Nowhere is the old adage “you have to spend money to make money” more true — or at least more literal — than forex trading. Trading on the foreign exchange means converting your money into and out of foreign currencies in an effort to time the changes in exchange rates to turn a profit.
Forex is one of the more complex and arcane areas of the investing world, so it’s most likely not a good option for anyone who doesn’t really enjoy things like economics, monetary policy and mathematics. It’s typically only people with an ability to analyze and a penchant for numbers who can make money trading forex consistently.
Here’s a step-by-step look at how you can get started trading forex so you can get a better sense of what this type of investing entails.
How To Get Started
Before you can begin trading forex, you’ll need to take some preliminary steps, including understanding what you’re getting into and actually setting up an account. Here are the first things to consider.
1. Be Absolutely Sure This Is for You
Before you make the transition from asking “what is forex trading” to “how to trade forex,” you should be certain this is something you want to undertake.
You can always try forex trading on a small scale to see if you like it, but generally speaking, it is not for the faint of heart. One of the first things beginners learn about how to trade forex is that it’s very difficult and involved, combining complicated mathematical formulas with knowledge of the economic and political climates of the currencies you’re trading.
If you’re just looking for another way to invest your nest egg, the odds are good that forex trading is not for you. If you still want to learn forex trading, however, be prepared for a major commitment on your part.
2. Find the Best Broker for You
Before you can learn how to trade currency, you should find a broker that suits your needs.
There are many online brokerages such as TD Ameritrade or Interactive Brokers that offer forex trading along with stock and futures trading. There are also some standalone forex brokerages which typically have smaller deposit requirements than the online options.
One of the key factors when choosing a forex brokerage is to ensure it is in good standing with the regulating agency. In the U.S., this agency would be the Commodity Futures Trading Commission and also the National Futures Association.
For beginners, it can make sense to use the paper trading tools offered by many brokerages so that you can experiment with trading without risking any real money. Once you’re comfortable, you can open a forex trading account with many brokers with just a few hundred dollars.
You should also examine the tools available on each platform to see which interface or options you like best. Make sure you’re asking about the broker’s policies and rates on margin trading, as that can be an essential part of forex trading.
The Ins and Outs of Actually Trading Forex
Once you’ve decided you want to begin trading forex and you’ve physically set up an account, you’ll need to chart a path to trading success. These are the most important steps in the process.
1. Decide on a Currency To Trade
There’s no rule saying that you can’t try to trade a variety of different currencies, but an intimate familiarity with both the economic status of the country involved and the trading patterns of that particular legal tender are essential to success, meaning that focusing on just one currency is advisable. If you speak a second language or have a particular familiarity with a different culture or country, you can use that knowledge to help guide your decisions.
2. Develop a Strategy for How To Trade Forex
There are a number of forex trading strategies that can produce positive results, but most tend to fall into one of two categories: fundamental and technical analysis.
Fundamental analysis involves looking at political and economic factors that might affect the value of a certain currency. Technical analysis is rooted in using patterns in past price movements to anticipate future ones. Any successful strategy should incorporate both elements, but depending on the trader, one or the other might end up being a greater point of emphasis.
One other key concept to understand in developing a strategy is leverage. The movements in value for currencies tend to be incremental, meaning turning a large profit requires putting large sums of capital behind any given trade. Forex traders typically create additional weight for each trade by buying on margin. Buying on margin means borrowing money to make investments. If you’re going to borrow on margin, make sure you’re familiar with your broker’s margin rates and policies.
3. Understand Pairs Trading
One of the distinguishing features of forex trading is that it is conducted in pairs. In other words, rather than simply buying or selling an individual stock, with a forex trade, you’re simultaneously buying one currency while selling another. For example, if you expect the price of the Euro to rise against the U.S. dollar, you can enter into a Euro/USD trade, in which you will buy the Euro and sell the U.S. dollar. If you want to get out of this trade, you’ll have to sell the Euro and buy the U.S. dollar.
4. Choose Which of the Three Ways You Want To Trade Forex
There are three types of markets you can use to trade forex: the spot market, the futures market and the forward market. For retail traders, the spot market is by far the most often used. The spot market is somewhat akin to buying or selling stocks on an exchange, in that prices are determined and trades are executed in real-time based on current supply and demand conditions. However, these trades are conducted in the over-the-counter, rather than on an exchange.
The futures market is the second most popular option, but it’s still used primarily by professional rather than retail traders. Futures market transactions are conducted on an exchange, rather than the OTC market, but they consist of contracts to buy or sell currencies at a specified rate at some date in the future, rather than being executed immediately.
Trades on the forward market are similar to those in the futures market, but they are conducted privately between traders rather than on an exchange. This type of trade is primarily undertaken by professional or institutional forex traders.
5. Manage Your Risks Carefully
One of the key things to remember in forex trading is that you want to keep each individual trade relatively small in relation to your total bankroll. Even the best traders are going to be wrong much of the time, so if you’re going to trade forex for a living, you have to give yourself the room to make mistakes without wiping out your resources.
Using leverage can be risky, but it’s typically necessary because currencies generally don’t make large movements. Leverage amplifies these movements and therefore allows traders to make — or lose — more money. But although using borrowed money to speculate can mean bigger profits when you succeed, it also means bigger losses when you fail. A bad trade can result in owing money well beyond what you risk initially, resulting in a margin call. This will require you to put up more money than you have already invested, so be sure to keep your trading within the levels that you can afford.
Remember also that forex trading is generally the realm of professional traders. According to figures from DailyForex, only about 5.5% of forex traders are placed by retail investors, meaning a whopping 94.5% are placed by professionals. This can put retail investors at a significant disadvantage. Data from CompareForexBrokers, for example, suggests that 71% of retail forex traders lose money. While some traders do get rich trading forex, you should be aware of these statistics before you begin. While some traders in any investment can get rich, many more end up with modest gains or even losses.
John Csiszar contributed to the reporting for this article.
Information is accurate as of Sept 1, 2022.