of factors affecting currency markets.
- Difficulty of market research, which involves the use of advanced charting and analysis tools.
What Causes FX Rates To Fluctuate?
Broad economic and societal conditions in different countries affect exchange rates, so it’s critical to stay abreast of the news, governmental policies, and financial market reporting.
The kinds of events that influence the strength of a country’s currency can include:
- Political changes, elections, new policy directions, major scandals or significant dissent and dissatisfaction with a government among a country’s constituency. For example, Britain’s pound depreciated significantly compared to the USD in the wake of its Brexit announcement.
- Macroeconomic data such as interest rate rises or falls, inflationary pressures, unemployment rates, GPD and consumer sentiment surveys. For instance, a surprise cut to interest rates by a country’s central bank could trigger a decrease in its currency’s value on the forex market.
Final Thoughts On Forex Trading In Australia.
Forex is a fast-paced market that gives retail traders more opportunities to make trades and potentially generate profits.
But those appealing traits must be balanced by the complexity and risk involved being able to reliably predict what to trade and when, having sound entry and exit strategies to realise profits, and strong risk management to limit your losses on leveraged positions.