Forex Fundamentals Explained: Must-Know Basics for New Traders

Foreign exchange, or forex, may seem complex and intimidating to new traders. However, understanding the fundamentals of how the forex market works is critical for anyone looking to get started in currency trading. This comprehensive beginner’s guide breaks down everything you need to know about forex fundamentals in simple terms.

What is Forex and How Does it Work?

The foreign exchange market is where currencies are traded 24 hours a day, 5 days a week. It is the largest, most liquid financial market in the world. The forex market determines the exchange rates for currency pairs like the EUR/USD and GBP/JPY.

Currencies are traded in pairs, with each currency having a 3 letter code. The first currency listed (EUR in EUR/USD) is called the base currency. The second (USD) is the quote or counter currency. The exchange rate shows how much one unit of the quote currency costs in the base currency. For example, if EUR/USD is 1.1250, one euro costs 1.1250 US dollars.

The forex market has no central marketplace like a stock exchange. Trading is conducted over-the-counter (OTC) between participants electronically via brokers. The forex market is decentralized and global, with major financial centers like London, New York and Tokyo operating 24 hours daily (except weekends).

Currencies are traded for a variety of reasons including commerce, tourism, speculation and converted by banks, businesses, governments, and investors. The sheer volume of currency conversion that occurs makes foreign exchange one of the most liquid markets worldwide.

What Moves Forex Prices?

Foreign exchange rates fluctuate based on macroeconomic factors that impact the perceived values of currencies:

• Interest rates – Central bank interest rate decisions influence forex. Higher rates make a currency more attractive.
• Economic performance – Strength of key indicators like GDP, employment affect a country’s currency valuation.
• Political climate – Elections, instability and reforms impact currency and investor confidence.
• Inflation – Rising consumer prices and Purchasing Power Parity affect forex prices.
• Trade flows – Export/import balances reflect competitiveness and demand for a nation’s currency.
• Sentiment – Investor optimism/pessimism about the economy influences currency rates.
• Credit ratings – Ratings assigned by agencies like Standard & Poor’s influence perception of an economy.
• Monetary policy – Central bank actions like quantitative easing impact the supply and demand for currencies.

Understanding how these factors influence currency valuations is key to fundamental analysis in forex trading.

What are the Major Currency Pairs?

There are many currencies and currency pairings traded in the forex market. However, a majority of trading volume is concentrated in a handful of major pairs:

| Currency Pair | Base Currency | Quote Currency |
|-|-|-|
| EUR/USD | Euro | U.S. Dollar |
| USD/JPY | U.S. Dollar | Japanese Yen |
| GBP/USD | British Pound | U.S. Dollar |
| USD/CHF | U.S. Dollar | Swiss Franc |
| USD/CAD | U.S. Dollar | Canadian Dollar |
| AUD/USD | Australian Dollar | U.S. Dollar |
| NZD/USD | New Zealand Dollar | U.S. Dollar |

These liquid, stable currency pairs offer new forex traders the best opportunity to learn trading strategies without taking excessive risk. Additionally, analysis and news coverage tends to be widely available for major pairs.

What are Forex Quotes and Pips?

Forex quotes show the bid and ask prices for a currency pair. For example, a EUR/USD quote might be 1.1250 / 1.1253. The bid price is what you can sell the base currency for. The ask is what you pay to buy the base. The difference between the two is called the spread, which is pocketed by the broker.

Pips refer to the smallest increment of price movement for a currency quote. For most pairs, one pip is 0.0001. If EUR/USD moves from 1.1250 to 1.1251, it has moved up 1 pip. Pip values do vary for certain exotic pairs. Monitoring pips lets you precisely track profits and losses.

What are Forex Lots and Contract Sizes?

Forex contract sizes are quantified in lots. The standard unit is the standard lot or 100,000 units of a currency. A micro lot equals 1,000 units. Mini lots cover 10,000 units. Different brokers may use varying definitions for micro, mini and standard lots.

Trading in high volumes means larger position sizes, pip values and profits or losses. New traders often start with micro/mini lots then gradually increase. Using excessive leverage and position size is risky. Consider your account size, risk tolerance and trading style when determining appropriate contract sizes.

How is Leverage Used in Forex?

Leverage allows forex traders to open much larger positions than their account balance would normally permit. With 50:1 leverage, just a 2% margin deposit is required for a full-sized 100,000 unit position. This enhances profit potential but also increases risk if the trade moves against you.

Choose a broker that offers flexible leverage up to standards set in your country. Utilize leverage wisely based on your style and risk tolerance. Monitor margin requirements carefully, as you may need to deposit additional funds if the account equity falls below the broker’s maintenance margin levels due to losses.

What are Bid-Ask Spreads in Forex Trading?

The bid-ask spread is the difference between the buy (ask) and sell (bid) prices quoted for a forex pair. This spread is effectively trading costs that are incurred on each trade. Wider spreads indicate higher trading costs. Bid-ask spreads tend to be wider for exotic currency pairs and during volatile market periods.

Actively traded major pairs like EUR/USD normally have tight spreads of 1-3 pips. Check typical spreads on a broker’s website or demo account. Overall lower spreads can significantly impact long-term trading profitability.

What are Long and Short Trades?

Long trades aim to profit from rising currency prices, while short trades aim to profit from falling prices. If you expect the EUR to strengthen vs the USD, you would go long EUR/USD. If the USD is expected to rise, you would place a short EUR/USD trade.

Long trades involve buying the base currency and selling the quote. Short trades involve selling the base and buying the quote. You close longs by selling and close shorts by buying. Whether the market moves up or down, there are always trading opportunities via long or short positions.

What are Forex Quotes and Spreads?

There are two main types of orders used in forex trading:

Market Orders – These execute immediately at the best available market price. Slippage may occur if prices move before the order fills.

Pending Orders – These orders allow more control and save re-quotes. Types include:

• Buy/Sell Limit – Executes at specified price or better if price moves favorably.
• Buy/Sell Stop – Triggers if price trades unfavorably to a specified level.

Stop loss and take profit orders are commonly used to exit trades at predefined levels. Using pending orders helps control order entry prices.

What are Forex Swaps and Rollovers?

Swaps and rollovers manage the interest rate differential between the two currencies when a position is held overnight. Traders are paid or debited swap/rollover points based on the interest rate spread.

If you are long a currency with an interest rate higher than the quote currency, you earn rollover points daily. Being short a higher yield currency costs rollover points. Swaps are factored into ongoing trade pricing.

What are Forex Trading Sessions and Market Hours?

The forex market trades 24 hours daily thanks to global time zones:

Sydney opens at 5pm EST and closes at 2am EST
Tokyo opens at 7pm EST and closes at 4am EST
London opens at 3am EST and closes at 12pm EST
New York opens at 8am EST and closes at 5pm EST

Peak liquidity occurs when sessions overlap. Volatility often follows news reports and data releases. Adjust your trading hours based on your strategies and lifestyle.

What is Technical Analysis in Forex?

Technical analysis studies short-term price charts to forecast future movements based on historical patterns. Charts display price trends over different timeframes using:

• Candlestick – Of Japanese origin, shows open, high, low, close for period.
• Line – Connects closing prices over time. Good for spotting direction.
• Bar – Similar to candlestick with vertical lines instead.

Common technical indicators include:

• Moving averages – Lagging indicator showing average price over periods.
• MACD – Moving Average Convergence Divergence indicator shows momentum.
• RSI – Relative Strength Index measures overbought/oversold levels.
• Bollinger Bands – Price envelope indicator shows volatility.

What is Fundamental Analysis in Forex?

Fundamental analysis examines macroeconomic and geopolitical factors driving currency valuations long-term. This includes:

• Economic strength – GDP, manufacturing, employment, housing data
• Monetary policy – Central bank rates, quantitative easing
• Fiscal policy – Taxation, government spending
• Political climate – Elections, new administrations and policies
• Credit ratings – Sovereign ratings by S&P, Moody’s, Fitch
• Trade flows – Export-import balances

Fundamental traders rely more on news events, data releases, and financial headlines to guide their trading decisions.

Which Trading Style Suits You?

There are advantages and drawbacks to different trading styles:

Technical Trading

Pros: Identify trading opportunities rapidly. Take short-term positions for fast profits. Automated trading systems.

Cons: Requires constant chart/indicator analysis. Prone to generating false signals. Limited longevity of technical patterns.

Fundamental Trading

Pros: Analyze underlying macroeconomic forces driving forex. Make strategic predictions based on data.

Cons: Slower reaction to changing conditions. Delayed response to news events and headlines.

Scalping

Pros: Open and close positions within minutes for small but consistent profits.

Cons: Requires intense focus. High transaction costs due to frequent trading. Increased stress.

Swing Trading

Pros: Hold positions for days to weeks. Less time intensive than scalping. Avoid noise in minor moves.

Cons: Larger drawdowns and risk per trade. Potential to miss major trend reversals.

Choose the style that best fits your personality, interests and schedule. Develop your skills through practice trading with a demo account. Stick with strategies that play to your strengths for long-term success.

How Much to Invest in Forex

Only risk capital that exceeds your basic living expenses and emergency savings. As a general rule, limit your forex investment to 1-5% of overall capital. This provides exposure while protecting your finances should trading losses occur.

Start small when learning to trade forex. Open a micro account or invest just several hundred dollars initially. Add funds slowly as your account grows and you gain experience. Patience and discipline will serve you better than rushing to invest large sums. Wait until consistent profits demonstrate you are ready for greater capital investment.

Developing a Trading Plan

Creating a trading plan is essential for guiding your forex trading strategy. Your plan should cover:

• Risk management – Acceptable loss per trade/day/week, exit levels
• Account management – Trading amounts based on account size
• Currency pairs – Which pairs you will trade and when
• Analysis – Fundamental, technical or both
• Trading schedule – Identifying best times based on lifestyle and sessions
• Trading journal – Recording activity, statistics, performance
• Improvement – Reviewing what works, making adjustments

Stick to your plan consistently. Review and update it as you gain experience. Trading discipline and following a plan is key to long-term forex success.

In Summary

Mastering forex fundamentals takes time, but doing so before you start trading real money is absolutely essential. Understanding currencies, analysis methods, orders, leverage and more will give you confidence to implement winning forex strategies.

Start putting your knowledge into practice today. Open a risk-free practice account to gain experience analyzing charts, identifying trades and refining strategies. The more time spent in preparation, the better chance you have of avoiding costly missteps when you transition to live trading.