Keep your head when trading forex

Currency or 'forex' trading is particularly popular with those who are new to trading. But beware, the risks are plentiful.

Foreign-exchange trading also known as forex, FX or currency trading is a particularly popular market among people who are new to online trading. That's not a good thing: studies and surveys suggest that most of them quickly end up losing their money.

This has given FX trading a reputation for being a relatively high-risk activity. But while currencies are not the best choice for a complete beginner, that verdict may not be entirely fair.

The foreign-exchange markets are not especially volatile in fact, big price swings are relatively rare. You can take on a lot more risk of unexpected price movements punting on small-cap stocks.

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Instead, the problem is that new traders dreaming of vast profits often pile on far too much leverage to compensate for the fact that individual moves are small. This makes it easy for them to lose everything through a few bad trades a problem made worse by the fact that they have little idea about risk management and aren't scrupulous about setting and sticking to stop losses.

Some providers promise leverage of up to 500:1 it can be difficult for novices to understand that just because this degree of gearing is available, it doesn't mean that any experienced trader would actually use it.

Those who are profitable over the long term are more likely to use overall leverage of around 10:1, depending on their strategy. And for traders who can avoid falling victim to temptation and pitfalls, FX can be attractive.

It offers a very large, liquid and continuous market: trading takes place 24 hours a day from Monday to Friday, although the best liquidity is concentrated in the times when Asian trading hours overlap with European ones and European hours with US ones.

Costs are relatively low the main cost of trading is the spread, which should be small when trading major currencies. And long-term trends are driven by economic fundamentals, which makes it a good market for macro-focused traders who want to base their decisions on issues such as inflation and interest rates.

How to trade forex

When you trade currencies, you take a view on how one will perform against another, rather than just buying one outright. For example, you might want to speculate on the pound (GBP) rising against the dollar because the Bank of England looks set to raise interest rates before the Federal Reserve.

Pairs are written in the form GBP/USD and the position is based on the currency on the left. So long GBP/USD is a bet that sterling will rise against the dollar.

Prices for major currencies are usually quoted to four decimal places, except for those involving the yen, which are quoted to two decimal places. The last digit in the quote is known as a pip or a tick so if GBP/USD is quoted at 1.5959 and moves to 1.6003, that's a four-pip move.

Traditionally, the pip was the small unit in which currencies were traded, but some providers now give quotes with an additional decimal place, known as a fractional pip. As with other forms of trading, currencies are quoted with a spread: for example, at the time of writing, GBP/USD was being quoted at 1.5959-1.5961, which is a spread of two pips.

The exact mechanics of a currency trade depends on what method you use. One option is to spread bet FX in terms of pounds per point, where one point equals one pip. So we might go long GBP/USD at £1 per point on the price quoted above (1.59613). If GBP rises to 1.65500, we'd make almost £590 on the trade.

Alternatively, we could trade a currency CFD (contract for difference), which is usually expressed in terms of a fixed value per contract, such as £100,000. This will work in a similar way to a spread bet.

Finally, the third way involves us notionally buying and selling a certain amount of currency. Trades are done in lots, with a standard lot being 100,000 units of the base currency so in our example, we would buy £100,000 and sell an equivalent amount ($159,613). When we wanted to close the trade, we would then buy back $159,613.

Which type of broker is best?

Different FX firms use different methods of carrying out your trades and it's useful to understand these, to identify the best one for your needs. The first is the dealing-desk model, used by spread-betting and CFD providers, among others.

These providers trade directly with you, taking the other side of your position. In other words, if you profit, they lose and vice versa. The provider may offset its exposure to clients by dealing in other markets.

With this kind of firm, it's important to understand that the price you get is what your provider offers you. Some providers will offer much better prices and tighter spreads than others.

Alternatively, your provider may act as a broker rather than your counterparty, requesting quotes from one or more banks and other brokerages (known as liquidity providers) and sending your order to the best one. This is called straight-through processing (STP).

Underlying spreads from the liquidity provider will usually be tighter, but the STP broker will either mark up the commission or charge an explicit brokerage fee, since it does not directly profit from your trade.

Lastly, an electronic communications network (ECN) aggregates quotes from a large pool of liquidity providers and other traders. You pay an explicit brokerage commission to a broker that lets you trade on the ECN, which may or may not be the same firm that manages the ECN. Quotes from an ECN will have the tightest spreads and the greatest transparency, but ECN brokers usually have large minimum account sizes.