What is Forex Trading

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Forex, also known as FX, is a combination of the words "foreign currency" and "exchange". It refers to the practice of converting one currency into another for various purposes, such as business transactions, trading, or travel. According to a report published by the Bank for International Settlements in 2019, the daily trading volume for forex reached an impressive $6.6 trillion. This makes forex one of the largest financial markets in the world.

Currency trading can be a challenging and intricate process. Due to the substantial volume of trades within the system, it is challenging for individual traders to manipulate currency prices. This transparency helps to maintain fairness and openness in the market, providing investors who have access to interbank dealing with a clear view of the market conditions.

Individual investors who wish to trade in the forex market should dedicate some time to educate themselves about the workings of the market. This includes researching and carefully selecting a forex broker that is regulated by authorities in the United States or the United Kingdom, as these jurisdictions have more stringent oversight. It is also essential to consider whether the broker is located in a country with more lenient rules and regulations. Additionally, it is wise to investigate the type of account protection that is provided by the broker in the event of a market crisis or if the broker becomes insolvent. These measures can help safeguard an investor's funds and minimize potential losses.

Continue reading to gain knowledge about the forex markets, its purposes, and the steps to begin trading.

What Is the Forex Market?

The foreign exchange market is the arena where currencies are traded. Currencies play a crucial role in facilitating the purchase of goods and services both domestically and across borders. In order to conduct foreign trade and business, it is necessary to exchange currencies of different countries.

For instance, if someone residing in the United States desires to purchase cheese from France, either the buyer or the seller must pay for the cheese in euros (EUR). This implies that the U.S. importer would have to exchange a corresponding value of U.S. dollars (USD) for euros to complete the transaction.

The same concept applies when it comes to traveling. If a French tourist visits Egypt, they cannot use euros to pay for a visit to the pyramids, as the local currency is not the euro. In this scenario, the tourist would have to exchange their euros for the local currency, which is the Egyptian pound, at the prevailing exchange rate.

A distinctive feature of the global foreign exchange market is the absence of a centralized marketplace. Instead, currency trading takes place electronically over the counter (OTC), which entails that transactions occur through computer networks connecting traders worldwide, rather than through a single centralized exchange.

The forex market operates continuously, 24 hours a day for five and a half days a week, and involves currency trading across major financial centers located in Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich, spanning almost every time zone. This implies that as the trading day comes to a close in the United States, the forex market commences anew in Hong Kong and Tokyo. As a result, the forex market can remain highly active throughout the day, with currency prices fluctuating constantly.

It is worth noting that the terms FX, forex, foreign exchange market, and currency market are interchangeable and all denote the same market, that is, the forex market.

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A Brief History of Forex

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In its simplest form, the forex market has existed for centuries, with people exchanging or trading goods and currencies to acquire goods and services. Nevertheless, the modern version of the forex market that we know today is a relatively new development.

Following the breakdown of the Bretton Woods accord in 1971, numerous currencies were allowed to float freely against one another. The values of individual currencies are subject to variation, which is determined by supply and demand and monitored by foreign exchange trading services.

The majority of forex market trading is conducted by commercial and investment banks on behalf of their clients. However, there are also speculative opportunities for individual and professional investors to trade one currency against another.

Currencies possess two distinct characteristics as an asset class:

1. Interest rate differential can be earned by holding two different currencies.
2. Profit can be made by taking advantage of fluctuations in exchange rates.

Investors can earn a profit by purchasing the currency with a higher interest rate and simultaneously selling the currency with a lower interest rate in two different economies. This approach is known as carry trade, and prior to the 2008 financial crisis, it was popular to sell the Japanese yen (JPY) and purchase British pounds (GBP) due to a significant interest rate differential.

Before the advent of the internet, currency trading was a challenging task for individual investors. Forex trading demanded substantial capital, thus limiting participation to large multinational corporations, hedge funds, and high-net-worth individuals (HNWIs). However, with the emergence of the internet, a retail market targeting individual traders has surfaced. This market offers convenient access to the foreign exchange markets through banks or brokers, who create a secondary market. Individual traders are often offered high leverage by online brokers or dealers, which allows them to control a large trade with a small account balance.

An Overview of Forex Markets

The FX market, also known as the foreign exchange market, is where currencies are bought and sold. It is the only market in the world that operates continuously and without any breaks. In the past, the forex market was primarily controlled by institutional firms and large banks, who traded on behalf of their clients. However, in recent years it has become more accessible to individual traders and investors of all sizes, leading to a more retail-oriented market.

One interesting feature of the global foreign exchange (forex) markets is that there are no physical buildings that serve as trading venues. Instead, the market operates through a network of connections established via trading terminals and computer networks. The market is comprised of a variety of participants, including institutional investors, investment banks, commercial banks, and retail investors.

The foreign exchange market is widely regarded as being less transparent than other financial markets. Currency trading takes place in over-the-counter (OTC) markets, where mandatory disclosures are not required. Institutional firms are a major source of liquidity in the market. While one might assume that a country's economic fundamentals would be the primary factor determining its currency's value, this is not necessarily the case. In fact, a 2019 survey discovered that the actions of large financial institutions were the most significant determinant of currency prices.

The foreign exchange (forex) market is primarily traded through three different channels: spot markets, forwards markets, and futures markets. Among these three, the spot market is the largest, as it serves as the underlying asset on which forwards and futures markets are based. When people discuss the forex market, they are typically referring to the spot market. On the other hand, the forwards and futures markets are more commonly used by businesses and financial institutions that require hedging for foreign exchange risks over a specific future date.

Spot Market

The spot market is the primary channel for forex trading and has consistently been the largest market as it trades the most significant underlying real asset for forwards and futures markets. In the past, trading volumes in the forwards and futures markets were higher than those in the spot market. However, the development of electronic trading and the growth of forex brokers have led to a surge in trading volumes for the forex spot market.

In the spot market, currencies are exchanged at their current trading price, which is determined by the forces of supply and demand. The price is influenced by several factors, including prevailing interest rates, economic conditions, local and global political situations, and future expectations regarding the performance of one currency compared to another. When a transaction is completed, it is referred to as a spot deal. It involves a bilateral agreement in which one party delivers an agreed-upon amount of currency to the counterparty and receives a specified amount of another currency at the predetermined exchange rate value. Once a position is closed, the settlement is made in cash. Although the spot market is often associated with transactions that occur in the present, the actual settlement of these trades takes two days to complete.

Forwards and Futures Markets

A forward contract is a private agreement between two parties to buy a currency at a future date and at a predetermined price in over-the-counter (OTC) markets. In contrast, a futures contract is a standardized agreement between two parties to take delivery of a currency at a future date and at a predetermined price. Futures trade on exchanges and not in the OTC markets.

In the forwards market, contracts are purchased and sold over-the-counter (OTC) between two parties who determine the terms of the agreement. In contrast, in the futures market, futures contracts are bought and sold based on a standardized size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange (CME).

In the United States, the National Futures Association (NFA) oversees the regulation of the futures market. Futures contracts have predetermined details, including the quantity of units being traded, the dates of delivery and settlement, and minimum price increments that cannot be altered. The exchange serves as a counterparty to the trader, providing clearance and settlement services.

Both types of contracts are legally enforceable and are usually settled in cash at the relevant exchange upon expiration, although they can also be bought and sold before the expiration date. The currency forwards and futures markets can provide protection against risk when trading currencies. Typically, large multinational corporations utilize these markets to hedge against future exchange rate fluctuations, but speculators also participate in these markets.

Besides forwards and futures, currency options contracts are also traded on certain currency pairs. Forex options provide the holder with the right, but not the obligation, to enter into a forex trade at a pre-set exchange rate and a future date before the option expires.

Unlike the spot market, the forwards, futures, and options markets do not trade actual currencies. Instead, they involve contracts that represent claims to a particular currency type, a specific price per unit, and a future date for settlement. This is why they are referred to as derivatives markets.

Uses of the Forex Markets

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Forex for Hedging

Businesses operating in foreign countries face the risk of currency value fluctuations when they buy or sell goods and services outside their domestic market. To manage this currency risk, they can use the foreign exchange markets to fix a rate at which the transaction will be completed, which is known as hedging.

To mitigate this risk, a trader can utilize the forward or swap markets by buying or selling currencies in advance, effectively locking in an exchange rate. For instance, consider a company that plans to sell blenders made in the United States in Europe when the exchange rate between the euro and the dollar (EUR/USD) is at parity, €1 to $1.

Assuming the company's manufacturing cost for the blender remains at $100, a €150 sale would now only generate $120 in revenue, meaning the company's profit per sale would now only be $20.

To mitigate this currency risk, the company could use a forward contract to lock in the exchange rate at which it will sell the blenders in Europe. For example, the company could enter into a forward contract to sell €150 at a rate of $1.20 per euro, which would guarantee a revenue of $180 per blender sale, regardless of changes in the exchange rate.

The company is now facing a problem because, even though it still costs $100 to manufacture the blender, it can only sell the product at the competitive price of €150. However, when the euros are translated back into dollars, the company receives only $120 (€150 × 0.80 = $120) because the U.S. dollar has appreciated in value against the euro. As a result, the company's profit is significantly lower than anticipated.

The blender company could have mitigated this risk by short selling the euro and buying the U.S. dollar when they were at parity. By doing so, if the U.S. dollar increased in value, then the profits from the trade would offset the reduced profit from the sale of blenders. Conversely, if the U.S. dollar decreased in value, then the more favorable exchange rate would increase the profit from the sale of blenders, offsetting the losses in the trade.

Currency futures markets offer a means of hedging such risks. Traders benefit from futures contracts that are standardized and cleared by a central authority. However, currency futures may be less liquid compared to the forwards markets, which are decentralized and exist within the interbank system throughout the world.

Forex for Speculation

Various factors such as interest rates, trade flows, tourism, economic strength, and geopolitical risk can affect the supply and demand of currencies, leading to daily fluctuations in the forex markets. These fluctuations offer an opportunity to profit from changes that may cause one currency to increase or decrease in value relative to another. As currencies are traded in pairs, a prediction that one currency will weaken is essentially the same as assuming that the other currency in the pair will strengthen.

For instance, suppose a trader anticipates that interest rates in the United States will increase compared to those in Australia, while the exchange rate between the two currencies (AUD/USD) is 0.71, which means it takes $0.71 USD to buy $1.00 AUD. The trader believes that higher U.S. interest rates will result in an increase in demand for USD, causing the AUD/USD exchange rate to fall since it will require fewer, stronger USDs to purchase one AUD.

Let's say the trader's prediction is correct and interest rates do rise, causing the AUD/USD exchange rate to fall to 0.50, meaning that $0.50 USD is needed to buy $1.00 AUD. If the trader had taken a short position on the AUD and a long position on the USD, they would have profited from this change in value.

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How to Start Trading Forex

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To begin your forex trading journey, you can follow these steps, which are similar to those involved in equity trading:

- Acquire knowledge about forex trading: Although not a complex process, trading forex requires specialized knowledge. For instance, the leverage ratio for forex trades is usually higher than for equities, and the factors influencing currency price movements differ from those that affect equity markets. There are numerous online courses aimed at beginners that cover the fundamentals of forex trading.

- Set up a brokerage account: To begin forex trading, you will need to create a forex trading account with a brokerage. Unlike equity trading, forex brokers do not charge commissions; instead, they earn money through spreads, also known as pips, between the buying and selling prices.

For those who are new to trading, it is advisable to open a micro forex trading account with low capital requirements. These accounts have flexible trading limits that enable brokers to restrict their trades to amounts as low as 1,000 units of a currency. For comparison, a standard account lot is equal to 100,000 currency units. Using a micro forex account can help you get more comfortable with forex trading and determine your trading approach.

- Develop a trading strategy: To increase your chances of success in forex trading, it is important to have a trading strategy. Although market movements cannot always be predicted or timed, having a strategy can provide you with broad guidelines and a roadmap for trading. It is crucial that your trading strategy is based on your individual situation and financial circumstances. This includes taking into account the amount of capital you are willing to risk, as well as the amount of risk you can tolerate without jeopardizing your position. Keep in mind that forex trading often involves high leverage, but can offer greater rewards to those who are willing to take on the risk.

- Always be on top of your numbers: It is important to stay on top of your trading numbers. After you begin trading, it is recommended to regularly check your positions at the end of the day. Most trading software automatically provides a daily accounting of your trades. It is crucial to ensure that you do not have any pending positions that need to be filled out and that you have adequate funds in your account to make future trades.

- Cultivate emotional equilibrium: Developing emotional stability is important when starting out in forex trading. Trading can lead to emotional highs and lows, and questions about missed opportunities or losses can create confusion. It is important to remain disciplined and not get too carried away by trading positions. Instead, focus on cultivating a balanced mindset and be prepared to close positions when necessary. This will help you navigate the ups and downs of the market without being overwhelmed by your emotions.

Forex Terminology

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To begin your journey in the forex market, it's important to first learn its terminology. To help you get started, here are a few key terms:

- Forex Account: A forex account is used to conduct currency trades. There are three types of forex accounts, depending on the lot size:

• Micro Forex Accounts: These accounts enable trading of up to $1,000 worth of currencies in one lot.
• Mini Forex Accounts: These accounts enable trading of up to $10,000 worth of currencies in one lot.
• Standard Forex Accounts: These accounts enable trading of up to $100,000 worth of currencies in one lot.

- Ask: An ask, also known as an offer, is the minimum price at which you're willing to purchase a currency. For instance, if you set an ask price of $1.3891 for the GBP, it means you won't buy a pound for a higher amount in USD. Usually, the ask price is higher than the bid price.

- Bid: A bid represents the price at which you're willing to sell a currency. A market maker who trades a particular currency is responsible for continuously issuing bids in response to buyers' requests. Although they tend to be lower than ask prices, in situations of high demand, bid prices can exceed ask prices.

- Bear Market: A bear market is characterized by declining currency prices. It represents a market downtrend and can be triggered by unfavorable economic conditions or catastrophic events, such as a financial crisis or a natural disaster.

- Bull Market: A bull market is marked by rising currency prices. It represents a market uptrend and is fueled by optimistic news about the global economy.

- Contract for Difference: A contract for difference (CFD) is a financial derivative that allows traders to speculate on currency price movements without owning the underlying asset. A trader who believes that the price of a currency pair will increase can buy CFDs for that pair, while those who anticipate a decline in price can sell CFDs for that currency pair. Using leverage in forex trading can result in significant losses if a CFD trade goes wrong.

- Leverage: Leverage refers to the use of borrowed funds to amplify investment returns. The forex market is known for its high leverage ratios, which traders often use to increase their positions.

For instance, a trader may invest just $1,000 of their own money and borrow $9,000 from their broker to speculate on a trade that bets against the EUR in relation to the JPY. Since the trader has used only a small portion of their own capital, they could potentially earn sizable profits if the trade moves in their favor. However, the flip side of a high-leverage environment is that it also enhances the downside risks, which could lead to substantial losses. In the example given, if the trade goes against the trader's expectations, their losses will be multiplied.

- Lot Size: Currencies in forex trading are typically traded in standard sizes called lots. There are four main lot sizes: standard, mini, micro, and nano. A standard lot comprises 100,000 units of the currency, while a mini lot consists of 10,000 units and a micro lot of 1,000 units. Some brokers also offer nano lots of 100 units to traders.

Selecting the appropriate lot size can significantly impact a trade's potential profits or losses. Larger lot sizes result in higher profits (or losses) per pip, while smaller lot sizes result in lower profits (or losses) per pip. Therefore, traders should carefully consider their risk tolerance, account size, and trading strategy when choosing a lot size.

- Margin: Margin is the funds that a trader sets aside in their account to cover potential losses in a currency trade. Margin serves as collateral and helps ensure that the trader can fulfill their financial obligations, even if the trade goes against them. The amount of margin required by a broker can vary based on the trader's account balance and their trading history over time.

Margin is often used in conjunction with leverage, as described earlier, in forex trading. The combination of margin and leverage enables traders to control large positions with a relatively small amount of capital, but it also increases the potential risk of substantial losses if the trade does not go as anticipated. Thus, traders should be cautious and have a clear understanding of the risks involved when using margin and leverage in their forex trades.

- Pip: A pip, short for "percentage in point" or "price interest point," is the smallest unit of measurement used in currency markets. It refers to the minimum price movement, usually up to four decimal places, that a currency pair can make. One pip is equivalent to 0.0001. The value of a pip can change depending on the lot size offered by a broker. For example, in a standard lot of $100,000, each pip will have a value of $10. Due to the use of leverage in forex trading, even small price movements, measured in pips, can have a significant impact on a trade's outcome.

- Spread: The spread is the difference between the bid (sell) price and the ask (buy) price of a currency pair. In forex trading, brokers do not charge commissions but instead make money through spreads. The size of the spread is affected by several factors, including the size of the trade, demand for the currency, and its volatility.

- Sniping and hunting: Sniping and hunting are strategies used by traders to make a profit by buying or selling currencies near predetermined points. However, brokers may also engage in these practices, which can be difficult to detect without observing patterns or networking with fellow traders.

Basic Forex Trading Strategies

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In the forex market, the two most basic forms of trades are a long trade and a short trade. A long trade involves a trader betting on the increase in currency price in the future to earn a profit, while a short trade involves a bet on the decrease in currency price in the future. Traders can also utilize various trading strategies based on technical analysis, such as breakout and moving average, to refine their trading approach.

Based on the trading duration and the number of trades, trading strategies can be further categorized into four types:

- A scalp trade is a type of forex trade where positions are held for only a few seconds or minutes, and the profit is limited in terms of the number of pips. The aim is to accumulate small profits from each trade, which can add up to a significant amount at the end of a trading day or period. Scalp trades rely on the predictability of price swings and cannot withstand high levels of volatility. As a result, traders tend to limit these trades to the most liquid currency pairs and during the busiest trading hours of the day.

- Day trades are trades that occur over a short period of time, typically within the same day. These trades involve opening and closing positions within hours or minutes. Day traders use technical analysis and technical indicators to maximize their profits. Similar to scalp trades, day trades rely on making incremental gains throughout the day.

- On the other hand, in swing trading, traders hold positions for a longer period of time, often for days or weeks. Swing trades can be beneficial during major government announcements or economic upheavals. Since swing trades have a longer time horizon, traders do not need to monitor the markets constantly throughout the day. In addition to technical analysis, swing traders must be able to assess economic and political developments and their impact on currency movements.

- A position trade is a type of trade where the trader holds the currency for an extended period of time, typically ranging from several months to even years. This strategy requires a greater emphasis on fundamental analysis, which provides a rationale for the trade.

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Charts Used in Forex Trading

Forex trading involves the use of three types of charts, which are:

Line Charts

Line charts provide an overview of the general trend for a currency. They are the most commonly used and basic type of chart in forex trading. Line charts display the closing price of the currency for the specified time period. Trend lines identified in a line chart can be used to develop trading strategies. For instance, traders can use trend lines to identify breakouts or changes in the trend for rising or declining prices.

However, line charts are generally used as a starting point for further trading analysis, as they provide limited information.

Bar Charts

Bar charts are used in forex trading to represent specific time periods and provide more detailed price information than line charts. Each bar in a bar chart represents a single day of trading and shows the opening, highest, lowest, and closing prices (OHLC) for that trade. The left dash represents the opening price, while the right dash represents the closing price. In some cases, colors are used to indicate price movements, with green or white indicating rising prices and red or black indicating falling prices.

Bar charts help traders to determine whether it is a buyer's or seller's market, as they provide a visual representation of market trends over time.

Candlestick Charts

Candlestick charts were originally used by Japanese rice traders in the 18th century and have become popular among forex traders due to their visual appeal and ease of interpretation. Unlike line and bar charts, candlestick charts use a candle-like structure to represent trading activity.

The upper portion of the candle represents the highest price point reached by the currency, while the lower portion represents the lowest price point. The opening price is indicated by the top of the body of the candle, while the closing price is indicated by the bottom of the body. A green or white candle represents an increase in prices, while a red or black candle represents a decrease.

Candlestick formations and shapes are used to identify market direction and movement, with common patterns including the hanging man and shooting star. These patterns provide valuable insights into market trends and can be used to inform trading decisions.

Pros and Cons of Trading Forex

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Pros

- The forex market is the largest in the world in terms of daily trading volume, which makes it highly liquid. This means that it is easy to enter or exit a position in any major currency quickly and with a small spread, even in most market conditions.

- Forex trading takes place 24 hours a day, five and a half days a week, with the market opening in Australia and closing in New York each day. This broad time horizon provides traders with many opportunities to profit or cover losses. The major forex market centers are located in Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo, and Zurich.

- Forex trading allows you to use leverage extensively, enabling you to start with a small amount of capital and potentially increase your profits. Forex markets are highly automated, which facilitates the quick execution of trading strategies.

- Compared to stocks, forex trading follows similar rules but requires less initial capital, making it easier to get started.

- The forex market is decentralized, unlike traditional stock or bond markets. There is no dominant centralized exchange for currency trade operations, which lowers the potential for manipulation through insider information about a company or stock.

Cons

- Forex trades, despite being highly liquid, exhibit greater volatility than regular markets.

- Excessive leveraging has caused many traders to become insolvent unexpectedly.

- Forex market participants such as banks, brokers, and dealers allow traders to utilize high amounts of leverage, which permits control over large positions with relatively little capital. Leverages as high as 100:1 are not uncommon. However, traders must comprehend the use of leverage and the accompanying risks.

- To trade currencies profitably, one must have a grasp of economic fundamentals and indicators. Understanding the economies of various countries and their interconnections is necessary for comprehending the basics that influence currency values.

- In contrast to other financial markets, forex markets are less regulated due to their decentralized nature. The degree and type of regulation in forex markets vary depending on the jurisdiction of the trade.

- Unlike other investments that provide regular income, such as dividend payments, forex markets do not offer such instruments, which may make them less attractive to investors seeking consistent returns. Instead, forex trading involves speculating on the fluctuation of currency values in order to generate profits.

FAQ

Why Do People Trade Currencies?

People engage in currency trading for two primary reasons: speculation and hedging. Traders speculate on the rise and fall of currency prices to make a profit, while companies use forex to lock in prices for their overseas manufacturing and sales.

Are Forex Markets Volatile?

Forex markets are highly liquid, making them less volatile than other markets like real estate. However, the volatility of a particular currency is influenced by various factors such as the political and economic climate of the country. Events like economic instability, payment defaults, or trading imbalances with another currency can lead to significant volatility in the forex market.

Are Forex Markets Regulated?

Forex market regulation varies by jurisdiction. In countries such as the United States with advanced infrastructure and established markets, forex trading is tightly regulated by organizations like the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC). However, due to the high level of leverage used in forex trading, developing countries like India and China have restrictions on the firms and capital that can be used. In Europe, the largest market for forex trading, the Financial Conduct Authority (FCA) is responsible for monitoring and regulating forex trading in the United Kingdom.

Which Currencies Can I Trade in?

Currencies that are highly liquid have a readily available market and their prices respond smoothly and predictably to external events. The US dollar is the world's most traded currency and is included in six out of the seven currency pairs with the most liquidity in the markets. Currencies that have low liquidity, however, cannot be traded in large lot sizes without significant market movement being associated with the price. These currencies usually belong to developing countries. When paired with the currency of a developed country, they form an exotic pair. For instance, a pairing of the US dollar with the Indian rupee (USD/INR) is considered an exotic pair.

How Do I Get Started With Forex Trading?

To get started with forex trading, the first thing you should do is familiarize yourself with the market's operations and terminology. After that, you need to develop a trading strategy based on your financial situation and risk tolerance. Finally, you should open a brokerage account. With the advancement of technology, it is now easier than ever to open and fund a forex account online and start trading currencies.

In conclusion

The forex market is a suitable place for day trading or swing trading with limited funds, compared to other markets. For traders with more substantial funds and longer-term horizons, fundamentals-based trading or a carry trade can be profitable. New forex traders can increase their profitability by gaining an understanding of the macroeconomic fundamentals that influence currency values and by using technical analysis.

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