What Is Forex Trading ? how it works | A Basic Guide To Forex Trading
Foreign exchange trading, also known as forex trading or FX,
is a global market for exchanging currencies. Forex is the world’s largest
market, and the trades that take place in it affect everything from the cost of
clothing imported from China to the cost of a margarita while on holiday in
Mexico..
What Exactly Is Forex Trading?
Forex trading is similar to currency exchange when travelling abroad in that a trader buys one currency and sells another, and the exchange rate fluctuates constantly based on supply and demand.
The foreign exchange market, a global marketplace open 24 hours a day, Monday through Friday, is where currencies are traded. All forex trading is done over the counter (OTC), which means there is no physical exchange (as there is for stocks), and the market is overseen by a global network of banks and other financial institutions (instead of a central exchange, like the New York Stock Exchange).
The vast majority of forex trade activity takes place between institutional traders, who work for banks, fund managers, and multinational corporations. These traders may not intend to take physical possession of the currencies; instead, they may be speculating or hedging against future exchange rate fluctuations.
A forex trader may buy US dollars (and sell euros) if she believes the dollar’s value will rise and she will be able to buy more euros in the future. Meanwhile, an American company with European operations could use the forex market as a hedge if the euro falls in value, lowering the value of their income earned there.
How Are Currencies Traded?
All currencies are given a three-letter code, similar to a stock ticker symbol. While there are more than 170 currencies in the world, the US dollar is involved in the vast majority of forex trading, so knowing its code is especially useful: USD. The euro, which is accepted in 19 European Union countries, is the second most popular currency in the forex market (code: EUR).
Other popular currencies include the Japanese yen (JPY), British pound (GBP), Australian dollar (AUD), Canadian dollar (CAD), Swiss franc (CHF), and New Zealand dollar (NZD).
All forex trading is expressed in terms of the two currencies being exchanged. The following seven currency pairs, known as the majors, account for roughly 75% of forex trading:
EUR/USD
USD/JPY
GBP/USD
AUD/USD
USD/CAD
USD/CHF
NZD/USD
How Are Forex Trades Quoted?
Each currency pair represents the two currencies’ current exchange rate. Here’s how to interpret that data, using the EUR/USD (or euro-to-dollar exchange rate) as an example:
The base currency is the currency on the left (the euro).
The quote currency is the currency on the right (the US dollar).
The exchange rate shows how much of the quote currency is required to purchase one unit of the base currency. As a result, the base currency is always expressed as one unit, whereas the quote currency varies depending on the current market and how much is required to purchase one unit of the base currency.
If the EUR/USD exchange rate is 1.2, €1 will buy $1.20 (or, to put it another way, €1 will buy €1.20).
When the exchange rate rises, it means the base currency’s value has increased relative to the quote currency (because €1 now buys more US dollars), and when the exchange rate falls, it means the base currency’s value has decreased.
Just a quick note: Currency pairs are typically presented with the base currency first and the quote currency second, though some currency pairs have a historical convention for how they are expressed. Conversions from USD to EUR, for example, are listed as EUR/USD rather than USD/EUR.
Three Forex Trading Strategies
Most forex trades aren’t made to exchange currencies (as you might at a currency exchange while travelling), but rather to speculate on future price movements, similar to stock trading. Forex traders, like stock traders, try to buy currencies whose values they believe will rise relative to other currencies and sell currencies whose purchasing power they believe will fall.
There are three ways to trade forex that will suit traders with varying objectives.
The current market. This is the primary forex market, where currency pairs are exchanged and exchange rates are determined in real time based on supply and demand.
The futures market. Rather than executing a trade right away, forex traders can enter into a binding (private) contract with another trader to lock in an exchange rate for an agreed-upon amount of currency on a future date.
Futures trading. Similarly, traders can choose a standard contract to buy or sell a predetermined amount of a currency at a specific exchange rate at a future date. Unlike the forwards market, this is done on an exchange rather than privately
Forex traders who want to speculate or hedge against future price changes in a currency use the forward and futures markets. These markets’ exchange rates are determined by what happens in the spot market, which is the largest of the forex markets and where the majority of forex trades are executed.
Forex Terms to Know
Each market has its own language. These are words to know before engaging in forex trading:
The currency pair. A currency pair is involved in all forex trades. There are less common trades in addition to the majors (like exotics, which are currencies of developing countries).
Pip. A pip, which stands for percentage in points, is the smallest possible price change within a currency pair. A pip is equal to 0.0001 because forex prices are quoted to at least four decimal places.
The bid-ask spread. Exchange rates, like other assets (such as stocks), are determined by the maximum amount that buyers are willing to pay for a currency (the bid) and the minimum amount that sellers must sell for (the ask). The bid-ask spread is the difference between these two amounts and the price at which trades will ultimately be executed.
Lot. A lot, or standardised unit of currency, is used in forex trading. The standard lot size is 100,000 units of currency, but micro (1,000) and mini (10,000) lots are also available for trading.
Leverage. Because of the large lot sizes, some traders may be unwilling to put up such a large sum of money to execute a trade. Leverage, which is another term for borrowing money, allows traders to participate in the forex market without having to invest large sums of money.
Margin. However, trading with leverage is not free. Traders must put money down as a deposit, which is known as margin.
What Influences the Forex Market
Currency prices, like any other market, are determined by the supply and demand of sellers and buyers. However, other macro forces are at work in this market. Interest rates, central bank policy, the rate of economic growth, and the political environment in the country in question can all influence demand for specific currencies.
The forex market is open 24 hours a day, five days a week, allowing traders to react to news that may not affect the stock market until much later. Because so much of currency trading is based on speculation or hedging, traders must be aware of the dynamics that could cause sharp currency spikes.
Forex Trading Risks
Because forex trading requires leverage and traders use margin, there are additional risks to forex trading than other types of assets. Currency prices are constantly fluctuating, but only in very small amounts, so traders must execute large trades (using leverage) to profit.
If a trader makes a winning bet, this leverage can greatly increase profits. It can, however, magnify losses to the point where they exceed the initial amount borrowed. Furthermore, if the value of a currency falls significantly, leverage users expose themselves to margin calls, which may force them to sell securities purchased with borrowed funds at a loss. Aside from potential losses, transaction costs can add up and potentially eat into a profitable trade.
Furthermore, keep in mind that currency traders are small fish in a pond of skilled, professional traders—and the Securities and Exchange Commission warns about potential fraud or information that may be confusing to new traders.
Perhaps it’s for the best that forex trading isn’t as popular among individual investors. According to DailyForex data, retail trading (a.k.a. trading by non-professionals) accounts for only 5.5% of the total global market, and some of the major online brokers don’t even offer forex trading.
Furthermore, of the few retail traders who engage in forex trading, the majority struggle to make a profit. According to CompareForexBrokers, 71% of retail FX traders lost money on average. As a result, forex trading is often best left to professionals.
