Foreign Exchange or Forex is a process of exchanging one currency in return for another. Frequent buying and selling of one currency in return for another with an expectation to book profit are called forex trading.

Forex is the most liquid capital market in the world with an average daily trading volume of more than 6 trillion USD. This means that more than 6 Trillion USD equivalent is exchanged in forex each day around the globe.

The trend to trade currencies has been rapidly increasing in recent years as visible from the growth in trading figures. Each day thousands of potential traders are getting their hands on forex trading with a positive hope of making extra bucks. However, most of these new traders face losses due to a lack of experience and basic knowledge of the forex market.

If you wish to start forex trading in Nigeria, it is better to learn the functioning, strategies, and risk associated with trading currency pairs. This guide covers every aspect of what forex trading is all about.

What is Forex?

Forex or foreign exchange is the process of changing currencies. Each currency has a different value with respect to the other. For eg USD 1 $ is equivalent to nearly Naira 406 ₦, 1 GBP is equivalent to 1.15 EUR, etc. The value of each currency against another never remains the same and can change at any time due to multiple reasons.

Each time you travel abroad to a different country, you participate in foreign exchange in order to buy foreign currency. However, the price you pay for the same amount of currency exchange can be different each time. Now if you return home and are left with foreign currency, you can again exchange it to get back your local currency. The price can again differ slightly this time.

In some way or other, most of the population around the globe is involved in foreign exchange. If you buy a car made in the USA or Germany in Nigeria, you are indirectly paying USD or EUR respectively with NGN. Hence participating in currency exchange. Even if you pay to watch a movie produced in England, you are adding to the revenue of the production house in GBP. Hence, participating in foreign exchange.

The process of import/export, tourism, services offerings in foreign countries, etc. is impossible without foreign exchange. With the enhancement in technologies and communication, the world is becoming a smaller place. As a result, more than 6 trillion USD equivalent is traded daily on an average through forex. This figure is destined to grow further in the future.

Trading on Forex

The price movement of each currency against the other can be speculated to book profits. In other words, each currency can be bought at low and sold at high with respect to other currencies to book profits. The process of buying and selling currencies with the hope to book profit is called forex trading.

Forex trading can be done in the spot market as well as derivative markets like futures, forwards, swaps, etc. Unlike stocks, forex trades are not executed on any particular exchanges. It is an over-the-counter (OTC) market that is managed by demand and supply on a network of major banks and liquidity providers worldwide. London, New York, Sydney, and Tokyo are the four trading centers as the forex market remains active 24 hours a day.

Forex trading is done through currency pairs. Certain preset currency pairs are traded worldwide. EUR/USD is the most traded currency pair in the world responsible for 20% trading volume of the forex market. The forex currency pairs can be grouped into 3 different categories based on their daily average trading volume.

• Major: The currency pairs that are most traded around the globe involving USD are grouped under major currency pairs. There are 4 major currency pairs namely EUR/USD, USD/JPY, GBP/USD, and USD/CHF.

  As they are actively traded around the globe, they have higher liquidity compared to other currency pairs. For the same reason, the spreads are generally narrower on major currency pairs compared to others.

• Minor: Forex pairs that do not involve USD but are traded on a wide scale are called minor currency pairs. EUR/GBP, GBP/JPY, and EUR/CHF are examples of most traded minor currency pairs. The markets of these currency pairs are not as liquid as major pairs but they do have decent liquidity.

• Exotics: These currency pairs include currencies of emerging markets that have lower liquidity. The spreads in these currency pairs are highest compared to minor and major pairs. A large number of currency pairs are grouped under exotic currency pairs. USD/SGD is an example of exotic currency pairs.

Forex Terminologies

Before understanding the working of the forex market, it is important to understand the basic terminologies that are used in forex markets.

• Currency Pair: A currency pair is a preset pair that involves two currencies denoted as quote currency and base currency. If you trade in forex, you are basically trading a particular currency pair. EUR/USD is a currency pair.

• Base Currency: It is the currency that appears first on a currency pair. Base currency is the currency that will be bought while trading forex. In EUR/USD currency pair, EUR is the base currency that will be bought or sold in return for USD.

• Quote Currency: It is the currency that appears second on a currency pair. The price of a single unit of the base currency is quoted in terms of the quote currency. In EUR/USD currency pair, USD is the quote currency that will be paid or received while buying or selling the EUR respectively.

• Bid Price: Whenever the price of the currency pair is quoted, two different prices can be observed separated by ‘/’. The first price is the bid price that is the maximum price at which the units of a concerning currency pair can be sold. If you wish to sell units of currency pair, the bid price is the price you will receive in return.

• Ask Price: The second price in the quoted currency pair price is the ask price or offer price. It is the minimum price at which the currency pair units are available to be bought. It is the price that you will be paying to buy units of a currency pair.

  Example: Suppose the trading price of EUR/USD is 1.2020/1.2030. Here 1.2020 is the bid price at which you can sell a unit while 1.2030 is the ask price at which you will buy a unit of EUR/USD.

• Long Position: If you are hoping the price to increase and buy a predefined lot of currency pair, you are opening a long position. Profit can be booked if the price increases otherwise loss will be faced.

• Short Position: If you sell the predefined lot of currency pair, expecting the price to decrease, you are opening a short position. Profit can be booked if the price drops otherwise loss will be faced.

• Pips: Pips or percentage in points is the smallest change in the bid and ask price of a currency pair. The movement in pips can change the profits and loss on an open position. It is equivalent to the fourth decimal unit of a currency pair price.

• Lots: Trading in forex can only be done in a fixed lot of currency units. A standard lot contains 100,000 units of the concerned base currency in a currency pair. In general, 0.01 standard lot is the minimum lot size that can be traded in forex.

• Spread: It is the difference between the bid and ask price of a currency pair. The spread is a fee that is paid to the market maker of the concerned forex pair. Wider spread means higher fees and lower profit for traders and vice versa.

• Commission: It is the fees that can be charged in trading as well as non-trading fees. The trading commission is a predefined fee charged for each executed order. Non-trading fees include account opening fees, deposit/withdrawal fees, currency conversion fees, inactivity fees, etc.

• Stop Loss: It is a type of order that can limit the risk factor or can also protect the profits in forex trading. Opened positions are automatically closed if the currency price hits the stop loss trigger price set by the trader. If a currency pair is currently trading at 1.2050 and the stop loss trigger price is 1.2030, then the risk is limited to 20 pips.

• Take Profit: It is also a type of order but works contrary to stop-loss orders. If the currency pair price hits the preset take profit trigger price, the trade position will be automatically closed booking the profits.

• Leverage: Leverage is a borrowed capital that is used for trading in capital markets. Leverages play a vital role in forex trading as the price movements are small. A leverage ratio of 1:200 means that 99.5% of the trading amount will be borrowed from the broker or liquidity provider.

• Margin: It is the amount that the trader actually pays to open a certain position in forex trading. If the leverage ratio is 1:200, then the margin requirement will be 0.5%. This means that to open a position worth 1000$, the trader needs 5$ in his account.

How Does Forex Trading Work?

Forex trading services are provided by forex brokers. There are a large number of regulated and unregulated forex brokers in the world. Traders should always choose a broker that is regulated by the national or international regulatory authority that safeguards traders’ interests and overlooks the activities of the brokers.

Forex brokers can be of 3 types namely STP, ECN, or market-maker based on the model of market execution followed.

• STP Forex Broker: STP or Straight Through Processing is a trading model followed by brokers with no dealing desk. In simple words, these brokers do not participate in forex trading but pass on the orders to liquidity providers in the market. Their earnings are based on spreads that are slightly wider but differs from broker to broker.

• ECN: Brokers with Electronic Communications Network model of market execution are similar to STP. The orders are directly transferred to banks and other liquidity providers for quick execution at very little spread. Although, a trading commission is charged for each order which makes it lesser attractive compared to an STP broker.

• Market Maker: Forex brokers following the market maker execution model do not transfer their trade orders to any third-party liquidity provider in the market. They match the orders of buyers and sellers and can also take the opposite side of a trade order. They participate in trades of their clients and hence are lesser trustworthy compared to STP or ECN brokers.

Clients can open a long or short position through any type of broker. The initial margin requirement to open any position in a forex trade depends on the leverage ratio offered by the broker.

How to Trade Forex?

Traders can trade forex through any of the available forex brokers by following these steps:

• Step 1: Select a Broker
  The selection of a broker is the most important step and various factors must be considered before choosing a broker. A resourceful broker must be well-regulated, should charge reasonable fees, offer excellent support service, and a user-friendly trading platform. You can refer to How to Choose a Forex Broker for more details on how to select a broker.

• Step 2: Open an Account & Make a Deposit
  After selecting a broker, you need to enter your basic details to open an account and complete the KYC process to start forex trading. Do not deposit a large amount initially as you may face drastic losses due to lack of experience.

• Step 3: Download and Login Trading Platform
  MetaTrader 4, MetaTrader 5, and cTrader are the commonly chosen trading platforms provided by forex brokers. Some brokers might have their own trading platforms.

• Step 4: Select Trading Instrument
  From the trading platform, you can select the desired currency pair that you wish to trade on. It is important to analyze the charts and trends of the trading instrument to make better trading decisions.

• Step 5: Select lot size
  The next step is to enter the lot size starting from 0.01 depending on your deposited amount. 1 standard lot has 100,000 units of the base currency which will be bought or sold in return for the denoted price in the quote currency. The amount you require in the wallet to open a position on a selected lot depends on the leverage ratio offered by the broker.

• Step 6: Go Long or Short
  If you buy, you are opening a long position and expecting the price of the selected currency pair to increase. If you sell, you are opening a short position in which profits will be booked if the price drops.

• Step 7: Book Profit/Loss
  After opening the position, you would be able to see movement under the profit/loss according to price movement by each pip. The moment you close your position, the amount under profit/loss will be booked.

Features like stop loss or take profit can be used before or after opening the position. For beginners or new traders, it is better to gain experience and learn basic strategies through virtual currency on demo accounts. Starting to trade with a real account can be fatal in the initial phase.

How to Predict Price Movement in Forex?

Forex markets are open for 24 hours 5 days a week all around the globe. Any international economic or non-economic event around the globe can trigger the price movement of any currency pair at any time of the day. Hence, it is nearly impossible to predict the price movements in the forex market with 100% accuracy.

However, with adequate research and analysis on the currencies involved, traders can enhance their decision-making ability in the forex market. The fundamental analysis can be done by analyzing the government policies and their impact on the financial markets of the countries concerning currency pairs. The economic growth/fall, GDP, fiscal policy, monetary policies, inflation, and other geopolitical activities can be analyzed to predict the price movement in the forex market.

The technical analysis can also be done which concerns the charts and graphs of the concerned currency pair. Analysis of patterns, moving averages, candlesticks, and various other indicators can assist the traders in making a better trading decision.

Frequently asked questions: Forex Trading