How to trade forex
Foreign exchange trading, or forex trading, is a popular investment choice in the UK. Read on to find out what you need to get started as a forex trader.
If you’ve ever thought about investing, you may have considered forex trading as an option.
Here, we run through the basics you need to know to get started as a forex trader.
What is forex trading?
Foreign exchange trading, or forex trading, is a type of investing that involves buying and selling currency.
The aim of forex trading is to correctly predict if the value of one currency will increase or decrease compared to the other.
For example, a trader might buy a currency today, thinking its value will go up tomorrow and plan to sell it for a profit then. This is known as going long.
Or, they may decide to sell a currency if they think its value will go down and buy it back later when it’s cheaper. This is known as going short.
Each currency has its own code to help you identify it more easily. For example, the code for pound sterling is ‘GBP’ and the code for US dollar is ‘USD’.
How to start trading forex
Before you can place your first trade you’ll need to find a forex broker to get access to the market.
A forex broker acts as the middleman between traders and the interbank, which is a global network of banks where you can buy and sell currency.
You can find a forex broker by searching online. There are lots of forex brokers to choose from so it helps to shop around and compare what they have to offer before signing up.
Many forex brokers offer free demo accounts that simulate real trading so you can try out their platform first without risking any money.
Once you’ve settled on a broker and are ready to start trading, you can open a forex trading account online.
It’s important to check if a broker is authorised by the Financial Conduct Authority (FCA) before investing.
The FCA has an online register with all of the authorised brokers you can check. If a broker isn’t listed, it could be a fraudulent firm trying to steal your money.
What are currency pairs?
In forex, currencies are traded in pairs - called currency pairs. That’s because when you buy one currency, you simultaneously sell another one.
Each currency pair is made up of two parts:
- Base currency: the first currency listed in the quote and always equal to 1
- Quote currency: the second currency listed in the quote
For example, let’s take a look at this currency pair:
GBP/USD = 1.38
Here, the base currency is GBP (pound sterling) and the quote currency is USD (US dollars). This means that £1 is worth US $1.38 if you wanted to change between the two currencies.
There are three main types of currency pairs:
- Major currency pairs: the most commonly traded currency pairs in the world.
- Minor currency pairs: don’t include the US Dollar (they’re sometimes called cross-currency pairs).
- Exotic currency pairs: includes the currency of a major economy and one from a developing economy.
What is the bid and ask price?
When you buy a currency pair, the price you pay for the currency you want is called the ‘ask’ price and when you sell, the price you receive is called the ‘bid’ price. This price for the same currency pair will be slightly different depending on whether you are buying or selling.
It may sound a bit confusing at first but it helps to remember that prices are always listed from the forex broker’s perspective rather than your own.
So, in a broker’s eyes, potential buyers have to place a bid when you sell a currency. And you’ll have to pay the seller's asking price when you buy a currency.
What is spread?
A spread is the difference between the buying price and selling price of a currency pair. It’s also known as the ‘buy-sell spread’ or ‘bid-ask spread’.
You can work out the spread of a currency pair by looking at a forex quote, which shows the bid and ask prices.
A high spread means that there’s a big difference between the bid and ask price. Whereas a low spread means that there is a small difference between the bid and ask price.
Forex brokers usually make money through spread rather than charging a commission or fee.
What are pips?
The spread is measured in something called pips, which stands for percentage in point. A pip is the smallest amount a currency price can change.
The price of most major currency pairs is shown with a maximum of four decimal places. So, a pip is usually equal to the fourth figure after the decimal point.
For example, in GBP/USD, one pip is 0.0001.
There is an exception to look out for though. If a currency pair contains Japanese yen (JYP) one pip is shown after two decimal places. So with the currency pair GBP/JPY, 0.01 is one pip.
How to read a forex quote
A forex quote shows you how much it costs to buy or sell a currency pair.
A forex quote is made up of:
- Base currency and quote currency
- Bid price and ask price
- Spread and pips
Forex quote example:
In this example the base currency is pound sterling (GBP), the quote currency is US dollars (USD).
The bid price is 1.3804 which means that you can sell £1 and get US $1.3804. The other way to think about it is if you wanted to sell your dollars, you would need $1.3804 for every £1 you wanted.
The ask price is 1.3806 which means that £1 will buy you US $1.3806.
The spread, which is the difference between the bid and ask price, is 2 pips (1.3806 - 1.3804).
Brokers usually charge you more to buy back the base currency enabling them to make a profit from the difference or spread. You’ll often see this when you exchange money to travel abroad.
Let’s say that you have a holiday booked in New York and need to exchange GBP for USD.
Using the example above, you will get US $1.3804 for each £1 you sell to the travel money office (who is the foreign exchange broker). And when it’s time to change your currency back, every US $1.3806 will buy you £1.
What are forex lots?
In forex, changes in currency value are so small that it’s not profitable to invest in one unit of a currency pair.
So currency pairs are traded in large batches called ‘lots,’ to increase the size of profits and losses generated by a trade.
There are four forex lot sizes:
- Standard lot: 100,000 units of the base currency
- Mini: 10,000 units of the base currency
- Micro: 1,000 units of the base currency
- Nano: 100 units of the base currency
Although large lot sizes could help you make a profit with forex trading, it also increases your risk of losing money if the currency goes down in value because you hold more of that currency.
What is leverage?
Leverage lets you borrow from a broker so that you can trade larger amounts of currency.
You have to put down a small initial deposit, called a margin, and the broker will top up the rest.
So if a broker offers leverage of 1:50 it means that you can trade currency 50 times the value of your margin. The amount of leverage offered varies between brokers.
Although using leverage can help increase your profit if the investment is successful, it’s important to remember that trading larger amounts of currency can also increase the risk of you losing money if the currency goes down in value.
Here’s an example: let’s say trader 1 and trader 2 both have £5,000 to invest in GBP/USD.
Trader 1 uses leverage of 1:20 to increase their investment to £100,000. They use their £5,000 as margin (or deposit) and their forex broker adds the additional £95,000 to their account.
Trader 2 decides not to use leverage.
If the value of GBP/USD increases 5%, trader 1 makes £5,000 profit from the investment whereas trader 2 makes £250.
But, if the value of GBP/USD decreases 5%, trader 1 loses £5,000 (which is all of their initial deposit) while trader 2 loses £250.
|Trader 1||Trader 2|
|GBP/USD increase 5%||+£5,000||+£250|
|GBP/USD decreases 5%||-£5,000||-£250|
It’s important to fully understand the risks involved and how much you could lose before using leverage, as it essentially leaves you with unlimited risk, there is no bottom limit to how much you could stand to lose unlike a traditional investment where the most you could lose is your initial capital.
How to manage your risk trading forex
Currencies constantly change in value and since the forex market runs 24-hours a day, it’s not always possible to keep an eye on how your trades are doing.
There are some automated tools that you can set up in your forex account to help you manage the risk of losing money if the market doesn’t go in your favour:
- Stop-loss orders: limit how much money a trader loses when a currency reaches a certain value. Once a stop-loss order is triggered your currency will be automatically sold at the next available market price.
- Limit orders: allow an investor to set the minimum or maximum price that they would like to buy or sell a particular currency pair. Limit-orders can save you having to monitor rates and automatically buy or sell a currency when it hits your desired price.
Is forex trading taxed in the UK?
You may have to pay tax to HM Revenue and Customs (HMRC) depending on the type of forex trader you are.
Speculative forex trading isn’t subject to capital gains tax (CGT) or income tax because it’s considered to be a form of betting or gambling.
That’s because speculative forex investments, such as spread betting, are purely based on guessing whether a currency will increase or decrease in value rather than a defined long term investment strategy.
Speculative traders usually have a main source of income and don’t rely on the gains from forex to live.
Self-employed or private investors usually use investing as their main source of income. If you trade for a living, either full time or part-time, you may need to pay income tax on your profits.
You will also likely have to pay capital gains tax on any profits because forex trading is seen as a form of derivative trading known as CFD or contracts for difference which is subject to CGT.
If you need to fill out a self-assessment tax return you should get advice from a qualified tax professional to make sure you report your trading profits correctly. The paragraph above should only be used as a guide and you should always consult with a professional whenever you are looking for tax advice in relation to trading, as the regulation is subject to change, and is very specific to your own unique financial situation.
Is forex trading worth it?
The forex market is international and offers 24-hour a day trading which increases opportunities for exchanging currency.
Traders can also access the market without having to put down a lot of money upfront, through leverage.
Forex can be complicated to get your head around at first and you need to invest time in understanding how different currencies could be affected by economic and political events.
In order to make a noticable profit from forex, you have to trade large quantities of currency. And even though leverage allows you to increase the volume of currency you trade, it also greatly increases the risk of you losing money to the point where you stand to lose much more than just your initial capital.
As with all types of investments, returns are not guaranteed and any past successes are not an indication of future ones.
So, it’s really important to do your research first and calculate whether you can afford to lose the money you trade in forex before getting started.
How to spot forex trading scams
From adverts on social media to setting up fake websites, fraudsters are using increasingly sophisticated scams to trick investors out of their money.
They often promise once unmissable investment opportunities where traders can make exceptional returns overnight.
The scammers often disappear after they’ve received payment, leaving investors with nothing.
Some telltale signs that can help you spot a forex trading scam before it’s too late include:
- Unsolicited offers: If you’re contacted out of the blue about a forex investment opportunity, it’s likely to be a scam. Never give away your personal information or transfer money to the firm if they do.
- Unrealistic returns: Forex scams often promise to make high returns from your initial investment that are too good to be true. Any company offering get-rich-quick investment opportunities is likely to be fraudulent.
- Social media adverts: A growing number of scammers are using social media to advertise fraudulent investment opportunities. They often use images and videos of luxury items to trick people into investing.
You can find more information on common forex trading scams and how to avoid getting caught out in our guide.
WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in.
Image source: Getty Images
Brean is a personal finance writer at NerdWallet. She covers a range of financial topics and has written for consumer titles including Which?, Moneywise and The Motley Fool. Read more