A Beginner’s Guide to The World of Forex Trading: Part 2

Jun 15, 2020

As we mentioned in the first part of our guide, the FX market is the world’s biggest financial market. Based on the data from a recent triennial report from the Bank for International Settlements, “Trading in Forex markets reached $6.6 trillion per day in April 2019, up from $5.1 trillion 3 years earlier.”

Forex is one of the most accessible markets for institutional and retail traders alike as it does not have a physical exchange but instead operates through online exclusively.

What affects exchange rates?

A Beginner’s Guide to The World of Forex Trading: Part 2

Exchange rates are heavily affected by global political turmoil, interest rates, and inflation.

Exchange rates define how much one currency is worth versus another currency; for example, how many USD dollars do you need to buy a EURO?

The value of a country’s local currency is extremely important when determined its financial health. The currency’s stability determines the country’s economic strength. Exchange rates fluctuate daily based on changing market forces, such as:

  1. Inflation rates: In economics, inflation refers to a continuous and significant rise in the price of goods and services with an economy over a specific period of time, which subsequently results in the local currency’s devaluation. Countries with lower inflation rates will see an appreciation in their currency.
  2. Interest rates: An interest rate refers to the amount a lender (i.e., bank) charges for the amount it lends. When interest rates change, currency value follows; for example, increases in interest rate can cause a country’s currency to increase since higher interest rates mean higher lenders rates. This subsequently causes a rise in exchange rates due to an increase in foreign capital investment.
  3. Public debt: In order to fund public sector projects, governments will borrow substantial amounts, and while this stimulates the domestic economy, countries that have high public debt tend to be less attractive for foreign investors and have much higher inflation rates. This subsequently decreases the local currency’s value.
  4. Terms of trade: Terms of trade refer to the ratio that compares import prices to export prices. Should the price of a country’s exports rise significantly in comparison to its imports, then its terms of trade have positively improved, and that there is a higher demand for the country’s exports. As demand for a country’s exports increases, so does the value of its currency.
  5. Political and economic factors: Currencies are profoundly affected by political turmoil, which is why countries with unstable governments and economies tend to be much more likely to have low-value domestic currencies. Countries with strong economic performance tend to attract foreign investors and create confidence in the country’s currency.

How does trading work?

Traders see the ask and bid prices when they trade currency pairs. The asking price is actually the purchase price of a currency, while the bid price is the selling price. You can either trade short or long:

  • Long trade: When you purchase a currency expecting that it will increase in value and therefore make you a profit on the difference between the purchase and sale price.
  • Short trade: When you sell a currency expecting that it will decrease in value and your profit on the difference.

The trading price of the currency pair is based on the current exchange rate of both of the currencies with the pair.  Brokers will benefit from the difference between the buy and sell prices, which is what is referred to as a spread. For the more popular currency pairs, better known as major pairs, the spread is usually quite low. The unit of measurement to express the price change in currency is called a pip.

Should the bid price of the EUR/USD pair go from 1.15556 to 1.15566, which represents the difference of 1 pip? The amount of money needed to place a trade is known as margin; however, due to the fact that most average individual traders do not have the capacity to trade large enough volumes that will give them a reasonable profit, many forex brokers offer their clients access to leverage. Leverage is capital that is provided by the broker to allow traders to increase the volume of their trades.

Currencies are traded in USD amounts called lots. Most brokers allow you to choose between two different lot sizes, standard lots or mini lots. One standard lot is equal to $100,000 in currency.

Forex price charts: How are they used?

A Beginner’s Guide to The World of Forex Trading: Part 2

Candlestick charts are the most popular method of interpreting historical changes in forex markets.

Forex charts represent the lifeblood of the market; they graphically represent the historical price movement between two currency pairs across varying time frames.

Price charts reflect the market participants’ actions, which is essentially the trading of currencies between buyers and sellers in the Over-The-Counter (OTC) or “interbank” market that creates price movement. Therefore, all fundamental factors are quickly discounted in price. By studying price charts, traders can indirectly see fundamental and market psychology altogether.

The most common types of price bars used in Forex trading are the line, bar, and candlestick charts:

  • Bar charts: Price bars are a linear representation (a line) of a period of time. This enables the viewer to see a graphic representation summarizing the activity of a specific time frame. Each bar has similar characteristics and tells the viewer several important pieces of information. The highest point of the bar represents the highest price that was achieved during that time period. The lowest point of the bar represents the lowest price during the same period. Regular bars display a small dot on the left side of the bar, representing the opening price of the period, and the small dot on the right side represents the closing price of the period.
  • Line Charts: Line charts are amongst the simplest charts to understand; however, many traders prefer to avoid them as they do not offer as much information as bar charts and candlesticks. They are mapped simply by drawing a segment from one closing price to the next during a certain timeframe.
  • Candlesticks – Japanese Candlesticks, or simply Candlesticks, are used to represent the high, low, open, and closing prices of currency pairs for a certain period of time. The red color means that the close was lower than the open, and the blue color represents that the close was higher than the open. The line going up from the box represents the high is called the wick. If the box has a line going down, then it’s declining, which is called the tail.

A chart’s timeframe refers to the duration of time that passes between the open and the close of a bar or candlestick. With the help of forex trading software, retail investors will be able to view a currency pair in a 1-hour time frame over a 2-day period, 5-day period, 10-day period, 20-day period, and 30- day period. Most of the short-term time intervals (5-min and 1-min charts) are used for entry and exit points, and the longer-term time intervals (1-hour and daily charts) are used to see where the general trend is.

How do emotions and psychology affect trading?

Trader’s psychology is driven by 2 core emotions: fear and greed.

Trading comes with significant emotional turmoil as it can easily provoke anxiety. Trading psychology is the study that represents how human emotion and mental state can affect rationality when trading and lead to either success or failure. The most vital aspects of trading psychology are discipline and risk-taking, which can help them either follow the trading plan or steer away from it. Fear and greed are the most common emotions associated with trading psychology, along with regret and hope, among many others.

Greed drives traders to take too much risk as their overwhelming desire for wealth can cloud their rational judgment. This sort of emotion may lead to risky behavior such as taking high-risk trades, buying shares from developing companies, or simply trying to monetize on increasing prices without. Greed may also inspire investors to keep a position open for longer in an attempt to get profits out of the trade. Greed is the emotion that drives bull markets.

Fear, on the other hand, can cause traders to close positions too quickly or completely refrain from taking risks because they are concerned with losing large amounts of money. Just like greed, it can cause traders to act irrationally and hurry to leave the market. Fear often transcends into a panic, which may lead to panic selling, which is what causes substantial selloffs and drive bear markets.

Another common emotion experienced by traders is regret. It often occurs when traders moved a stock too fast because and ended up with a loss.

Stay tuned for part 3 of our Forex trading guide…